The New Way to Measure Your 401(k)

via Wall Street Journal

 

The whole way that 401(k) savings are measured is about to be turned on its head—if a new approach catches on.

Under the new approach, investors could get a clearer picture of whether they are nearing their retirement-savings goals by focusing less on the dollar amounts they’ve accumulated and more on how much income that money can generate in the future.

A lump-sum figure, the thinking goes, doesn’t tell you much more than how well your portfolio has fared and how much you have saved. The new approach—known as projected income—would show instead what your current balance would pay out as income beginning at a certain age.

Projected income has some prominent supporters. Last year, the Labor Department sought comments on proposed rules that would encourage company plan sponsors to provide a projected retirement-income calculation for their participants as well as information about current account balances.

The Total-Return Fixation

John Rekenthaler, vice president of research at investment-research firm Morningstar Inc., says projected income could sit alongside more-traditional yardsticks such as total return in measuring portfolio performance. Morningstar analysts are having internal discussions about adding a projected-income calculation to the part of its website that advisers use to analyze client portfolios. “As we refine our thinking, total return is a fine metric, but annual income is the most relevant number,” he says.

Investors struggle to translate the lump sum of money they see each quarter on their account statements, he says. That is particularly true of retirement savings, which accumulate over long periods. People tend to fixate on total return and ignore the effects of inflation and interest rates on future spending power. A projected-income calculation would show them how their current balance translates into, say, an annuity that pays out starting at age 65, or set annual withdrawals beginning at that age.

A 35-year-old man with $50,000 socked away in a 401(k) plan doesn’t have an easy way to understand what that quantity of money means for him 30 years down the road when he hits retirement age. He might be tempted to take a loan from the account today to pay for a car. If he could see not only how much he has saved but how much income that translates into three decades from now, he might forgo the loan and leave the money to grow in the plan instead.

That leads to better investor behavior, Mr. Rekenthaler says. “Any action that you take on your 401(k) should make people think twice,” he says, adding that the approach might also be used for college saving. “This is certainly a starting point.”

How It Plays Out

For a look at how projected income might play out, consider some new offerings from BlackRock Inc. Last year, the New York asset-management firm, with $4.5 trillion under management, rolled out a set of indexes that were designed for those age 55 to 65 to track how much they need to save now to produce $1 of inflation-adjusted annual income starting at age 65 and running the rest of their life (based on actuarial calculations). There are 11 indexes that follow each retirement year of the current 55- to 65-year-old age group. A set of mutual funds to track those indexes was introduced earlier this year.

Chip Castille, a managing director of BlackRock and the firm’s chief retirement strategist, says the shift gives investors a more concrete way to look at their savings—as a source of potential income, not a lump sum. “We’re not trying to build a big pot of money that we’re going to roll around on later,” he says. “We’re not building a money slide.”

Each index level reflects the performance of bonds picked to mimic median annuity prices for each age, and their values change daily. For example, as of Nov. 13, it would take a 65-year-old $20.54 of current savings to generate $1 of annual retirement income beginning this year. But someone retiring at age 65 in 2024 would need $14.54 of current savings to generate every $1 of income, measured in 2014 dollars, starting 10 years from now.

BlackRock uses three variables for measuring projected income: the portfolio value, current annuity rates and years remaining until age 65. BlackRock factors in the effects of inflation, interest rates and risk, too. The withdrawal rate is floating rather than the rule-of-thumb 4% fixed amount because it adjusts daily to current annuity prices.

Say you are 61 years old and have $750,000 in savings. You are going to retire in 2018. BlackRock’s index projects you will need $16.35 in savings now to generate $1 of income starting at age 65. The projected annual income off your savings is $45,871. That is a much higher number than the $30,000 in annual income you would get from a $750,000 portfolio if you just used the 4% formula to calculate income.

Quirks of Return

BlackRock’s process also shows how it is possible for a portfolio to do well in terms of total return, but slip when it comes to projected income.

That is because bond prices fluctuate and affect annuity rates. If annuity prices increase faster than total return, projected income will decline. Median savings for current 55-year-olds this year through September rose 16.5%, to $271,620, BlackRock data says, boosted by market gains. But the estimated cost of retirement income rose even faster, 18.5%.

This year a 55-year-old would need $15.12 to generate $1 in annual income beginning a decade from now. A 55-year-old last year would have needed only $12.76. Falling interest rates over the past year have made it difficult to maintain spending power.

Liz Moyer – WSJ

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About thebenefitblog

Eric is a Producer at Lockton Insurance Brokers, Inc., the world’s largest privately held commercial broker. Eric has over 23 years of experience in the insurance industry and has spent the last 11 years with Lockton. Eric specializes in Health & Welfare Benefits, Retirement Planning, and Executive Benefits. Eric's clients utilize his expertise in the areas of Plan Due Diligence, Transaction Structure, Fiduciary Oversight, Investment Design, Compliance and Vendor negotiation to improve the operational & financial outcome for each client. The Benefit Blog is a place to share that expertise and industry news.
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