By Olivia S. Mitchell
Olivia S. Mitchell is a professor of insurance/risk management as well as business economics/public policy, and Director of the Pension Research Council, all at the Wharton School of the University of Pennsylvania.
Defined contribution plans – often known as 401k plans – have become the mainstay of US company pensions, yet their main function has been to get employees to save and invest during their work years. These plans haven’t been successful at delivering lifetime income benefits, as a rule: fewer than one-fifth of all such plans today help workers convert their plan assets into retirement paychecks.
One reason annuities or lifetime income streams are not a standard feature of 401k plans is that many people don’t understand these products. For instance, some older individuals tend to underestimate their chances of living a long time, so they don’t take proper precautions against outliving their assets. Others don’t understand financial concepts, and so they’re reluctant to take unfamiliar financial decisions. After all, retirement is usually a once-in-a-lifetime event!
Yet even when workers do wish their retirement plans to pay them lifetime income streams, their employers have not wanted to help them do so at retirement, due to concern over fiduciary liability. This is why the US Department of the Treasury recently launched an initiative to provide firms and employers new ways to “put the pension back” into private sector defined contribution plans. Specifically, the new tax rules now allow not only 401(k) plans but also Individual Retirement Accounts (IRAs) and 403(b) tax-sheltered annuities for employees of nonprofit employers, to convert their retirement nest eggs into longevity income annuities (LIAs).
Longevity income annuities are income streams that begin paying out the buyer at some future age (e.g., age 85) and continue for life. They can be quite economical, and very attractive to retirees wanting what would feel like a retirement paycheck. For instance, even in the current low interest rate environment, a deferred single life annuity purchased at age 65 by a man (woman) costing $50,000 can generate an annual benefit flow from age 85 onward of $24,200 ($19,400) per year for life.
In my recent research with Raimond Maurer and Vanya Horneff, we figured out the optimal LIA purchase strategy for the average man or woman, and also for those anticipating higher than normal mortality rates. We showed that including a longevity income annuity in the defined contribution plan menu would be very attractive to the majority of DC plan participants. Overall, workers would optimally commit 8-15% of their plan balances at age 65 to a LIA that started paying them out from age 85 for the rest of their lives.
When retirees can freely select their annuitization rates optimally, and assuming average mortality rates, their wellbeing rises substantially – as much as 5-20% of average retirement plan accruals as of age 66 – compared to not having access to the LIA. If, instead, a plan sponsor automatically enrolled participants into deferred annuities using a flat 10% of their retirement plan assets, this would be improve retiree wellbeing just about as much as letting them do their own thing.
For people with much higher mortality than population averages, a fixed 10% default would not leave them as well off, since annuity prices based on average mortality rates would be too high for them. Yet we also showed that, if employers converted 10% of retirement assets into a longevity annuity only for those having at least $65,000 in their retirement accounts, this solves the problem.
In other words, including well-designed longevity annuities as defaults in 401k plans and IRAs would make most workers better off. Putting the pensions back into retirement plans is a sensible way to manage retirement risk.
This article first appeared as a WSJExpert posting on October 23, 2016.
Views of our Guest Bloggers are theirs alone, and not of the Pension Research Council, the Wharton School, or the University of Pennsylvania.