The ‘New’ 401(k) Retirement Savings ‘Problem’

 For years, the retirement industry has been obsessed with one key problem: people aren’t saving enough. Now, “suddenly,” we have another.

Retirees aren’t spending “enough.”

There’s a certain irony in that. After decades of urging discipline, restraint, and delayed gratification, we’re now concerned that retirees are too disciplined — that they’re depriving themselves of the very retirement they spent a lifetime preparing for.

Some of that is clearly a byproduct of the defined contribution system itself. We’ve spent years focusing workers on how much they can accumulate, not how much they can spend. Defined benefit plans answered a very different question: What will I get? Defined contribution plans leave retirees staring at a balance and wondering how long it will last. 

And once the paycheck stops, that question gets very real, very fast.

Because while you can model returns, you can’t model life. Inflation, healthcare costs, longevity—those aren’t just variables, they’re uncertainties. So yes, retirees tend to be cautious. Frankly, it would be surprising if they weren’t.

That hasn’t quieted a growing chorus worrying that retirees are being too cautious— “hoarding” assets out of fear they’ll run out of money before they run out of…life.

Distribution Defaults

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There’s some data behind that concern. The Employee Benefit Research Institute has long documented the extent to which retirees rely on required minimum distributions (RMDs). They don’t withdraw until they have to, and when they do, they tend to take …about what’s required. The RMD doesn’t just trigger withdrawals—it effectively defines them. Like it or not, the IRS life expectancy tables have become the default decumulation strategy.

And then there’s the work of David Blanchett and Michael Finke, which suggests retirees are far more comfortable spending income than they are dipping into savings. Frame it as income, and people spend it. Frame it as an asset, and they preserve it. Hence, the now-popular notion of a “license to spend.”

Now, I get it. As someone now in retirement (though not yet subject to RMDs), I’ve done the math. The 4% rule, the RMD tables, the various projections—all of them, in one way or another, are trying to answer the same question: how do I make this last? And how do I do that not just for me, but for my wife — who, actuarially speaking, is likely to outlive me?

As we approached retirement, we focused on two things: what we were spending (admittedly, figuring out retirement expenses is easier the closer you are to retirement), and what income we could count on. Social Security for both of us (for the moment, anyway), plus a couple of modest partial pensions, gave us something important—not just income, but reliable income. Enough to cover the basics of our chosen lifestyle. And yes, we spend that money just like we spent our pre-retirement paychecks.

What we didn’t do was annuitize the rest of our savings.

Puzzle Pieces

And that’s where some of this current messaging starts to feel …binary. Maybe that’s not the intent, but it’s often how it comes across: if income is good, more must be better—and converting a big chunk (or all) of your savings into an annuity is the logical next step.

And yet, even when the option is available, most still …don’t.

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This is what the academics label the annuity “puzzle” – the continued reluctance of American workers to embrace annuities as a distribution option for their retirement savings. It’s an academic headscratcher because they tend to assume workers are “rational” when it comes to complex financial decisions, specifically because “rational choice theory” suggests that at the onset of retirement, individuals will be drawn to annuities because they provide a steady stream of income and address the risk of outliving their income.

Human beings are, in fact, mostly rational (academics not always so much) – and, despite record annuity sales (outside of retirement plans) most human beings (still) can’t quite get their arms around the notion of handing the biggest sum of money they’ve ever seen over to an insurance company …which will then “dribble” it back to them in considerably smaller sums each month, albeit for the rest of their lives. 

The industry’s current “solution”? If they won’t buy it on their own – and if plan fiduciaries are (still) hesitant to put it on the menu – well, let’s default them into it - by embedding it in a target-date fund or managed account. Now, honestly, if a target-date fund is a “blunt” asset allocation instrument, how is defaulting participants with a myriad of personal financial and physical circumstances, retirement needs, and health concerns any less so?

Look, reliable lifetime income is valuable. In many cases, invaluable. It is the baseline for a successful retirement financial plan. But so is flexibility. So is liquidity. So is the ability to respond to whatever retirement actually throws your way. Things that the limits of “regular” lifetime income won’t address.

So, maybe don’t assume that the only way to give retirees a “license to spend” is to ask them to hand over the keys to the entire portfolio – certainly via a default mechanism they likely never really understood or appreciated.

And if that’s not what’s being suggested—if the intent is really about partial solutions, flexibility, and choice—then perhaps the messaging could use a little more clarity.

Because if I’m hearing it the other way, I’m probably not the only one.

— Nevin E. Adams, JD

Do Roth and 401(k) Pre-Tax Holders Really Spend Differently?

An interesting—and somewhat counterintuitive—report came out last week, one that cast doubt on the “common wisdom” regarding Roth versus traditional pre-tax savings.

The assumption underlying the research[i] was that those who had not yet paid taxes on their savings (the traditional pre-tax savings) would be hesitant to tap into those savings and trigger taxes, certainly more so that individuals that had already paid those taxes. Instead, the research suggested that the opposite occurred; that individuals who had saved on a pre-tax basis actually withdrew more/sooner—but with a twist. 

This they hailed as good news. They noted that the research suggests investing in a CT (current-taxed, or Roth) plan could help ease concerns about outliving funds—because they spend at a lower rate (though they saw this as a negative for those who saved on a deferred tax (DT) basis).  They even managed to find a silver lining in the “cloud” of faster spending by the pre-tax crowd because those individuals appeared to be trying to adjust for the effect of taxes (with the caveat “despite our findings that they do not appear to adjust sufficiently, if at all”). And they saw as a positive this report’s contribution to the “accounting literature exploring the effectiveness and consequences of incentivizing behaviors through tax policy, by highlighting how past decisions motivated by taxes (e.g., retirement plan type) may continue to affect one’s quality of life long into the future.”

