What if there was a way to “put the pension back” into 401(k) plans? Intriguing question, one in which Olivia Mitchell believes could lead to better 401(k) participant outcomes. The Wharton professor notes that less than one-fifth of all defined contribution plans today help workers convert their plan assets into retirement paychecks.
Her solution? Annuities, or more specifically longevity income annuities.
“Most defined contribution pension plans pay benefits as lump sums, yet the United States Treasury has recently encouraged firms to protect retirees from outliving their assets by converting a portion of their plan balances into longevity income annuities (LIA),” she writes in a new paper for the National Bureau of Economic Research. “These are deferred annuities which initiate payouts not later than age 85 and continue for life, and they provide an effective way to hedge systematic (individual) longevity risk for a relatively low price.”
Using a lifecycle portfolio framework, she and her colleagues, Vanya Horneff and Raimond Maurer, measure the improvements from including LIAs in the menu of plan payout choices, accounting for mortality figures by education and sex.
“We find that introducing a longevity income annuity to the plan menu is attractive for most DC plan participants who optimally commit 8-15 percent of their plan balances at age 65 to a LIA that starts paying out at age 85.”
Optimal annuitization, they add, boosts outcomes by between 5 percent and 20 percent of average retirement plan at age 66, compared to not having access to the LIA.
“We also compare the optimal LIA allocation versus two default options that plan sponsors could implement. We conclude that an approach where a fixed fraction over a dollar threshold is invested in LIAs will be preferred by most to the status quo, while enhancing welfare for the majority of workers.”