In a recent survey, almost three quarters of respondents said they do not have the financial skills to manage their money in retirement. And they are probably right. Converting retirement savings into income is one of the most complex financial tasks people face. The necessary decisions – made in the presence of uncertainty about investment returns, future healthcare expenses, lifespan, and other factors – must balance the twin desires to boost current living standards and to avoid outliving one’s assets.
For some people, the answer is an annuity. In its simplest form, an annuity is a product that is purchased with a lump-sum payment to a life insurance company and that pays the owner a fixed amount on a monthly basis until death. But annuities can be complex and expensive, and they are typically inflexible with respect to the owner’s economic circumstances.
What retirees need is an automatic mechanism that can help guide them in much the same way that automatic enrollment and similar tools help people during the savings phase.
In a new paper and policy brief, Bill Gale, Mark Iwry, Aaron Krupkin, and I put forth just such an option. Our proposal centers on managed payout funds that deliver monthly income that is likely, though not guaranteed, to last a lifetime. Coupled with longevity annuities that begin to make payments when the owner reaches an advanced age and a separate fund for emergencies and extraordinary payments, managed payout funds would help protect retirees from longevity risk without unduly reducing their current living standards.
Managed payout funds are similar in some respects to Target Date Funds (TDFs), but they have a different objective. Their investment strategy generally is designed to produce regular earnings with carefully managed risk to reduce losses. The goal is to provide stable income payouts stemming from consistent investment returns, and possibly growth, over time rather than maximum gains. The annual income amounts are calculated using both investment performance and, in the case of many managed payout funds, a gradual distribution of the principal amount invested in the fund.
Because it is not mandatory, an automatic income mechanism does not need to – and could not – provide a perfect solution to every retiree. It should, however, provide significant value to the largest number of retirees possible. To meet this goal, we believe that the mechanism should meet several standards:
- It should be simple, transparent, and inexpensive;
- It should protect against the risk of outliving one’s savings and provide regular lifetime income that is reasonably stable over time;
- It should be reasonably protected against risks relating to sequence-of-returns, market volatility, and inflation;
- It should be flexible enough to allow the retiree to change course and pursue a different income strategy without causing undue problems or expense; and
- It should include a separate fund that allows retirees to make lump sum withdrawals for emergencies or other purposes without unduly disrupting their regular retirement income.
Our proposed structure meets all these standards, and it is simple to explain. Appropriately managed and regulated, the plan would generate low costs. The proposal is structured to provide income for life through the longevity annuity as well as predictable, regular income and funds available for emergencies. Investments through the managed payout fund would help to protect retirees against inflation, while the separate fund could be drawn upon to help protect against sequence-of-returns risk. The proposed structure is also flexible enough to allow for both different circumstances and different retirement income choices. If some participants wish to use a different retirement income strategy, they only need to opt out of the default in much the same way that someone whose savings are automatically enrolled into a TDF can opt out and choose another investment.