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Monday, December 22, 2008

Tackling Longevity Risk

Wouldn’t it be nice if we could use 401(k) money to buy annuities with pretax dollars?

Financial Advisor Magazine

By Mary Rowland

When I have questions about changes in the retirement landscape, I go first to Ethan Kra, worldwide partner and chief actuary for retirement at Mercer, the New York-based benefits consultants. Kra has been—for nearly 20 years—an infallible guide to what’s going on in this marketplace. ...

... The biggest danger is longevity risk—the possibility retirees will outlive their money. ...

He has done considerable work on longevity risk, and says the average 65-year-old has no concept of how much risk he has. There’s a one-in-four chance, for instance, that one of the spouses in a 65-year-old couple will celebrate his or her 95th birthday—and there is a one-in-ten chance that one of the spouses will live into the 100th year of life.

“For a 65-year-old couple, the odds are greater that one will see their 100th birthday than that the house will burn down,” Kra says. “How many people don’t carry fire insurance?” And, he asks: “How many don’t carry longevity insurance?”

Not only are the chances for an extremely long life good, but as people pass the age of 85, their ability to manage their finances decreases. “We’re asking people to do something they’re not capable of doing,” Kra says.

His solution? Longevity insurance in the form of an annuity that starts paying at age 85 and pays for life. He suggests that a person at age 60 take 10% of the money from his 401(k) plan or IRA, go to an insurance company and buy an annuity that spreads the money across the risk pool—an annuity that starts paying out when the client is age 85. The client then takes the other 90% of the money and spends it down over his expected remaining life. There is no provision yet for someone to do this with pretax dollars, Kra says. ... “That would require an act of Congress,” he says. “They’re looking at it.” ...

... “It doesn’t pay anything to those who die.” That means there is less possibility of “adverse selection” against the insurance company, in other words, for the less risky policyholders to opt out and the more risky ones to opt in and inflate premiums. Therefore the product would pay out two to three times what you would expect to get for a life annuity. ...

Although it seems that it might be difficult to persuade people to buy a product that might not result in a payoff, Kra points out, “When you buy fire insurance, you pray you don’t need it.” ...

Having A Reliable Income Stream These questions come amid vast changes in the way people are retiring.

Kra frets, for instance, that over the last generation we’ve moved from annuities to lump sum distributions. ... And if you are pondering whether lump sums are better for society, Kra says consider this: Half the people who take one will outlive their money.

People’s anxiety about how much they might have after retirement can also be seen in the re-emergence of the defined benefit plan. Since their introduction 25 years ago, defined contribution plans such as the 401(k) have slowly eclipsed DB plans and been touted for portability. In a defined contribution plan, the amount of the annual contribution is defined instead of the amount of the ultimate benefit (the pretax contribution limit was at $15,500 for 2008).

For young people who moved to new jobs often and got nothing from a DB plan, the 401(k) once looked good because the money you put aside could travel with you. But now that bias has flipped, according to Kra. “Today American workers appreciate the defined benefit plan,” Kra says. For instance, in Florida and Nebraska, he says, state workers were offered a choice between the defined contribution plan and the defined benefit plan, and 97% chose the latter.

Kra says people start thinking about their pensions in their 40s. Baby boomers are now beginning to retire. The next generation, Generation X or the baby busters, born between 1965 and 1979, will demand better pensions. Thus he predicts defined benefit plans will be a competitive draw for companies, especially those that are going to see a talent drain with so many employees retiring. ...

Dealing With A 401(k) With a 401(k) plan, on the other hand, employees have an increasing responsibility for their own retirement. Still, it is the responsibility of the employer to look at fees and performance and determine whether they are acceptable. The employer must decide that the funds it offers are good ones so that a diligent employee could build up an adequate retirement stake by contributing to the 401(k) plan.

Kra says the government is focusing more and more on the details of 401(k) plans. ... Now under new law, employers can automatically enroll their workers. When enrollment was voluntary, the employer had to do complex nondiscrimination testing to demonstrate that the plan did not favor highly compensated employees over the lower-paid ones. But automatic enrollment eliminates the requirement for such testing.

Kra says that the touted Roth IRAs and Roth 401(k)s offer no advantage over their non-Roth predecessors if all the assumptions remain the same. ... For example, if you receive $3,000 in regular income and you pay one third in tax, you can put in $2,000, and in 20 years, you have $8,000. If you put the entire $3,000 into a regular IRA, in 20 years you have $12,000. But then you pay one third in taxes and have $8,000 left. “As long as the tax bracket is the same and earnings are the same, there’s no difference in the amount of money you have,” Kra says. ...