Retirees Who Cash Out Could Take Their Lumps

As the fiasco at Enron demonstrated, many Americans haven't exactly done a bang-up job of managing their 401(k)s. Indeed, the last two years of stock market declines had already revealed the fault lines in the nation's system of individually managed retirement accounts. Too many investors took on massive risks, disregarding basic investment rules, and their retirement accounts have suffered as a result.

But things could be about to get even worse.

Consider that before long, more Americans than ever will start retiring, as the baby boomers begin turning 65. When that happens, some of the same investors who've struggled to manage their retirement savings accounts all along will suddenly have to manage a massive sum of money -- their 401(k) accounts -- worth hundreds of thousands of dollars.

But there will no longer be time to recover from screwups. Since they've stopped earning an income, they'll have to make sure the money lasts until they die. In short, average Americans will have to make complicated financial forecasts that are considered tough even by financial planning professionals.

And the stakes are extraordinarily high: If they make bad choices, they'll end up broke in their old age.

"For the baby boom generation, their 401(k), in addition to Social Security, will be the main retirement plan," says economist Annika Sunden, associate director for research at Boston College's Center for Retirement Research.

The potential for trouble is all the more striking, given the massive size of the boomer generation: By 2015, as the first wave of them begins leaving the workforce, the percentage of Americans eligible for Social Security benefits will have jumped 38% from current levels. By 2030, 55 million Americans will be receiving benefits, a 90% increase from 29 million in 2000. (Typically, workers begin making 401(k) withdrawals when they become eligible for Social Security.)

But as Enron has underscored, many 401(k) investors don't understand basic investing principles, such as diversification, let alone how to stretch a finite amount of money over their remaining life span, which could be decades. "Many Americans who receive such sums [upon retirement] have little experience in budgeting and make startlingly inaccurate assumptions about how much they can withdraw annually," said Norman Stein, a pension expert and law professor at the University of Alabama, in testimony before Congress this year.

Self-Management Means No Going Back

Granted, 401(k) plans have been around for a while -- since 1981, in fact. What's new -- and worrying -- is that retirees in the future will be depending on them so heavily for income.

By comparison, the current crop of retirees rely on traditional defined-benefit plans, which pay out guaranteed sums each year. Though some retirees may have 401(k)s, they've typically only owned them for 10 or 15 years, and the accounts don't contribute a major part of their retirement income.

Yet the shift to 401(k)s as a retirement savings vehicle is already well-established. Between 1980 and 1996, the latest year for which data is available, the number of participants in defined-benefit plans increased only 8% to 41 million.

Meanwhile, the ranks of workers in defined-contribution plans such as 401(k)s jumped 155%, to 51 million.

Are Lump Sums a Good Idea?

Not only have workers assumed more investing responsibilities amid the shift to 401(k)s, but many are unwittingly taking on an even bigger challenge because of the way they take their retirement benefits.

In the past, Americans with pension plans didn't have a choice. They simply received an annuity when they retired, guaranteeing them a regular income stream.

But today, 401(k)s increasingly offer investors the option to take their benefits in a lump sum. The same is true for cash-balance plans, a kind of defined-benefit plan that has become more common.

Companies like to give lump-sum benefits because they're absolved of any administrative costs for distribution options such as installment plans or annuities, which would be paid (and incur costs) over the course of a retiree's life.

Many 401(k) investors say they like lump sums, too, because they allow for more latitude in financial planning. It's easier to make allocations with large sums of money than with small sums, and that money has more room to grow over time.

A survey by the Investment Company Institute found that when given a choice, 49% percent of retirees chose to receive their benefits in a lump-sum distribution, while 26% opted to defer the distribution (leave their balance in their plans), 17% selected an annuity and 8% wanted installment payments.

Two-thirds of investors who took lump-sum distributions reinvested all the proceeds, typically rolling the money over into IRAs.

The Case for Annuities

Yet managing a lump sum requires a lot of financial savvy and, for that matter, luck. Even if you're confident in your investment abilities, you could encounter market trouble beyond your control. If you happen to retire amid a period of market volatility, your retirement fund could take a serious haircut. And if you start withdrawing money at the same time, your base of capital takes a double hit.

So what can retirees do to be able to sleep at night? If you plan to take a lump-sum benefit, the only way to provide yourself some measure of income security is to buy an annuity. An annuity is a contract, sold by an insurance company, that will pay you regular benefits over your lifetime. Like any type of insurance, annuities simply work by pooling risk: policyholders who die relatively soon subsidize payouts to those who live longer.

"An annuity hedges longevity risk, insuring against the possibility that you may live longer than you'd expect," explains John Ameriks, a senior research fellow at the TIAA-CREF Institute. TIAA-CREF, a nonprofit provider of financial services, sells annuities among its other products.

Consumers can sometimes arrange to receive their 401(k) payouts in the form of an annuity, or they can purchase an annuity on their own from insurance companies.

Yet relatively few do. Up until now, at least, demand for the products has been weak, since workers who retired under traditional pension plans have already been receiving annuities in the form of their defined-benefit payouts. The other big reason annuities haven't caught on is that they're widely viewed -- by both consumers and financial planners -- as overpriced.

Ameriks predicts that competition will drive down prices for annuities as more people retiring with 401(k) plans seek income security. Even in the current market, it's possible to find reasonably priced annuities if you spend some time comparison shopping, he says.

One factor to consider is whether you'll be able to tap into other sources of reliable income. If you expect to receive substantial defined-benefit payouts or Social Security benefits, you're less likely to need an annuity. Take stock of your health -- if your life expectancy is short, an annuity would be a poor investment.

Finally, consider how important it is to you to leave a bequest. If you want to leave a lot of money to your children, you can't afford to invest a large sum in an annuity. Once you die, any principal left over from your investment will go to the insurance company, not to your heirs.

In an upcoming companion article, we'll offer advice on how to make sure your money goes the distance, including a look at a strategy that lets you draw down income at the same time your portfolio keeps growing.