Very few defined contribution retirement plans in the U.S. today pay out lifetime income streams, leaving retirees at the risk of runing out of money in old age. In a report issued by the Brookings Institution, researchers propose to include deferred lifetime income annuities (DIAs) as a default in employer-provided 401(k) plans.
They conclude that defaulting a portion of retirees’ portfolios into DIAs “is a practical and attractive way for plan sponsors to provide a lifetime income for workers in defined contribution accounts.”
To illustrate how this idea would work, the researchers built and calibrated an economic model to assess the impact of defaulting a portion of retirees’ 401(k) assets at age 66 into a DIA that commenced paying benefits at age 85. This model was used to measure how much better off people would be from defaulting a relatively small portion—10% of retirement plan assets above a threshold –into such a deferred income annuity.
Researchers Vanya Horneff, with the Finance Department at Goethe University; Raimond Maurer, with the Finance Department and Goethe University; and Olivia S. Mitchell, with the Wharton School at the University of Pennsylvania note that required minimum distribution (RMD) regulations were amended in 2014 to allow the provision of longevity income annuities within the 401(k) space, as long as they were deferred lifetime income annuities (starting benefits no later than age 85) and limited to less than 25% of the retiree’s account balance. Accordingly, a retiree’s DIA annuity purchase need not be counted in determining her RMD basis, meaning that this change dramatically relaxed the RMD requirements that had precluded the offering of longevity annuities in the 401(k).
The U.S. Department of Labor has interpreted the 2006 Pension Protection Act by identifying the types of products that can be included in the plans while still maintaining fiduciary protection. These new deferred lifetime income products are referred to as “qualifying longevity annuity contracts” (QLACS).
For the analysis, annuities are priced using a unisex table derived from the US Annuity 2000 mortality table provided by the Society of Actuaries (SOA) and assuming an interest rate of 1%. The researchers say they are also sensitive to the concern that some workers may anticipate higher mortality rates than the population at large, and for such workers, it may be less attractive to buy longevity annuities. They address this by defaulting 10% of workers’ assets into a DIA only so long as they have at least $65,000 accumulated in their 401(k) accounts.
The analysis found that prior to age 85, consumption differences are small either way: the median difference is only $3 at age 50. But by age 85, the retiree with the default DIA can consume about $700 more per year on average, and $2,600 more by age 95. “Overall, we conclude that the risk of consuming less is very low for those with the default DIA, while the possibility of enhanced consumption at older ages with the DIA is very high,” the report says.
The researchers also looked at the change in welfare if retirees were to optimally switch their 401(k) assets into the DIA, instead of the employer having to default 10% over the $65,000 threshold. As an example, the analysis finds in the optimal case, women having at least a college education use 14.5% of pension accruals to purchase the DIA, which increases welfare by $15,384 (or 7% of retirement assets). This is a relatively small difference ($1,863) versus the default case of using 10% over the $65,000 threshold to purchase a DIA. Differences are even smaller for the other education groups and similar for males. “Accordingly, including well-designed DIA defaults in DC plans yields quite positive consequences for 401(k)-covered workers,” the report says.
What plan sponsors can do
The researchers note that one factor that all seem to favor in the design of retirement annuitization is to avoid an “all-or-nothing” decision, where the retiree is forced to convert his or her entire nest egg into an insured income stream. The partial annuitization of 10% of assets over a threshold should reduce retirees’ concern about lacking liquidity in old age. The researchers suggest persuading defined contribution (DC) plan sponsors to describe all benefit amounts in the 401(k) plans as monthly or annual income streams, so as to emphasize the role of the DIA in helping retirees meet consumption needs, rather than as a “loss” of access to a portion of their account balances.
“It is also likely that retirees whose consumption needs are covered by a relatively secure income stream from Social Security paired with their DIA benefits would be willing to take more investment risk with their liquid 401(k) or IRA assets. In this way, the DIA could help enhance retirement security, enabling households to benefit from the equity premium later in life. This could be a particularly important strategy in light of the permanently lower interest rates that many financial economists expect in the future,” the report says.
The researchers also say a related approach might be to include DIAs into a target-date fund (TDF) intended to carry older workers not only ‘to’ but also ‘through’ retirement. Regulations issued by the U.S. Department of Labor (DOL) have made it possible to embed lifetime income offerings into TDFs, naturally with full disclosure provided to participants. Because annuities generally do not provide workers with an option to move from one firm to another, it is believed that the appropriate point to begin offering embedded annuities would be at or near the employee’s retirement age, the researchers suggest.
They also suggest directing the assets generated by the employer contributions and matches to the DIA. Current law allows plan sponsors to require that the employers’ contributions be held in a deferred annuity, and it would even be feasible for the employer contributions to be defaulted into a DIA.