We Need to Talk About Retirement Decumulation

On The Long View podcast is David John, senior strategic policy advisor at the AARP Public Policy Institute, who joins us to talk about retirement planning and portfolio management.

Here are a few excerpts from John’s conversation with Morningstar’s Christine Benz and Jeff Ptak:

Retirement Decumulation

Benz: Wanted to get your thoughts on retirement decumulation, for people who are retired and drawing upon their portfolios. There seems to be a big gap in our current system, the fact that we hand people their money upon retirement and basically tell them to go figure it out, that there aren’t good nudges and guardrails to ensure against a disastrous outcome of some kind. What are the best ideas to address that, in your view, to help people along the way figure out how to spend from their assets in retirement?

John: This is the worldwide problem. We are seeing this question being addressed in every single country that has a defined-contribution system at this point, for very good reasons. The first focus was on building an accumulation system. But now, we are reaching the point where we are starting to see a significant number of people retiring and using those savings. And we are seeing solutions being discussed in every country. Australia, for instance, is in the process of implementing a retirement income program that superannuation programs will be required to offer to their membership.

As far as the U.S. goes, the worst possible option that you can have, to some extent, is to be automatically enrolled, automatically invested, automatically chosen or urged to save a specific amount and now, having absolutely no experience managing investments to be handed your lump sum of retirement benefits and say, “OK, go ahead, only you know how to manage this.” That’s a prescription for disaster. And we see that when people retire, they break into two different groups. On one hand, we have a smaller group who looks at this money and says, “Wow, I’m rich. I can basically go afford to spend it on just about anything I want because I’ll never be able to use that much money,” and they spend too quickly. And then, the flip side, which is actually the larger group, is that they look at this lump sum regardless of how big it is, and say, “Oh my gosh, this is all we’ll ever have,” which is not correct. “And there will be some sort of a terrible financial crisis, and if we spend any of this or much of this,” depending on the person, “we will not be able to handle that crisis.” So, they basically have a retirement life that has less income than they should have. We do need desperately an automatic option that is flexible and easy to understand to help people move from the psychological question of savings and a lump sum to using this money and seeing it as a stream of income.

Probably the one that Mark Iwry, Bill Gale, and I addressed in a Brookings paper, which was one option, was to have people automatically enrolled in what’s essentially a phased withdrawal program. And in this case, the retirement savings would be moved into a professionally managed investment fund where hopefully it would continue to grow throughout their retirement, and the retirement program would send them a monthly income based on the annual performance of the pool of assets. So, essentially, they would be guaranteed that they would receive a monthly income, but that monthly income could vary from year to year. The value of this is that it is a default on one hand, so it’s something that helps to move them psychologically from seeing the lump sum to seeing the income stream, but also is very flexible, so at any point they could decide I’m going to pull out a certain amount of my money and buy an annuity to guarantee that I have income to cover my expenses, and I don’t have to worry about the investment returns of my pool. Or if they have a terrible health diagnosis, they could decide a different way to use their retirement income. But that’s only one option.

Another option is for people to be encouraged or helped to determine, based on their Social Security benefits as a set amount, how much additional guaranteed income they need to meet their basic expenses and then have a separate pool for emergency savings and the like. There are a lot of different ways that we can do this. There is a great deal of innovation going on at this point, which is very encouraging. But one thing that I think is a mistake is to focus solely on existing investment products like annuities and the sort, rather than encouraging the kinds of innovations that we should see. This is especially true now that we’ve moved into an inflationary environment, which changes the picture long term.

Social Security, Annuities, and the SECURE Act

Ptak: You mentioned Social Security, and we want to pick your brain about that. But you also mentioned annuities just now, and we’re curious, the SECURE Act, as you know, made way for more plan sponsors to offer annuities in the 401(k)-plan context. Do you think that’s a good idea and should the types of allowable annuities have been more narrowly defined?

John: Yes, actually, they should have been. When it comes right down to it, the big problems with including an annuity during the retirement savings period before you retire is portability on one hand. What happens if you have worked for employer X for 15 years and you’ve accumulated 15 years’ worth of an annuity and you now change jobs to someone who has a different provider or a different retirement plan? Do you find yourself with slices of annuities, small slices of annuities that could be expensive, or do you find yourself having a fairly large surrender fee to liquidate that annuity part and move it to your new employer’s plan? Those are problems that need to be dealt with. Already there are some providers who actually have an investment that mimics the purchase of an annuity, but the actual purchase isn’t made until retirement.

The other question is, to what extent the annuity provides significant retirement income? This is especially true for lower-income individuals. The U.K. had a requirement up until several years ago where 75% of your retirement savings had to be annuitized by the time you reached age 75, and in practice that meant that most people annuitized when they retired. Unfortunately, because this was a universal requirement, this meant that some people were receiving annuity payments of $25 or $50 a month when it would have been far more effective for them not to have annuitized to have access to a lump sum. So, the SECURE Act made it much easier for employers to add annuities to a retirement savings program.

But the devil is in the details and how those are implemented, how you deal with questions of portability, suitability based on income level or other purposes and things like that. We did hear stories during the U.K. requirements of individuals who annuitized and then finally almost immediately came up with a terminal diagnosis for cancer or something like that. And at that point then, because most of the annuity products tended to be single pay, that meant that most of their retirement savings were not available for their family to use going forward.

Will Social Security Run Out?

Benz: Wanted to ask about Social Security, which you referenced, David. Many younger workers and even older workers approaching retirement age are dismissive of Social Security because the Trust Fund is set to run out of money in 2034 unless Congress takes steps to shore it up. Are they being overly pessimistic, in your view?

John: Yes, very definitely so. Even without the Trust Fund, Social Security can pay somewhere in the neighborhood of 75% of the benefits just from its cash flow. And years ago, I talked to a very conservative public trustee of Social Security, and he pointed out that if Congress can find the money to pay the last year of the Trust Fund, therefore, to pay full Social Security benefits, they can also find roughly the same amount of money the following year when the Trust Fund is exhausted to continue to pay full benefits. I worked on Capitol Hill for 13 years. And during, especially my last stint on the Hill, which started in 1995, Social Security was an issue. And the number and vehemence of phone calls that came in from people who are concerned about receiving their full Social Security benefits cannot be underestimated. The real pressure is there. If necessary, Congress could change the structure of the Trust Fund fairly simply. I don’t anticipate that they do that other than a major Social Security reform. But these benefits, especially for people who are approaching retirement or even in their 40s at this point are very, very unlikely to ever be changed downward. Maybe for the various highest income, but even in that case, that would be very unpopular. This is a commitment that our society has made to retirees. And I don’t see any way, practically or politically, that that commitment won’t be honored.