Very few defined contribution retirement plans in the U.S. today pay out lifetime income streams, leaving retirees at risk to run out of money in old age.
That’s why a highly regarded team of academics are proposing the inclusion of deferred lifetime income annuities (DIAs) as a default in employer-provided 401k plans.
In a report produced in concert with the event, “Retirement Policy and Annuitization: A View from the Experts,” held at Northwestern University’s Kellogg School of Management in May and co-sponsored by Brookings and the Kellogg Public-Private Initiative, authors Vanya Horneff, Raimond Maurer and Olivia S. Mitchell investigate the pros and cons of the proposal.
The authors use a life cycle economic model which takes into account the value of having true longevity protection in one’s retirement account.
“We show that automatically enrolling retirees using only a small portion of their 401k assets can substantively enhance retirement security and improve welfare,” the report states in its abstract.
“Overall, we conclude that defaulting workers into a DIA worth 10% of plan assets provides individuals with the potential to save less, yet consume substantially more, particularly at older ages,” the authors summarize. “Defaulting a portion of retirees’ portfolios into deferred income annuities is a practical and attractive way for plan sponsors to provide a lifetime income for workers in defined contribution accounts, partially compensating for the lack of defined benefit coverage in the private sector.
The root of the issue is that without a lifetime income stream, non-pension retirees themselves must figure out how to draw down their retirement wealth in an orderly fashion without running out of money in old age, something most are ill-equipped to handle. Consequently, policymakers are increasingly concerned that millions of financially inexperienced—and very likely, inattentive—older consumers may do a poor job handling investment and longevity risk in their self-directed retirement accounts.
The authors acknowledge a number of institutional factors (a phenomenon often referred to as “the annuity puzzle”) have long discouraged the inclusion of lifetime income products in retirement accounts, but point to proposed new legislation before Congress (the SECURE Act) that would encourage retirees to convert a portion of their 401k accounts at retirement into deferred annuities.
“There is growing interest in proposals to include annuitization into retirement plans so as to ‘put the pension back’ into 401k plans and thus help retirees avoid outliving their assets. Even more interesting is the idea to include deferred annuities as a default in defined contribution plans.”
Helping plan sponsors to default a portion of retirees’ retirement plan accruals into a deferred lifetime income annuity without negative tax consequences will do much to correct Americans’ traditional reluctance to annuitize.
“Our realistic and richly specified life cycle model demonstrates this, taking account of uncertain capital market returns, labor income streams, and lifetimes, as well as rich institutional details on taxes, Social Security benefits, and RMD rules for 401k plans,” the paper states. “Moreover, our proposal is particularly timely given that many employers have begun to express concern that their workers may be unable to manage their retirement assets sensibly when they take their assets out of their employer-sponsored plans.”
All told, the inclusion of a deferred annuity within U.S. retirement plans can be a valuable proposition for plan sponsors, active employees, and retirees, the paper concludes.
- Read the complete report here