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. Knock on wood.
He doesn't beat around the bush when citing the pitfalls and opportunities facing retiring Americans. The biggest danger is longevity risk-the possibility retirees will outlive their money. Not surprisingly, Kra has a solution, though the product he has in mind is not yet on the market.
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. But it might happen. "That would require an act of Congress," he says. "They're looking at it." Meanwhile, at least two life insurance companies have put the product into development, he says, though he won't name names for the record.
The longevity product has a special annuity feature, Kra says. "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. There is no cost for insurance.
The idea for the product came from actuaries, insurance companies and academics, folks like Kra who always have their thinking caps on. Half the people who buy the annuity will die before it pays out. That's one of the things that make it attractive: It is a true spreading of risk. The people who buy it do not know whether they will need it. "This is for the person who has enough money to last until life expectancy," Kra says. "For them, it offers inflation protection."
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."
That's true. Yet that view of risk requires a certain sophistication. My 18-year-old son believes we carry way too much insurance, particularly health insurance, because we hardly ever get sick! He reasons that we would have more money by keeping the insurance premium ourselves. Perhaps it requires a direct experience (or indirect experience) to learn the importance of real insurance-to safeguard against catastrophe.
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. Thirty years ago, most plans didn't offer lump sums, Kra said-they weren't common in public or union plans, nor even in non-collective bargaining. 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.
"We already see the problem in nuclear plants, in the space program," Kra says. "Retiring engineers take with them a wealth of knowledge. Coal mining can't hire enough engineers to certify the mines. We are seeing companies that froze defined benefit plans in the 1990s reopening them to attract more people."
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. For example, in the past, employees had to sign up to be included in the 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. With a Roth, you pay tax going in. All earnings are tax-exempt. 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.
Talking with Kra got me thinking about my own retirement fund, a topic I would like to avoid, particularly after recent market meltdowns. I agree with him about longevity insurance, though I fear that buying it would not leave me with enough money to exist until age 85.
I was also left with a big question: When must the longevity insurance be purchased? Clearly, you can't buy it when you're 84½ and in good health. Kra quotes me figures that assume a client buys such an annuity at age 60. What if he waits? Will there be a deadline or will the price just keep going up?
I'd like to talk with some insurers who plan to offer longevity insurance and get some more details.