When preparing your retirement budget, don’t blindly rely on estimates in a retirement income … [+]
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In the coming months, you might receive a statement from your 401(k) plan that estimates the amount of retirement income your account might generate. While the information provided in these statements can help you decide how much you still need to save for retirement, they can be dangerously misleading for people who are approaching retirement. Let’s see why.
Why will 401(k) plans be issuing retirement income statements?
Many workers don’t have a clue about the amount of retirement income that their accounts can generate each year. They often overestimate the value of their retirement savings, and as a result, they might not be saving enough for retirement. Retirement plan professionals believe that workers might increase their retirement savings if they only knew how much retirement income their accounts could possibly generate.
To address this issue, the SECURE Act, passed in late 2018, requires that 401(k) plan sponsors issue statements to their plan participants that show estimates of the amount of regular income that their accounts could generate. The U.S. Department of Labor recently released guidance on how 401(k) plan sponsors and their administrators should prepare these estimates.
The rationale behind giving you a retirement income statement is well-intentioned. And indeed, these statements might be useful to help you decide how much you should save to build enough retirement income to supplement your Social Security benefits.
Why might retirement income statements be a trap for the unwary?
While it’s certainly a noble goal to help you understand how your savings might convert into retirement income, the devil is in the details. If 401(k) plan sponsors and administrators aren’t careful with the design of their retirement income statements, they could end up misleading their plan participants. In the process, they might enable inappropriate decisions on the part of workers, such as deciding to retire too soon.
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Here’s the problem: The estimated amount of your retirement income shown on your statement can vary substantially from the actual amount of retirement income you might receive when you retire.
There are a few important reasons for this discrepancy. To start with, when preparing retirement income estimates, 401(k) administrators often assume you’ll buy a fixed annuity with your account balance. But most retirees don’t spend all of their account balance on an annuity, and many retirees don’t buy any annuity at all.
The problem with this situation is that fixed annuities often generate more immediate income than most other retirement income generators; in some cases, annuities generate up to twice as much retirement income compared to other retirement income generators. You can see this result in my recent retirement income scorecard, shown below.
As a result, if you don’t buy an annuity with your savings, you’d actually end up receiving lower amounts of retirement income compared to the estimates. And if you blindly rely on the retirement income estimate, you might retire earlier than you should if you want that retirement income to completely cover your living expenses in retirement.
There are two more challenges that occur with these retirement income statements. First of all, in order to prepare these estimates, 401(k) administrators must make an assumption about the age at which you’ll retire. But this age could be different from your actual retirement age. The problem here is that the amount of retirement income you’ll receive will be significantly impacted by the age when you retire.
The second challenge is that plan sponsors must make assumptions regarding the rate of investment return that your accounts will earn between the date of the statement and your assumed retirement date. Again, the actual amount your accounts earn could be very different from this assumed rate of return.
The differences between these two assumptions and your actual experience mean your retirement income statements could miss the mark, sometimes significantly.
What should you do?
Before you turn 50, retirement is still far enough away that it’s probably OK to use your retirement income statements to help you decide whether you should increase the amounts you save for retirement.
However, as you approach your retirement years, you’ll want to learn about the different methods you can use to generate retirement income from your savings and figure out which methods will work best for your goals and circumstances. Then you’ll need to estimate the amount of retirement income you might receive, using the methods that work best for you, and the age when you plan to retire.
The bottom line here is that you shouldn’t blindly rely on the estimates from a retirement income statement when you’re trying to determine if you’ve saved enough to retire, or if you’ll have enough income to cover your living expenses in retirement.
Yes, it will take more time for you to investigate the retirement income strategy that works best for you. But given what’s at stake—your financial security for 20 years or more—it’s well worth your time.