A few words of caution would seem to be in order, however. This wasn’t based on the patterns of actual people spending their actual money in the real world. Rather, and to their credit, they constructed a laboratory environment of sorts; they selected a group of volunteers, gave them certain criteria—basically a role they would “play” in the experiment—and set out a spending scenario. They then had them read about various spending choices—and, well—recorded how the individuals chose.

As for their conclusions, when you probe into the results more carefully, what you see is that even though those who had pre-tax accounts ostensibly feel the “pain” of taxes due on their retirement withdrawals—and that appeared to restrict their spending—it seemed to be offset by another reality. That, for reasons not understood/explained, those same individuals appeared to relish the expected benefits of consumption more than Roth holders. Said another way, their “reservations”— the cognizance of taxes—didn’t seem to constrain their spending because they were (more) enamored of the benefits of spending. Indeed, the researchers commented that those with “equivalent nominal balances” actually spent at the same rate.

I’ll just comment that it’s an interesting premise—and that the test environment created struck me as detailed and complex to map out, establish and execute. That said, I would be hesitant to draw any substantive conclusions on actual human behavior from this analysis. To me, all it seemed to “prove” is that people selected for an experiment tend to spend to the perceived “limits” of their hypothetical account, regardless of taxation. It didn’t strike me that Roth holders spent less (as many headlines covering the report suggested), but rather that pre-tax holders spent the same, even though they were going to have to deal with a tax bill at some point (hypothetically, of course).

And that, to me, isn’t a positive thing for Roths so much as it is a cautionary note for pre-tax savers—who may have forgotten that tax deferral is just that.

 - Nevin E. Adams, JD

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[i] How Does Tax Timing Affect Spending in Retirement?  

Means 'Tested'

Pundits have long worried that retirees wouldn’t have accumulated enough to live on in retirement, but the data suggests that most retirees aren’t exactly burning through their retirement savings.

I remember my one and only conversation with my father about retirement income. He had already decided to quit working, and had gathered his assorted papers regarding his savings, insurance, etc. for me to review. Determined to “dazzle” Dad with my years of accumulated financial acumen, I proceeded to outline an impressive array of options that offered different degrees of security and opportunities for growth, the pros and cons of annuities, and how best to integrate it all with his Social Security.

And when I was all done, he looked over all the materials I had spread out before him, then turned to me and said – “so how much will I have to live on each month?”

See, my dad, like many in his generation, were accustomed to living within their means. And, according to new research, he isn’t the only one.

The study shows that retirees generally exhibit very slow decumulation of assets. More specifically, the nonpartisan Employee Benefit Research Institute (EBRI) found that within the first 18 years of retirement, individuals with less than $200,000 in non-housing assets immediately before retirement had spent down (at the median) about one-quarter of their assets; those with between $200,000 and $500,000 immediately before retirement had spent down just 27.2%. Retirees with at least $500,000 immediately before retirement had spent down only 11.8% within the first 20 years of retirement at the median.

Those with pensions were much less likely to have spent down their assets than non-pensioners. During the first 18 years of retirement, the median non-housing assets of pensioners (who started retirement with much higher levels of assets) had declined just 4%, compared with a 34% decline for non-pensioners.

The median ratio of household spending to household income for retirees of all ages hovered around 1:1, inching slowly upward with age – a finding that the EBRI researchers said suggests that majority of retirees had limited their spending to their regular flow of income and had avoided drawing down assets, which explains why pensioners, who had higher levels of regular income, were able to avoid asset drawdowns better than others.

Not that that’s necessarily a heartening result, since those pensioners, arguably having guaranteed income for life, such as a pension, doesn’t lead them to spend down their assets. Indeed, of all the subgroups studied, pensioners have the lowest asset spend-down rates – though one might well expect that, with that pension “cushion” they might be more inclined to dip into their savings and “splurge.”

Why are retirees not spending down their assets? The EBRI report offers a number of reasons:

• People don’t know how long they are going to live or how long they have to fund their retirement from these assets.
• Uncertain medical expenses that could be catastrophic if someone has to stay in a long-term care facility for a prolonged period.
• A desire to pass along assets to heirs.
• A lack of financial sophistication – people don’t know what is a safe rate for spending down their assets, and are thus erring on the side of caution.
• A behavioral impediment – after building a saving habit throughout their working lives, people find it challenging to shift into spending mode.

Now, the EBRI research was based on government data from the U.S. Health and Retirement Study to track retirees born between 1931 and 1941 with assets ranging from stocks, bonds, mutual funds, real estate and CDs to savings and checking accounts (individual homes were excluded). That’s “greatest generation” territory – retirees who were, as my father, accustomed to living within their means. Even then, it’s not all sunshine and unicorns; some retirees are indeed running out of money in retirement – though, at the same time, instead of spending down, a large – and to my ears, largely unacknowledged ­– number of retirees are continuing to accumulate assets throughout retirement.

But I’d still argue that the question “how much will I have to live on each month” winds up being a lot easier to answer at retirement – if you’ve been thinking about it pre-retirement.

- Nevin E. Adams, JD