By Chris Farrell
Could a defined-contribution retirement savings plan launched in 1918 provide insights into one of the most vexing questions in personal finance with 401(k)s?
The quick answer is yes. The retirement savings plan is TIAA, which draws participants from colleges, universities, and other nonprofit organizations.
The difficult personal finance question involves how employees with 401(k) accounts can turn their accumulated savings into an income they can rely on in retirement.
The basic conundrum: Spend too much, too fast, early on and retirees might have to drastically cut down on their living standards later in life. Retirees too cautious with their savings might die flush and saddled with regrets about experiences not taken. The complexity is compounded by uncertainty about life expectancy. Will retirees need to rely on their retirement savings for five years or 25 years?
If that weren’t hard enough, the 401(k), which is about four decades old, wasn’t designed with the distribution phase of retirement in mind. “I would say the 401(k) isn’t a retirement plan,” says David Richardson, managing director of research at the TIAA Institute, the company’s think tank. “They are meant for people to save to retirement. Not much thought about how people take their distributions.”
In other words, near retirees in 401(k)s are largely left to their own devices to figure out what to do. A large literature has developed to help them decide how much they can safely withdraw from their savings. The best-known guideline is the 4% rule: Withdraw 4% the first year and each year after that another 4% plus an adjustment for inflation.
Many economists would prefer 401(k) participants turn their savings into lifetime annuities. The basic idea is in return for an investment in an annuity with an insurance company the retiree locks in an income for life. A small sliver of companies with 401(k) plans offered their participants the ability to annuitize their savings. Retirement legislation from 2019—the so-called Secure Act—made several changes intended to encourage more employers to offer an annuity option. A similar intent informs the current bipartisan bill known as Secure Act 2.0 that has passed in the House and now is with the Senate.
In a number of respects TIAA is much like a 401(k), the main employer-sponsored retirement plan for private sector workers. But, in contrast to the typical 401(k), TIAA offers several distinct withdrawal options.
In “Trends in Retirement and Retirement Income Choices by TIAA Participants” economists Jeffrey Brown (Gies College of Business, University of Illinois at Urbana-Champaign), James Poterba (MIT) and David Richardson mine the retirement income selections to learn about what choices retirees favor. The data-driven results are illuminating, especially two trends.
First, economists may like annuities, but savers don’t. Specifically, while 61% picked the life-contingent annuitized payout stream in 2000 only 18% did in 2018. The shift is dramatic, considering TIAA participants had to annuitize until 1989. A number of factors are probably in play, including the market environment of high equity returns and low interest rates during the time studied, which might have encouraged fewer people to annuitize.
Nevertheless, annuities aren’t popular with the average retiree either. Annuities are complex contracts. Annuities are inflexible when household circumstances change. “So, what do people want?” asks Meir Statman, author of “Finance for Normal People” and professor of finance at Santa Clara University “They don’t want annuities. How many times do people have to say this?”
Second, many more participants are delaying tapping into their TIAA retirement accounts until their Required Minimum Distribution date. The RMD is the percentage of assets individuals are required to withdraw starting at a particular age. Among TIAA participants the numbers waiting until their RMD rose from 10% in 2000 to 52% in 2018. The RMD age was 70 ½ during the period studied. But in late 2019 the Secure Act raised it 72 years and, if the Secure Act 2.0 becomes law, the RMD age will eventually rise to 75.
“RMD is tax policy,” says Richardson. “It’s not designed a drawdown strategy.”
He’s right, of course. But there is research showing that the IRS’s RMD table is a more effective strategy than other better-known rules of thumb such as the 4% guideline. “RMD is a very good rule,” says Statman. “RMD is a very useful guide to how much one can spend.”
Here’s my takeaway. Retirees value flexibility. Yes, annuities protect against the risk of living longer than expected, but there are other risks retirees face, including health risks and unexpected expenses. Retirees may want accumulated savings in case a spouse suddenly medical help, or an adult child moves back home with grandchildren after divorce. The RMD option is a reasonable choice for those with sufficient assets to wait.
There are other ways to reduce longevity risk besides buying a private annuity. For one thing, spending adjusted for inflation declines throughout retirement (with a healthcare driven increase later in life). Retirees consume more early in retirement when healthier and cut back spending on travel and other leisure activities later with a “been there done that” attitude, conclude three Rand Corp. economists in “Explanations for the Decline in Spending at Older Ages.”
For another, working into the traditional retirement years makes it practical to delay filing for Social Security, an inflation-adjusted annuity. The benefit is about 76% higher filing at age 70 (the latest you can file) rather age 62 (the earliest).
Perhaps it’s no coincidence that the average retirement age among TIAA participants rose at the same time the RMD option grew in popularity. Specifically, among participants the age of retirement rose by about 1.3 years for women and 2 years for men.
From a public policy perspective, legislators are right to encourage companies to offer their retirees-to-be an annuity option. Not many retirees may take up the offer unless the product itself is dramatically improved. The TIAA data suggest retirees would rather keep control over their nest egg—just in case.
An earlier version of this column misidentified the university affiliation of one of the researchers. It was corrected .