This Is Not Your Father's 401K: The Retirement Product You Should Know About

Chances are you’re like most Americans and, regardless of your age, you aren’t saving enough for retirement, if you’re actually saving anything at all.

Nearly 40 million U.S. households (45%) have no retirement assets, according to a recent report by the National Institute on Retirement Security, and half of those households are headed by someone aged between 45 and 65. In fact, savings rates are so bad that many Americans are dying with an average of $62,000 of debt.

Even if you are saving enough for retirement, you might still wonder if that money will last your entire lifetime. Defined contribution plans like 401Ks are great at helping employees save for retirement, but they provide no guarantee of income as pensions do. On top of that, most 401Ks are self-directed, meaning those who do a poor job handling their investments could end up with significantly less money than they need in retirement.

But what if you could guarantee yourself income for life, just like ubiquitous company pension plans used to provide (and government pension plans still do)?

Well, you can. Here’s how.

Back in 2014, the Treasury Department started an initiative focused on “putting the pension back” into 401K retirement savings. (Need to brush up on retirement lingo? Here’s a handy guide.) Through loosened restrictions and some tax-law changes, the Treasury made it easier to convert funds from retirement savings into plans known as longevity income annuities, or LIAs, that provide guaranteed lifetime income.

Income for Life

LIAs are deferred annuities and, while they’ve been around for a while, they’ve only recently become a part of mainstream retirement planning. The Treasury initiative could even cause them to become an integral part of 401K target funds. Here’s how they work: Say you have $100,000 in retirement savings. At age 65, you use $10,000 of that money to purchase an LIA. “Even in the current low-interest-rate environment, a deferred single-life annuity purchased at age 65 for a male costing $10,000 can generate an annual benefit flow from age 85 onward of $4,830 ($3,866 for a female) per year for life,” a recent National Bureau of Economic Research working paper concluded.

It’s easy to see how helpful this kind of guaranteed income could be, particularly given larger investment amounts. Of course, it’s a hedge that you’ll live long enough to take advantage of those funds, but some programs provide for reimbursement should you die before accessing all of your money. More on that in a minute.

According to Olivia S. Mitchell, a professor at the Wharton School of the University of Pennsylvania and a co-author of the working paper mentioned above, LIAs are available to investors but are not yet tied to defined-contribution plans.

“There has been discussion about including them in the target-date suite of funds, and some employers are actively looking for options,” she said in an email. “Relatively few insurers have them available as yet.”

“One reason annuities or lifetime income streams are not a standard feature of 401K plans is that many people don’t understand these products,” she wrote in an article for Forbes. “For instance, some older individuals tend to underestimate their chances of living a long time, so they don’t take proper precautions against outliving their assets. Others don’t understand financial concepts, and so they’re reluctant to take unfamiliar financial decisions. After all, retirement is usually a once-in-a-lifetime event!”

Just because they aren’t directly tied to defined-contribution plans just yet doesn’t mean LIAs aren’t easily accessed. AARP, for example, has been offering its Lifetime Income Program through New York Life since 2006. AARP’s plan has a cash refund feature so, as we mentioned earlier, if you die before your payments equal your annuity purchase price, your beneficiary will be paid the difference.

Is an LIA Right for Me?

As with most financial tools, some people will benefit from an LIA more than others. “People in poor health might not want to elect deferred annuities, particularly if they have a poor survival prognosis,” Mitchell said. “Some very wealthy people will not need the LIA as they can self-insure against outliving their assets. Retirees with a (well-funded) defined benefit pension probably don’t need additional annuitization. And people with a very small nest egg might not find it worthwhile to annuitize, say, $10,000. But much of the middle class could benefit.”

In considering LIA plans, Mitchell recommends asking how highly rated the insurer is who provides it. She also suggests knowing how well the state insurance guarantee fund is being run and the maximum amount you’d recover should the insurer go bankrupt. (As you’re planning your retirement, you should also make sure you have a full picture of your finances, including your credit. You can get a free snapshot of your credit report on Credit.com.)

So how much should you consider putting into an LIA? “Older individuals would optimally commit 8% to 15% of their plan balances at age 65 to a LIA, which begins payouts at age 85,” Mitchell, et al, wrote in their working paper.

As for timing, it doesn’t really make sense for someone who isn’t at or near retirement age to purchase an LIA. For one thing, you can’t access your retirement funds without penalty until age 60.

“It makes sense to decide how much to devote to the LIA in your mid-60s, since that gives 20 years over which the annuity value can build up,” so you can begin taking payments at age 85, Mitchell said.

Of course, there are a variety of annuity products to suit different personal needs, such as earlier payout options, so it’s a good idea to speak with a financial professional who can help you decide what product might be best for your financial situation.

Image: wundervisuals