Pooled Income: The secret to getting more out of your retirement savings

One of the hardest things for people to do in retirement is translate nest-egg savings into reliable income that lasts. A way to do so – and generally get back more income per dollar compared to other alternatives – is through “pooled income.”

Though entities as commonplace Social Security and defined-benefit pension plans utilize pooled income approaches, few are aware of how such arrangements actually function.

Baby Boomers – especially those with 401(k)s and no traditional pension to fall back on – can benefit tremendously from a better understanding of the benefits of pooled income.

Below, from the writings of economist Moshe Milevsky, PhD., is one of the best – and most entertaining – descriptions I have ever read on how pooled income works.

The 95 Year Old Bridge Club

“My 95-year old grandmother loves playing bridge with her four best friends on Sunday every few months. Coincidentally, the five of them are exactly 95-years old, are quite healthy and have actually been retired – and playing bridge – for 30 years. Recently this game has gotten somewhat tiresome and my grandmother has decided to juice-up their activities. Last time they met, she proposed that they each take $100 out of their purse wallets and place the money on the kitchen table. “Whoever survives to the end of the year, gets to split the $500…” she said. “And, if you don’t make it, you forfeit the money…Oh yeah, don’t tell the kids.”

Yes, this is an odd gamble, but you will see my point in a moment. In fact, they all thought it was an interesting idea and agreed, but felt it was risky to keep $500 on the kitchen table for a whole year. So, the five of them decided to put the money in a local bank’s one-year certificate of deposit paying 5% interest for the year.

So what will happen next year? According to statistics compiled by actuaries at the U.S. Social Security administration, there is a 20% chance that any given member of my grandmother’s bridge club will pass-on to the next world during the next year. This, in turn, implies an 80% chance of survival. And, while virtually anything can happen during the next 12 months of waiting – actually, there are 120 combinations, believe it or not — the odds imply that an average four 96-year olds will survive to split the $525 pot at year-end. (I sure hope
grandma is one of them.)

Note that each survivor will get $131.25 as their total return on the original investment of $100. The 31.25% investment return contains 5% of the bank’s money and a healthy 26.25% of “mortality credits”. These credits represent the capital and interest “lost” by the deceased and “gained” by the survivors.

The catch, of course, is that the average non-survivor forfeited their claim to the funds. And, while the beneficiary’s of the non-survivor might be frustrated with the outcome, the survivors get a superior investment return. More importantly, they ALL get to manage their lifetime income risk in advance, without having to worry about what the future will bring.”

Click to view the original paper, “Grandma’s Longevity Insurance,” from Moshe Milevsky, PhD.

Important notes on the story:

In a real pooled income arrangement, the people don’t get to keep the money at the end. Instead, funds are allocated to assure that income for the remaining participants persists.

Those who live the longest do reap the greatest rewards. But, that’s really the point. People have the choice to cling to the funds they have and risk running out of money at later ages, or, let go, “jump in the pool,” and rest assured they will always have a guaranteed income no matter how long they end up living.

Few argue that individuals should put all of their funds into pooled income products. The key is to cover basic living expenses – food, shelter, utilities, everyday expenditures. Therein lies security. Once basic expenses are covered, more traditional investment alternatives would be preferred due to their liquidity, growth potential, and suitability for inheritance planning.

Relative to the issue of inheritance, it is useful to recall the warning flight attendants give to airline travelers, “Put the oxygen mask on yourself, before putting it on your child.” Similar logic applies to retirement funding, “Make sure to cover your basic income security, before worrying about leaving money to your kids.” (One idea is to leave kids your “stuff” instead – house, physical assets, etc.)

Mentioned in the story above is the concept of “mortality credits.” Mortality credits are what create the magic and give pooled income arrangements – including Social Security, pension plans, and individual annuities – the ability promise more long-term income to participants than other comparable mechanisms.

