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Payouts from 401(k) Plans

Payouts from 401(k) Plans. September 25, 2007. By the end of this lecture, you should be able to:. Explain payout options from 401(k) plans Discuss the importance of longevity risk in planning retirement withdrawals Explain how life annuities address this risk Why might they be valuable

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Payouts from 401(k) Plans

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  1. Payouts from 401(k) Plans September 25, 2007

  2. By the end of this lecture, you should be able to: • Explain payout options from 401(k) plans • Discuss the importance of longevity risk in planning retirement withdrawals • Explain how life annuities address this risk • Why might they be valuable • Why might people not buy them

  3. Accumulation: The “First Half” of 401(k) / Retirement Planning • How much money will individuals have at retirement? • Key issues: • Savings rates • Own contributions • Employer match • Investment choices • Administrative expenses

  4. Payout: The “Second Half” of Retirement Planning • How do individuals convert their wealth into a sustainable stream of retirement income? • Key Issues: • Longevity risk • Inflation-protection • Spousal protection

  5. Payout Period is Lengthening

  6. Individuals are Living Longer • Life expectancy at birth in 1900 was only ___ years for men and ___ for women – it has increased approximately ___ years! • Today’s 65-year old man can expect to live to age ___ • Today’s 65-year old woman can expect to live to age ___

  7. But Uncertainty Remains • Fraction of 65 year olds dying by age 70 Men ____ Women ____ • Fraction of 65 year olds living to age 90+ Men ____ Women ____

  8. Your Mortality% Chance of Living to Age …

  9. Payout Options • Lump sum distribution Rules • Systematic withdrawals • Life annuities/reversionary annuities • Note: All three are covered by minimum distribution requirements

  10. Minimum Distribution Requirements • What is Congress’ objective? • Distributions must begin at retirement or April 1 of year after turn 70 (whichever is later) • Acceptable methods • Life annuities that are non-increasing (except for inflation protection) • Payments made based on (IRS) life expectancy • Anything faster is okay • Google: Minimum Distribution Tables • Problems with these rules?

  11. Why Does Uncertainty about Length of Life Matter? • Retirement financial planning difficult • Trade-off two risks • Longevity Risk • The risk of outliving one’s resources • Under-Consumption Risk • The risk of dying with substantial wealth that could have been used to finance higher consumption levels while living

  12. How Address this Risk? • Life Annuities • Trade a stock of wealth for an income stream that cannot be outlived • Solve the consumer’s retirement wealth allocation problem • Save early & Often: Rich Dad’s Cash Flow Quadrant

  13. Annuity Provider’s Perspective • Companies can pool and share longevity risk across a large number of individuals • In the United States, the primary provider of annuities is the Social Security system, which pools longevity risk across nearly the entire population

  14. Why Are Annuities Valuable? • Individual Perspective • Eliminates risk of outliving one’s resources • Provides higher level of sustainable income than is available without annuities • “Mortality Premium”: the insurer can pay a higher rate of return while living in exchange for loss of principal upon death

  15. Example • 65 year old male in year 2000 • $100,000 of financial wealth • Interest rate = 6% • Inflation = 3% • Compare income from: • Inflation indexed annuity • Nominal annuity • Various “self-annuitization” strategies

  16. What is the cost? • What do you give up when you annuitize???? • Compare & Contrast to an SPDA • Compare & Contrast to a Variable Annuity • www.immediate annuities.com • Tax implications of Annuities

  17. Economic Theory • Economic “life-cycle” theory of savings and consumption indicate that annuities ought to be extremely valuable • Simulations indicate that the ability to access annuities is equivalent to a substantial increase in wealth

  18. Few 401(k) Plans Offer Annuities • In late 1990s, only about ¼ of plans offered life annuities  even smaller today • Why? • Demand side: workers do not ask for them • Supply side: some fiduciary responsibility for choice of insurer, OR, company carries the longevity risk itself (if set up as trust)

  19. Consumer View of Annuities • Lack of consumer understanding • Individuals view annuities as a gamble – what if I die the next day? • They are used to insuring against “bad” events, and living a long time is “good” • Already annuitized by Social Security • Want liquidity for unexpected expenses • Want to leave money to kids • Other?

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