Why don’t pensioners like pensions?

Could a 401(k)s defined contribution plan introduced in 1918 provide insight into one of the most vexing personal finance issues?

The quick answer is yes. The retirement savings plan is TIAA, which attracts participants from colleges, universities, and other non-profit organizations.

The tough question of personal finance is how employees with 401(k) accounts can turn their accumulated savings into income they can count on in retirement.

The basic conundrum: spend too much, too fast, early, and retirees may have to drastically cut their standard of living later in life. Retirees who are overly cautious with their savings could die flush and regretful for not having had the experience. The complexity is compounded by the uncertainty about life expectancy. Do retirees have to depend on their old-age provision for five years or 25 years?

As if that wasn’t harsh enough, the roughly four-decade-old 401(k) wasn’t designed for the distribution phase of retirement. “I would say the 401(k) is not a retirement plan,” says David Richardson, research director at the TIAA Institute, the company’s think tank. “They are for people who want to save for retirement. Didn’t give much thought to how people take their distributions.”

Read: How to protect yourself from running out of money in retirement

In other words, near-retirees in 401(k)s are largely left to their own devices to figure out what to do. An extensive body of literature has developed to help them decide how much they can safely withdraw from their savings. The most well-known guideline is the 4% rule: Withdraw 4% in the first year, then a further 4% each year plus adjustment for inflation.

Read: Is a bucket strategy superior to the 4% rule?

Many economists would prefer 401(k) participants to convert their savings into lifetime annuities. The basic idea is that in exchange for investing in an annuity with an insurance company, the retiree secures a lifetime income. A small group of companies with 401(k) plans offered their participants the opportunity to annul their savings. The 2019 Pensions Act – known as the Secure Act – made several changes to encourage more employers to offer a pension option. A similar intent underlies the current bipartisan bill called the Secure Act 2.0, which passed the House of Representatives and is now before the Senate.

In many ways, TIAA is similar to a 401(k), the premier employer-sponsored retirement plan for private sector employees. But unlike the typical 401(k), TIAA offers several different payout options.

In “Trends in Retirement and Retirement Income Choices by TIAA Participants,” economists Jeffrey Brown (Gies College of Business, University of Illinois at Urbana-Champaign), James Poerba (Harvard), and David Richardson examine retirement income choices to see what choices Retirees have favors. The data-driven results are revealing, with two trends in particular.

First, economists may like annuities but savers don’t. While 61% opted for the life annuity payment in 2000, only 18% did so in 2018. The shift is dramatic considering TIAA participants had to make annuity payments until 1989. A number of factors are likely to play a role, including the market environment of high stock returns and low interest rates during the period studied, which may have prompted fewer people to take out pensions.

Despite this, pensions are not popular with the average retiree either. Annuities are complex contracts. Pensions are inflexible when household circumstances change. “So what do people want?” asks Meir Statman, author of Finance for Normal People and professor of finance at Santa Clara University. “They don’t want pensions. How often do people have to say that?”

Second, many more participants are deferring use of their TIAA retirement accounts until their minimum distribution date. The RMD is the percentage of wealth that individuals over a certain age are required to withdraw. Among TIAA participants, the number of waiting times until their RMD increased from 10% in 2000 to 52% in 2018. The RMD age was 70 ½ years in the examined period. But in late 2019, the Secure Act raised it to 72, and when Secure Act 2.0 becomes law, the RMD age will eventually rise to 75.

“RMD is tax policy,” says Richardson. “There is no drawdown strategy designed.”

Of course he’s right. However, there is research showing that the IRS’s RMD table is a more effective strategy than other more well-known rules of thumb such as the 4% guideline. “RMD is a very good rule,” says Statman. “RMD is a very useful guide to how much to spend.”

Here’s my snack. Retirees value flexibility. Yes, pensions protect against the risk of living longer than expected, but there are other risks that retirees face, including health risks and unexpected expenses. Retirees may want accumulated savings in case a spouse suddenly needs medical help or an adult child returns home with grandchildren after divorce. The RMD option is a sensible choice for those who have sufficient assets to wait.

Besides buying a private pension, there are other ways to reduce longevity risk. For one thing, inflation-adjusted spending falls at retirement age (with a health-related increase later in life). Retirees consume more earlier in retirement when they are healthier, and cut back on travel and other leisure activities later with a “done it before” attitude, three Rand Corp economists conclude. in “Explanations for the Decline in Spending at Older Ages.”

Second, working in traditional retirement years makes it practical to delay filing for Social Security, an inflation-adjusted pension. The benefit is about 76% more filing at age 70 (the latest you can submit) rather than at age 62 (the earliest).

Read: How much will my Social Security contribution increase if I delay filing?

Perhaps it is no coincidence that the average retirement age of TIAA participants rose at the same time as the RMD option became more popular. Specifically, the participants’ retirement age increased by around 1.3 years for women and by 2 years for men.

From a public policy perspective, it is right that the legislature encourages companies to offer their prospective retirees a retirement option. Not many retirees will take up the offer unless the product itself is dramatically improved. The TIAA data suggests retirees would rather stay in control of their nest egg – just in case. Why don’t pensioners like pensions?

Brian Lowry

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