401k Retirees, Take An Annuity for a Test-Drive

You do-it-yourselfers don't understand those of us who pick up the phone when its time to remodel the kitchen, fix the car, or learn about investing. Grab a hammer, pick up a torque wrench, or do some research on the internet, you say.

You may be right. But there will always be two kinds of people: those who hire a professional, and those who prefer to do things themselves. It's as true in retirement planning as it is in other areas of life. The common goal is funding a secure retirement, but there are two vastly different approaches to getting there. On one end of the spectrum is the 'hire it done' mentality of a defined benefit plan. The employee's participation is minimal: enrollment is automatic; contributions are based upon years of service and pay; investments are handled by professionals, and the risk inherent in those investments is borne by the plan sponsor. When retirement comes, payment is generally made in the form of an annuity, unless the participant decides on another method. Payments arrive each month, more or less as a continuation of the monthly paycheck, as long as the retiree, and possibly his or her spouse, lives.

Way at the other end of the spectrum is the 'do-it-yourself' mentality of a 401k plan. The employee decides whether or not to participate in the plan, how much to contribute from each paycheck, and how to invest the accumulating funds. At retirement, the default distribution option is usually a lump sum, which choice requires that the retiree continue to manage his or her money for as long as he or she lives. Will the money last? Maybe, but there are no guarantees.

J. Mark Iwry of The Brookings Institution says both approaches have merit. But he, along with Brookings Institution colleague William G. Gale, David C. John of the Heritage Foundation and Lina Walker of the Retirement Security Project would like to see the two ends meet in the middle, especially at the time of retirement. The convergence of three factors - the aging of America, the decline of defined benefit plans, and the increase of 401k plans - is leading to a critical problem, they say. As more people take their retirement distribution in a lump sum, the likelihood increases they will outlive their funds.

Annuities, say these experts, where payments are paid over the life of the annuitant, or the joint lives of the annuitant and his or her spouse, would resolve at least some of the problem. But in their article, Increasing Annuitization in 401k Plans with Automatic Trial Income (www.brookings.edu), Gale, Iwry, John and Walker recognize that Americans don't often choose annuities from their 401k plans. This may be due in part to a lack of understanding or trust in annuities. To increase understanding and ramp up the level of trust, the authors say, participants have to become more familiar with this form of payment.

To that end, the authors suggest the 'DB-ification' of the 401k. In their paper, they suggest that what works when buying a car might also work when choosing a form of distribution: a test drive. Plans could set a temporary annuity as the default form of payment, they say. Participants would be free to take another form of payment, but if they don't, some of the participant's account balance would be paid in 24 equal installments, to give the retiree a chance to try it out. After the two years, participants could take their remaining funds as a lump sum, or continue with a life annuity. "This DB-ification, if you will, making the 401k a little more like a defined benefit plan, is a constructive step toward curing the do-it-yourself nature of the 401k."

"We anticipate that insurance companies might take the initiative in offering reasonably priced products of this kind to plans," Iwry continues. But if they don't, plans could make the temporary payments themselves, without purchasing an annuity from an insurance company. If the retiree decides to continue with an annuity or another form of regular, long-term income, an appropriate product could then be purchased based on the retiree's age at that time. Once an annuity is in place, the retiree can rest assured that his or her payments will continue for life. "With an annuity," says Iwry, "you can rely on a specified monthly payment that continues, no matter how long you live." Whether you're a do-it-yourselfer, or prefer to hire it done, that could provide the peace of mind you hope for in retirement.

This is for educational purposes only. The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

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