The case for pooling savings

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One of the key differences between 401(k) plans and old-fashioned defined benefit pensions is that you don’t get the advantage that comes with sharing risk among a large pool of other retirees.

The American Academy of Actuaries offers this illustration in its new report, “Retirement for the Ages”:

Two 65-year-old retirees know that they will live an average of 20 years. What they don’t know is which one will live an additional 15 years and which one will live for 25 years. If each has saved $300,000 in his retirement savings accounts, actuaries will calculate that both can withdraw $1,746 a month. One of them will die after 25 years, when he hits 90, with no money left. The other will die in 15 years at age 80, leaving $165,000 to his heirs. The calculation assumes annual returns of 5 percent.

If the two retirees choose to pool their money, then both could increase monthly withdrawals to $2,008, or $262 more a month, but neither would be able to leave anything for heirs. Old-fashioned pensions work this way, but the longevity risk is pooled over a much larger number of retirees. That’s why people who get old-fashioned pensions after working a lot of years are entitled to such generous monthly checks.

Given this mathematical reality, the actuaries suggest that the problem of longevity-driven shortfalls in retirement savings could be partially resolved if the government would change laws affecting 401(k)s to encourage the establishment of regional or national plans that would enroll people without access to defined benefit plans or even well constructed 401(k) plans. Their money would be pooled and that would give them more retirement-planning security.

Lacking that, the actuaries suggest that people plan to self-manage their savings in the early years of retiring, but buy a deferred annuity — also known as a longevity annuity — at age 65, payable at age 85. This will ensure that they will have enough money if they reach a very old age.

The actuaries point out that creating a government plan to make sure that people have enough money to last throughout their life spans isn’t just a humanitarian mandate. People of all ages have a vested interest in creating a secure system of retirement for everyone. “If individuals run out of money, future generations — successive generations of taxpayers — will be called upon to address the shortfall through public programs or some other systemic effort to forestall retirees’ financial distress. An efficient retirement income system will minimize the potential that future taxpayers will bear the burden of supporting today’s taxpayers in retirement,” the actuaries conclude.