A new law passed by Congress will now require your 401(k) to show you this very important piece of information: How much income to expect in retirement.
The Setting Every Community Up for Retirement (SECURE) Act enact several sweeping changes to qualified retirement savings plans such as 401(k)s.
One of the most significant aspects of the new law is that employers must now provide each 401(k) plan participant with a simple projection that shows their monthly retirement income via an income annuity bought with a lump sum.
In addition, the retirement legislation says that as long as plan sponsors comply with the Department of Labor’s pending regulations they will be protected from any liability for providing the lifetime income estimate.
An annuity is a binding contract where an insurance company promises to pay a specified monthly amount to the purchaser (annuitant) for life in exchange for a lump sum payment. The benefit of an annuity is that the purchaser will never have to worry about outliving his retirement fund income. It’s lifetime income, like Social Security.
The insurance company makes a calculated risk, based on actuarial tables, that the purchaser will die before the income-producing assets are depleted.
There are two kinds of annuities — immediate and deferred. Under the terms of an immediate annuity, monthly payments begin upon receipt of the lump sum amount. The monthly income continues until the death of the annuitant.
A deferred annuity pays the purchaser a specified amount in the future based on their monthly contributions or premiums. Since the payments start later, they should be larger monthly checks.
The purpose of the annual lifetime income estimate is to encourage plan participants to monitor their accounts and potentially increase contribution amounts if necessary.
The annuity projection provided to employees is based on several variable factors: the life-expectancy of the plan participant; the projected interest rate assumption used by the insurance company upon which the lifetime income figure is based; the starting date for the monthly income stream; the projected inflation rate; and the dollar amount of the lump-sum needed for variable monthly income scenarios.
Since the law now insulates employers from liability for offering annuities to their employees, insurance companies stand to gain. No doubt they will aggressively market their annuity products to plan sponsors.
While the intent of the new rule is to insure that plan participants are better informed, the annuity assumptions that are used in the annual lifetime income projection by insurance companies may prove unrealistic. They could paint too rosy a future scenario for employees currently planning for their retirement.
Critics believe that annuity future payment projections are fraught with risk of erroneous or unrealistic assumptions that may misstate or grossly exaggerate the actual monthly income stream at retirement.
If the assumptions used in an annuity model are unreasonable or dubious, for instance, the projected lifetime income benefits promised could be wildly overstated.
The annual rate of return figure could be unrealistic as well. Some insurers use a 6% annual rate of return for the annuity, yet interest rates over the past decade rarely have exceeded 3%.
Some insurers estimated monthly retirement income based on the purchaser living until 95. Yet standard actuarial tables indicate that a 67-year-old woman annuity buyer has a life expectancy of approximately 90. By overstating the life-expectancy factor the lump-sum annuity is always going to appear better than the income generated by the employee’s 401(k) investment account.
Projections based on variable immediate lump-sum annuities are especially suspect as they can vary widely based on the set of assumptions used to calculate the monthly retirement payout.
Projected inflation rates also can be overstated. Inflation has rarely exceeded 2% for the past decade, yet some annuity lifetime income estimates use a 3% or greater factor.
The estimate of monthly retirement income is only as meaningful as the financial assumptions on which it is based. Those 401(k) plan participants considering making a lump-sum annuity purchase should be prepared to conduct their own due diligence with regards to the viability of the annual lifetime income projections.