Assuming proper funding, mortality credits allow for the assets of pooled funds to be invested in highly safe instruments, such as intermediate and long-term bonds, and still deliver superior results.

Arguably, mortality credits may afford pooled funds the ability to take on a bit more risk to achieve their objectives. In grandma’s story above, if the group had put the $500 into a hot growth stock and lost 20%, the survivors would have still each gotten their money back.

Finally, securing basic living expenses with pooled income can give individuals more freedom to pursue higher investment returns with their remaining funds. This happens because a person’s “base” income is safely separated from his or her overall investment risk.

In summary, here are several major benefits provided by pooled income mechanisms,

  • They serve as a form of insurance to cover basic expenses in retirement.
  • They generally provide more retirement income per dollar allocated.
  • They protect against the risk of living too long and outliving retirement funds.
  • They insulate retirees from the ups and downs in the market.
  • They allow greater freedom to pursue higher returns with remaining retirement funds.
  • They provide a simplified means of translating retirement savings into steady, reliable income.

If you would like to learn more about the suitability of pooled income products for your situation, you are welcome to contact me by email or through my Cincinnati, OH based insurance agency, McCarthy Stevenot Agency, Inc.

Bonus content: Use this simple method to calculate how much basic income you may need in retirement.

Amazon links to other works by Moshe Milevsky, PhD. (Purchasing books through these “sponsored” links help defray the cost of this website. Thank you!)

How to generate income in retirement

Most people spend their careers saving and accumulating funds so that one day they can retire. But when retirement finally arrives, a whole new process begins.

Economists call it, “the decumulation phase.”

This is the process of turning saved or invested assets into regular income.

Decumulation is an entirely different animal than accumulation. Paying regular bills by slowly liquidating investment shares can be an extremely complicated task to undertake.

  • Which stock (or fund shares) should you sell first?
  • Should you sell shares of a stock that is up or a stock that is down?
  • Should you sell an average of all the stocks you own?
  • Should you be selling shares of some other investment such as a bond fund?

I often think of the challenges of decumulation when I am at the grocery store and see very senior people doing their shopping.

(OK…if that makes me some kind of economics/financial nerd, so be it. There is a serious human side to this story.)

I think to myself,

“Does this person now have to go home, log in to his or her online brokerage account, and sell shares to pay for those groceries?”

I also often wonder,

“What if this person is alone and has lost his or her spouse?”

What if the spouse who is now gone was the one who “took care” of the money?

What’s left is someone at a very delicate and vulnerable senior age – who is likely intimidated or even downright afraid – forced by necessity to manage an extremely complicated and difficult task, just to pay for basic things like groceries.

Yikes…

There is a better way.

There are products designed to generate and distribute income more smoothly. These products generally “pool” funds in order to distribute income steadily and predictably over time.

  • Funds of this general type date back to the Roman Empire when individuals were paid an annual stipend called an “annua.”
  • Roman soldiers received such stipends in exchange for military service.
  • Participants would make a single payment to the fund and receive payments each year until they died.
  • Other funds of this type – called tontines – were used during the middle ages by kings and lords to finance the cost of frequent military campaigns.
  • The first annuity used in America was established in Pennsylvania as a retirement fund for pastors in 1759.
  • Lotteries today use similar mechanisms to distribute prize money to winners. After an initial lump sum is contributed, funds are paid out evenly over a number of years.

Converting savings into income can be a very complicated process, but it doesn’t have to be.

After a certain age, for mercy’s sake, it really shouldn’t be.

Don’t leave your spouse trying to manage a “do-it-yourself” decumulation plan.

Learn how annuities can help convert savings into guaranteed, worry-free income and make the decumulation process a whole lot easier.

Try this simple method to calculate how much income you may need in retirement.

If you would like to contact me to discuss whether annuities may be suitable in your situation, I can be reached by email or through my Cincinnati, OH insurance agency, McCarthy Stevenot Agency, Inc., at 513-891-9888.