Data & Research February 13, 2014

Annuities, LTC Insurance Help Savings

Overall retirement income adequacy for Baby Boomers and Generation X households improved last year.
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Using its proprietary Retirement Security Projection Model (RSPM), the Employee Benefit Research Institute (EBRI) finds last year’s gains in the financial markets and housing values mean fewer of these households are likely to run short of money in retirement. However, factors such as age, income, and especially access to an employment-based defined contribution retirement plan, can produce significant individual differences, EBRI says in a report.

The risks of a long life and high health-care costs drive huge variations in retirement income adequacy, the model shows. For both of these factors, a comparison between the most “risky” quartile with the least risky quartile shows a spread of approximately 30 percentage points for the lowest income range, approximately 25 to 40 percentage points for the highest income range, and even larger spreads for those in the middle income ranges.

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EBRI says annuities and long-term care (LTC) insurance could mitigate much of the variability in retirement income adequacy at or near retirement age. For example, the annuitization of a portion of the defined contribution and individual retirement account (IRA) balances may substantially increase the probability of not running short of money in retirement. Moreover, a well-functioning market in long-term care insurance would appear to provide an extremely useful technique to help control the volatility from the stochastic, long-term care risk, especially for those in the middle-income quartiles.

“It would appear that while retirement income adequacy depends to a large degree on the household’s relative wage level and future years of eligibility in a defined contribution plan, a great deal of the variability in these values could be mitigated by appropriate risk-management techniques at or near retirement age,” explains Jack VanDerhei, EBRI research director and author of the report.

According to the report, eligibility for participation in an employer-sponsored 401(k)-type plan remains one of the most important factors for retirement income adequacy. Gen Xers in the lowest-income quartile with 20 or more years of future eligibility in a defined contribution plan are half as likely to run short of money as those with no years of future eligibility, while those in the middle-income quartiles experience increases in the EBRI Retirement Readiness Ratings (RRR) values by 27.1 to 30.3 percentage points.

In addition, future Social Security benefits make a huge difference for the retirement income adequacy of some households, especially Gen Xers in the lowest-income quartile. If Social Security benefits are subject to proportionate decreases beginning in 2033 (when the Social Security Trust Fund is projected to run short of money), the RRR values for those households will drop by more than 50%, from 20.9% to 10.3%.

The RSPM takes into account a combination of deterministic expenses from the Consumer Expenditure Survey (as a function of age and income) as well as health insurance and out-of-pocket, health-related expenses, plus stochastic expenses from nursing-home and home-health care (at least until the point such expenses are covered by Medicaid).

The report, “What Causes EBRI Retirement Readiness Ratings to Vary: Results from the 2014 Retirement Security Projection Model,” is published in the February EBRI Issue Brief, online at www.ebri.org.

Data & Research February 13, 2014

Fidelity Sees More 401(k) Balance Growth

Financial services provider Fidelity Investments finds the average 401(k) balance has continued to increase, ending the fourth quarter of 2013 at a record high of $89,300.
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According to an analysis by Fidelity, the growth represents a 15.5% increase from a year earlier and nearly doubles the low reached in March 2009, when the average 401(k) balance was $46,200. For preretirees age 55 and older, the average balance is $165,200. While 78% of the year-over-year increase was due to positive stock market momentum, 22% of the growth came from employee and employer contributions. Fidelity cites this as demonstrating the importance of continued participation and contributions, regardless of market conditions.

Fidelity also examined the combined balance for investors who hold both a 401(k) account and an individual retirement account (IRA) with the firm. For such investors, the combined average balance between the two accounts is $261,400, an increase of 16% from $225,600 at the end of the fourth quarter 2012.

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The analysis also reveals that more than one-third (35%) of participants cashed out their 401(k) balances when leaving their job in 2013. The trend is highest for younger participants, ages 20 to 39, with four in 10 participants in the age group (41%) cashing out when leaving a job last year. With the average cash out value at nearly $16,000, the analysis notes that many 401(k) investors are forfeiting years of potential investment growth and retirement cash flow.

“People with a 401(k) who change jobs have a critical decision to make: take the quick cash, or keep the balance in their existing plan or roll it over into another tax-advantaged account, two options that may provide them considerable income in retirement,” says James MacDonald, president of workplace investing at Fidelity, based in Boston.

“This decision isn’t easy,” MacDonald says. “Everyone’s personal financial situation is different and there are times when a person must have access to cash. However, we urge all investors—especially young savers with years of potential investment gains—to keep their 401(k) savings working for them in a tax-advantaged retirement account when changing jobs.”

The consequences of cashing out a 401(k) may be significant, notes MacDonald. For example, a hypothetical 30-year-old who cashes out $16,000 could lose $471 per month in retirement income cash flow by not leaving it invested in a retirement account (assuming that he or she retires at 67 and lives through age 93). People also pay applicable federal and state taxes plus a 10% penalty for early withdrawal. In this hypothetical example, a $16,000 cash out would result in about $3,200 in taxes and another $1,600 in penalties, leaving the participant with about $11,200.

The Fidelity analysis notes that there are alternatives to cashing out a 401(k) that provide investors investment flexibility. They include keeping the balance in a former employer’s plan; rolling the balance into a new employer’s plan, if eligible; or rolling into an IRA. In doing so, investors preserve their opportunity to build long-term positive outcomes by keeping their assets in a tax-advantaged retirement savings account, MacDonald says.

“Cashing out is tempting, especially in times of transition like changing jobs,” says MacDonald, stressing that it is important for employers to educate employees on both the cost of cashing out and the opportunity for growth by remaining invested.

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