Millions of retired employees may live to regret what they were taught about asset allocation by their 401(k) plan sponsors.
Virtually all 401(k) education programs emphasize that asset allocation is a powerful tool to help accumulate wealth. However, there is an inherent, structural and strategic flaw in using asset allocation over time to generate secure income. Retired employees with qualified asset bases in the low- to mid-six-figures may expose themselves to the risk of fully depleting their account balances or seriously diminishing their purchasing power, if they manage their retirement portfolios as an income-producing variation of their 401(k) portfolios.
My analysis based on data from the Investment Company Institute, the U.S. Census Bureau and the Federal Reserve's survey of consumer finance suggests that of a million middle-class couples (those with incomes between $65,000 and $100,000) that retire today, 18% will have depleted their money or will be financially vulnerable in 10 years. The proportion jumps to 44% after 20 years and 84% after 30 years. Even if these projections were halved, the magnitude of the potential shortfall in retiree income is cause for concern for plan sponsors and regulatory agencies. (In this analysis, a "couple" was defined as a male aged 65 and a female aged 62 at retirement.)
According to standard actuarial tables, the average life expectancy of a person who retires in 2003 will be 28 to 30 years. In light of this long time horizon, it might be unreasonable to expect asset allocation strategies alone to cushion the impact of extended market declines, periods of low interest and dividend rates, inflation, personal medical and caregiver expenses, and unforeseen events. In effect, sponsors that allow retired employees to keep their assets in a 401(k) plan might inadvertently fail to provide those individuals with the appropriate tools to generate secure income over their lifetimes.
Are annuities the answer? Although fixed annuities can keep a household from literally running out of money, they have potential drawbacks. Most offer little or no protection against inflation and cannot be adjusted to address changing life circumstances. More significantly, fixed annuities can be an unattractive solution if they are purchased when interest rates are low, and once an individual is locked into a rate, there often is no structural recourse to improve the level of income through market performance or rising interest rates.
In response to these shortcomings, retired employees may divide their qualified assets between an annuity and mutual funds or other securities. This requires the retiree to have a large enough asset base to purchase an annuity that will generate sufficient income, with enough money left over to fund a market-risk portfolio of a meaningful size. That is not the case for many, if not most, employees scheduled to retire in 2003, according to the latest Fed data.
What is the social responsibility of plan sponsors for retiring 401(k) participants? The traditional relationship between 401(k) sponsors and participants often ends at retirement. Even if employees are allowed to remain in the plan and opt to do so, there generally is no instruction from the plan sponsor regarding how to optimize and extend retirement income.
By default, 401(k) sponsors are in the best position to inform and educate employees as to the unique financial risks of retirement and to identify investment approaches that can help extend and optimize income. Indeed, sponsors have a social responsibility to convey this information, given the potential damage to the social fabric if large numbers of retired individuals drop from the middle class into poverty.
It is unrealistic to expect plan sponsors to assume additional fiduciary responsibility for retired employees whose remaining lifetime may extend across two or three decades. However, 401(k) sponsors, with encouragement from the Department of Labor, have achieved considerable success educating employees about saving for retirement and the importance of diversification. It is essential for the DOL and related agencies to also encourage plan sponsors to distribute information that can help retired employees negotiate the financial risks of retirement. Plan sponsors, 401(k) providers and regulatory agencies can work in concert to compile information that will become the approved industry standard, for use by all plan sponsors that opt to distribute it.
Certainly, there is a need to take action. The largest generation in this nation's history is rapidly nearing retirement, and low savings rates and the impact of the recent bear market, combined with greater life expectancies, will make it difficult for many middle-class households to generate a sufficient level of lifetime income. This may be especially true for former participants who attempt to employ asset allocation strategies that were appropriate in their 401(k) plans but may be problematic in a retirement context.
Jerome S. "Jerry" Golden is founder and chief executive officer of Golden Retirement Resources Inc., New York.