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It’s important to have future plans

By Stephen Kelley - Freelance Writer | Oct 9, 2019

This is a theme that I come back to a lot because it’s such an important thing to grasp if your financial plan is going to work. In order to ensure the highest probability of success, you must focus, not on the inputs, but on the outcomes.

We used to understand this. Back before the late 1980s, when 401(k)s began to take over, most people who had employer-sponsored retirement plans had pensions. Pensions, while quite expensive for the employers, were great for employees. Also known as “defined benefits” plans, these could also be called, “defined outcome” plans. In other words, the design, management, and delivery of these plans was based on the outcome, rather than the income.

To see how markedly different that notion is to today’s retirement paradigm, let’s take a look at what outcomes someone might want from their retirement plan. From my perspective, they would include, lifetime income you cannot outlive, inflation protection, maximum payouts, survivorship benefits, and guarantees that should any of these things be threatened, the plan has provisions to mitigate them, thus absorbing the risk. Based on years of talking to people about what they wanted their retirement plans to deliver, I believe most people agree with me.

So, let’s look at what we have today in our employer-sponsored, defined-contribution (defined-input) retirement plans. Start with lifetime income. That’s why there was a “4% Rule,” which according to Morningstar, is now a 2.8% rule. According to Wall Street dogma, if you limit your withdrawals to 2.8% to 4%, you should have a 90% chance of not running out of money over a 30-year retirement. This violates three of our stated criteria: guaranteed lifetime income, maximum income payouts, and plan guarantees. All of the risk is shifted from the plan to the individual retiree.

Back in 2000, the 4% Rule was the accepted rule of thumb. To understand how weak this was, it’s important to understand that at that time, the 4% Rule was only five years old. It’s true. The 4% Rule was first posited in 1995 by a San Diego-based planner by the name of William Bengin. He had looked at past market history (the number-one thing we are warned against) in order to determine that, assuming markets continued their then current performance, a person who limited their withdrawals to 4% of the beginning balance plus a 3% (of the 4%) inflation adjustment would have a “mere” 10% chance of running out of money during a 30-year retirement.

Let’s be clear. That doesn’t mean if your plan broke down, you would still have 90% of your income. That statistic means that 10% of the time, you are 100% out of money. What other 10% failure rates are we OK with? Imagine getting on a plane run by an airline that gets people to their destinations 90% of the time. Or relying on brakes in your car that work 90% of the time. Or working for an employer who pays you 90% of the time. Would you accept that? Of course not. So why would you accept a retirement plan that only works 90% of the time?

And is it really 90%? T. Rowe Price, a major Wall Street wire house, conducted a study in 2010, after the dismal decade of the 2000s. TRP determined that a person who lived by the 4% rule during that period would run short 94% of the time. In other words, their 90% success rate went to 6%, just 15 years after the principle was adopted. Worse, it’s still the generally accepted rule of thumb used to ensure income viability. So guaranteed lifetime income is pretty much out the window.

What about maximum income payouts? Well, if you are willing to settle for 4%, I suppose so. But let’s look at an alternative. Pensions are able to pay out much more than 4%. How do I know that? Because the lump-sum payouts for pensions are invariably much less than the 25 times multiple required by the 4% Rule. For example, I recently saw a pension plan that paid my client $2,000 a month. The offered buyout was less than $200,000. That means the pension was paying more than 12% annually. How can it do this?

In order to leverage an asset, there must be some element of risk. A CD, for example, requires a time-based “interest rate” risk. The saver must commit to allow the bank to use its money for a specific amount of time. A bond is similar, although it can also take on further risk by being resold on the market. A share of stock or a mutual fund bears market risk. This is “pure” risk, based solely on what a person is able to sell their stock or funds for at any given time. It’s to protect against this extreme pure risk that one must limit their payouts to such small amounts. This sets up a Catch-22. In order to get more income, one must increase risk, thereby requiring a reduction in withdrawals to reduce the increased risk.

A pension uses a different risk class. A pension uses life expectancy. In other words, a pension knows how many people will pass each year, how many will live to life expectancy (half), and how many will live beyond life expectancy. Using these calculations, the pension can then calculate how much it can afford to pay pensioners in lifetime income. It’s logical, scientific, and safe.

“But I don’t have a pension,” you might be thinking, “so what can I do”? Well, it’s possible to purchase a “personal pension” that works just like an employer pension. It uses the very same actuarial calculations to maximize payouts and guarantee lifetime payments. It’s a common product that’s been around for more than 2,000 years.

It’s called an annuity. And it provides guaranteed lifetime income that is often two to three times the 4% limitation of your 401(k). And, since it’s guaranteed by the insurance company, the risk is shifted off the retiree onto the plan.

The desired outcome. Just like a pension.

Stephen Kelley is a recognized leader in retirement income planning. Located in Nashua, he services Greater Boston and the New England areas. He is author of five books, including “Tell Me When You’re Going to Die,” which deals with the problem unknown lifespans create for retirement planning. It and his other books are available on Amazon.com. He can be heard every weekend on the “Free to Retire” radio show on WCAP and WFEA, and he conducts planning workshops at his New England Adult Learning Center, located in Nashua. Initial consultations are always free. Steve can be reached at 603-881-8811, or at www.FreeToRetireRadio.com.


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