Today’s 401(k) and other plan participants transitioning to retirement cannot help but be disappointed by the low yields in fixed income.
Ten-year Treasury bonds are paying about 2.3%. Roughly speaking, a 401(k) plan participant who invests $8,000 in a 10-year Treasury today will get just $10,000 in 10 years. Of course, participants can try to earn higher returns by having their 401(k) plans invest in the stock market or junk bonds, but those investment options are much riskier — and risk is exactly what most retirees try to avoid. They simply cannot afford to lose their nest eggs.
Wouldn’t it be great if there were a way to get higher returns on short-term investments — without having to risk eating dog food in your 70s and beyond because you made risky investments that went bad?
There is. With what we call “survivor funds,” 401(k) plan participants could get significantly higher returns.
There are no survivor funds out there today, but there should be. Our survivor-fund idea is brand new. Lots of 401(k) plan participants want higher returns on their investments, and we think that it would be fairly easy for investment companies to create survivor funds for them.
Of course, there is always a catch. With survivor funds, that catch is one that most participants and retirees could “live” with: You need to be alive at the end of the term of the survivor fund, or you get nothing. That is, with a survivor fund, you will get more money if you live until the end of a short investment period, but if you die before then, you will get nothing. But who cares? You are dead! No worries then, mate.
Here is a simple example that shows how a survivor fund works.
At the outset, imagine that 10 65-year-old male participants each invest $8,000 in a pool that buys 10-year Treasuries. At the current Treasury interest rate, that $80,000 investment would return about $100,000 in 10 years, and each participant — or the heirs — will get $10,000, reflecting that pitiful 2.3% yield.
But what if we instead divided that $100,000 only among the participants who survived 10 years to reach age 75? Say eight of our 10 participants will live to 75.
With a survivor fund, those eight survivors will divide the $100,000, and the two participants who died will get nothing. In short, in 10 years, each of the eight survivors will get $12,500 on an $8,000 investment, and that works out to be a 4.6% return, double the 2.3% return.
What happens is this. If you are willing to give up leaving money to your heirs, you can enter into a survivor game with other investors. If you win, you get more; but if you die, your heirs get nothing.
Of course, you could play this kind of survivor game until there is only one survivor who gets all the money. Historically, such last-survivor-takes-all games were often called tontines — after the 17th-century Italian banker Lorenzo de Tonti, who came up with the survivor principle.
But the survivor principle can be used to design financial products that benefit multiple survivors, not just the last survivor. With survivor funds, each time an investor dies, that investor’s account balance would be divided among the survivors. These survivor funds would be attractive investments because the survivors would get a greater return on their investments.
And even if no other investors die during the term of the fund, the survivors will never get less than the return on the underlying investment.
The returns could be even higher when a survivor fund invests in stocks instead of bonds. For example, if our hypothetical survivor fund had instead invested in a Standard & Poor’s 500 index-fund that earned, say, 7%, the survivors would get 9.4%. If that S&P 500 index-fund earned 10%, the survivors would get 12.5%.
Survivor funds should find a home with today’s 401(k) plan sponsors and with mutual funds that help participants transition to retirement.
Research should focus on how to create these survivor funds — and how they should be regulated. As we envision it, survivor funds could easily accommodate 401(k) plan participants of varying ages and investment levels. Administrative fees would be low, and the returns for survivors would be high; and that is exactly what today’s retirees want.