Here's How It Could Have Been Worse

By Allan Sloan
Tuesday, January 13, 2009

If your year-end 401(k) statement made you ill, I have one consolation for you: It could be worse. How's that possible, given how horrible last year was for investors?

Simple. If you're not close to retirement, you've got time to recover. If you're in the retirement-age zone, as I am (I'm 64), at least you've got the option of hanging on until things get better. If you're in the mandatory-withdrawal part of life (older than 70 1/2 ) or just need some retirement cash, you can take a minimal distribution this year and hope for the best.

If, however, you were forced to buy a lifetime annuity with your current balance -- when you buy such an annuity, you trade your cash for a series of guaranteed payments for the rest of your life -- you'd be making your loss permanent. That's how things could be worse.

That is what could have happened to many people under President Bush's proposed Social Security privatization program. It would have required people of modest and very modest means who invested their Social Security taxes in the market to turn some or all of those accounts into annuities when they hit retirement age. (Yes, Bush never proposed a specific plan, but annuitizing private accounts for some people is what his 2001 Social Security privatization commission proposed.)

I'm a big fan of individual initiative and saving -- but a year like 2008 gives you an idea of how risky investing can be. If you have to cash out at a particular time, you might make out well (during market highs of October 2007) or terribly (now).

Let me give you an idea of what we're talking about, using numbers I commissioned from Vanguard. Let's say a couple, about to turn 66, had $500,000 in their account at the end of 2007 and used it to buy a joint and 100 percent survivor annuity. This is a common type of annuity, which guarantees a reliable income stream until the longer-lived spouse dies. A Vanguard version of this annuity would have paid these folks $3,005 a month. (See the assumptions behind the numbers below.)

If, however, a year-younger couple had ended 2007 with a $500,000 balance and bought their annuity at the end of 2008, they'd have gotten way less: $1,985 a month if their money had been in Vanguard's S&P 500 index fund, $2,500 a month if it had been in Vanguard's Target Retirement 2010 fund, a "life cycle" fund that gives holders less-risky asset allocations as they get older.

Why these huge differences -- $505 to more than $1,000 a month for life -- when we're talking about couples who start collecting only a year apart, just after each turns 66, the current age for getting full Social Security retirement benefits?

It's because of two main factors that determine annuity payments -- the market value of their account (the higher, the better), and long-term interest rates (ditto).

A Target Retirement 2010 account with $500,000 in it at the end of 2007 would have shrunk a bit more than 20 percent, to $396,645, by the end of 2008, Vanguard said, while the S&P fund would have fallen 37 percent, to $315,000. Those market losses were offset a tad by Vanguard's annuity partner -- American International Group -- giving slightly more generous terms because some long-term interest rates were higher in 2008 than in 2007.

I'm not shilling for Vanguard or recommending that you buy an annuity from AIG. I asked Vanguard for annuity numbers because it's a low-fee outfit, is effectively owned by its customers rather than by profit-hungry Wall Street types and wasn't part of the privatize-Social Security crowd.

Should things go well in the markets this year, next year I could be writing about how much better off you'd have been buying an annuity at year-end 2009 than at year-end 2008. That's the point of this exercise. It's fine for you to take market and timing risks if your basic retirement needs are already being met with your own sources of income. It's another thing to have to take those risks with your eating money, which is what Social Security represents for perhaps two-thirds of retirement beneficiaries.

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