Retirement account owners have long had trouble translating the money in their 401(k) into income.
That’s about to change.
Later this year, possibly in the third quarter, plan sponsors will be required to include two lifetime income illustrations on participants’ pension benefit statement at least once annually. In essence, the illustrations show how much income a participant’s account balance would produce in today’s dollars if used to purchase either a single life annuity or a qualified joint and 100% survivor annuity.
And some are praising the new rule, despite the shortcomings to the Labor Department’s interim final rule, which was required as part of The Setting Every Community up for Retirement Enhancement (SECURE) Act.
The final rule, when it goes into effect, should help those saving for retirement not only better understand how much income they will receive from their 401(k), but it will also give folks a fairly good idea if all their sources of income in retirement — Social Security and defined-benefit plans, for instance — will be enough to meet their expected expenses in retirement.
On paper, it all sounds great.
The defined contribution industry, in general, is in favor of the idea of lifetime income illustrations, said Drew Carrington, a senior vice president and head of institutional defined contribution at Franklin Templeton Investments.
“It helps frame the savings and 401(k) plans in sort of the appropriate terms,” he said. “This (the 401(k)) is here to provide income when you’re in retirement. And this is a way to start communicating about your 401(k) balance in those terms, as opposed to more wealth-oriented terms. So, we think that’s all really good. Anything that helps start the process of getting people to think about their retirement accounts as retirement accounts is a positive step.”
Others have a similar point of view. It helps “workers focus on the future and amount of income they may have for retirement, rather than on their account balance today or projected for the future,” said Stacy Schaus, the CEO and founder of the Schaus Group. “The right steps are being taken to improve retirement security.”
Social Security, by way of background, provides would-be beneficiaries an estimate of monthly income at various claiming ages in today’s dollars. The same goes for defined-benefit plans. Participants generally have a sense of how much monthly income they can expect to receive, in the form of an annuity, from their pension plan.
IRA and 401(k) account owners have always had the ability to translate how much income they could expect to receive from their 401(k), it just required them to do some math, and you wouldn’t want to plan the rest of your life based on those calculations.
Multiplying the account balance in your 401(k) and/or IRA by 4% was and is the simplest way to do that. So, for instance, if you had $1 million in your retirement account you could expect that to generate $40,000 a year in today’s dollars.
This, of course, is a very simplistic example. It doesn’t really take into account contributions, investment returns, date of retirement, inflation rates, and so on. But it is a rough-cut way to determine how much income your retirement accounts would generate.
And now the Labor Department wants to make that calculation even easier, though it plans to use different math. As the rule is currently proposed, plan administrators would show participants how much income they could expect from their ERISA-governed retirement account first, as a single life annuity; and second, as a qualified joint and survivor annuity that factors in a survivor benefit.
These monthly income illustrations would use prescribed assumptions such as the participant’s marital status and assumed age at the start of the annuity, the Labor Department noted in its fact sheet.
|Current account balance||$125,000|
|Single life annuity||$645 a month for life, assuming Participant X is age 67 on Dec. 31, 2022|
Qualified joint and 100% annuity
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|$533 a month for participant’s life, and $533 for the life of spouse following participant’s death, assuming Participant X and her hypothetical spouse are age 67 on Dec. 31, 2022.|
According to the Labor Department, the interim final rule “requires various explanations about the estimated lifetime income payments that plan administrators must provide to participants. These explanations will help participants understand, among other things, how the plan administrator calculated the estimated monthly payments and, importantly, that these estimates are illustrative only and are not guarantees.”
What’s more, the Labor Department cites two benefits to its lifetime income illustration rule: One, it will encourage those currently contributing too little to increase their plan contributions, and two, it should help participants learn how prepared or unprepared they are for retirement.
But while it’s a good start, it’s not perfect. There are limitations that plan participants need to consider. What’s more, the lifetime income illustrations might even be inferior to some of the existing tools that plan sponsors are already providing plan participants.
So, what are some of the limitations?
Well, the interim rule doesn’t include future contributions, future earnings, or the account’s performance growth. In other words, it’s not necessarily a realistic projection. It’s a static number.
In fact, plan administrators must assume that a participant is age 67 on the assumed commencement, which is the Social Security full retirement age for most workers, or the participant’s actual age, if older than 67, and they are retiring with their current balance. “There’s not a lot of flexibility around the standardized illustration,” said Carrington.
And that could be problematic, especially for those still saving for retirement. By making no assumptions about future savings or the future value of an account it might in fact discourage plan participants from saving more if they view the amount of income their current balance produces as incredibly low, according to Carrington.
It also means that when you switch employers the illustrations you get will reflect only the savings in your new employer’s 401(k).
The proposed rule also assumes that a plan participant would immediately start drawing down their 401(k) balance at age 67 using an annuity. Again, this doesn’t quite reflect reality. Some people retire at 67, some before and some after. Some start drawing down their retirement accounts when they retire while others don’t. And most plan participants hardly ever purchase an annuity to generate income retirement.
What’s more, a retiree hardly ever has 100% of their assets in any one investment. So, using a lifetime income illustration tool that uses only an annuity doesn’t reflect reality either. “The likely optimal answer for most folks is some sort of partial allocation to annuities, not a 100% allocation nor a 0% allocation,” said Carrington.
The methodology for the calculation may be concerning as it may overstate or understate what future income the individual may have and also may not appropriately account for inflation, Schnaus said.
And those limitations have plan sponsors working overtime to make sure the sophisticated interactive lifetime income tools they already provide (or plan to provide) to plan participants are viewed as educational in nature and not viewed as fiduciary advice.
Those tools, among other things, let a plan participant play what-ifs with savings rates, retirement dates, investment returns, and the like. Some even let plan participants incorporate accounts outside of their 401(k) — IRAs, Roths, taxable accounts, a spouse’s retirement accounts — into the plan sponsor’s retirement income illustration tool, said Carrington.
“People get a much richer picture,” he said.
A richer — no pun intended — is certainly what those saving for retirement deserve.
But that picture may have to wait for the next version of the SECURE Act, which experts like Jack Towarnicky, a researcher with the American Retirement Association and author of Discordant Disclosures, say could allow for other “disclosure options,” and improve upon what is a good, but really only a good enough start.