What is it about annuities that causes experts to unanimously agree that just about every retiree should have one, but makes most people reluctant to sign up? Should the government mandate such supposedly beneficial payment schemes, or should it treat retirees as responsible adults who can choose for themselves?
The Pension Protection Act of 2006 (PPA) created both incentives and protections to allow employers to default their workers into saving through a 401(k) plan. The PPA's success has now led academics, regulators, and politicians to focus on the flip side of retirement planning—distributions. The evidence is overwhelming that age does not necessarily bring financial wisdom; rather, many imminent retirees remain clueless about critical payout issues such as life expectancy, investment strategy, Social Security, inflation, and compound interest. Yet a basic grasp of such concepts is necessary to reach the Zen-like state of spending precisely the right amount of money in each year of retirement to make it last until you die. Spend too fast, and you end up relying on Social Security alone; spend too slowly, and you end up depriving yourself of comforts or even essentials that you could have afforded after all. Financial experts and economists have concluded (I believe correctly) that other than the lucky minority of workers who can count on a sizeable monthly pension, reasonably healthy retirees should use at least half their 401(k) nest eggs to purchase an annuity.
Yet as a practical matter, few 401(k) or other defined contribution (DC) plans even offer annuities as a distribution option. Even when DC plan participants are allowed to elect an annuity, installments, or a lump sum, they nearly always grab the cash upfront. Even more telling, participants in cash balance and other pension plans act similarly when given the option, electing a lump-sum distribution over a lifetime pension check.
This has led some to predict a doomsday scenario where millions of Baby Boomers prematurely blow through their 401(k) accounts and, unable to survive on Social Security alone, overwhelm the US social welfare system. (For younger readers who are fed up with the spendthrift Baby Boomer generation and wonder "when will it end," check the Web site www.boomerdeathcounter.com for an up-to-theminute estimate of boomer morbidity.)
Many among the pension intelligentsia believe the solution is to coerce retirees to take an annuity. Among the proposals circulating through Washington: mandating that DC plans offer an annuity as a distribution option or, like a pension plan, as the normal form of payment; defaulting participants into an annuity at retirement; requiring that at least half of DC accounts be used to purchase an annuity; requiring that new retirees "test drive" annuity-type payments for two years before they can change to a different form of payment; or giving a tax break for annuity payments and/or penalizing single-sum retiree distributions.
Slow down, Big Brother. Let's think this one through.
Clearly, employers prefer not to offer an annuity distribution option because it is a large pain. It saddles them with fiduciary responsibility for selecting a provider and the hassles of complying with the Internal Revenue Code Section 401(a)(11) spousal joint and survivor rules. The US Department of Labor offered employers some fiduciary relief in 2007, when it slightly relaxed the rules for selecting an annuity for a defined contribution plan distribution. Employers still lack, however, a Section 404(c)-like safe harbor to let the participant choose for him- or herself. Plus, employers know that not offering an annuity option does not stop a motivated retiree from buying an annuity with his or her 401(k) account. With a few mouse clicks, it is easy to find and purchase an annuity from numerous insurance companies via an individual retirement account (IRA) rollover. For employers, offering retirees an annuity really has no upside—particularly since there is no clamor from workers for that payout option.
The real issue is why do annuities remain uniformly unpopular with retirees despite their obvious benefits. Retirees face four major financial risks—living too long (mortality), investment (down markets and/or poor choices), inflation, and unexpected uninsured expenses (illness, injury, fire, etc.). An annuity neatly takes care of mortality and investment concerns. For a price, some annuities include a cost-of-living adjustment, making it three for four. Unless a retiree is independently wealthy or intends to leave a large inheritance, a good hedging strategy against financial risk would be to purchase an annuity with roughly half his or her nest egg, keeping the rest liquid to cover unexpected expenses and/or inflation.
Unfortunately, employees approaching retirement tend to view the world differently. First, they are apt to worry more about dying too soon than living too long. That makes them uncomfortable weighing the prospect of getting a future windfall by beating the actuarial tables against the possibility that the insurer might end up pocketing their hard-earned savings if they die prematurely and the annuity ends. Although term certain and survivor benefit features offer protection against early death, these features require the retiree to accept significantly lower monthly payments, an equally unpleasant result.
Second, annuities are not cheap. The minority of retirees who choose to annuitize their 401(k) savings usually believe that they stand a better than average chance of living beyond their life expectancy. Insurance companies know this and price their products accordingly, making annuities expensive, especially for those likely to be on the "wrong end" of the mortality curve. Add in insurance company administrative costs and profits, and annuities become pricey investments.
Third, most people want to maintain control over their money. Unlike virtually any other investment choice, an annuity is irreversible— you can't cancel because the insurance company's finances deteriorate, inflation heats up, or a sudden illness strains your finances. People have to be very, very confident about turning over 50 percent or more of their life's savings. (Although some insurers have engineered products that guarantee a minimum payout while allowing retirees to cash out and even offer some income appreciation potential, these new products are untested and rather pricey.)
Fourth, annuities are highly complex. The product itself is simple— a monthly payout for life—and there are several reputable insurance companies offering a choice of commission and load-free products with help from the 401(k) plan vendor, a financial planner, or just a Web-savvy relative. The hard part is evaluating whether a particular annuity is a reasonable deal. As an experiment, I easily obtained quotes on annuities from the Web site of a name brand company famous for low fees and financial soundness. Prices were provided for immediate single, joint, and survivor annuities, with and without a cost-of-living adjustment (COLA), for a hypothetical retiree and the retiree's spouse, both age 65. I then reviewed the quotes with a very able pension actuary. Yet even after extensive analysis, we could not agree which policy, if any, was a good deal. While I leaned towards a single-life annuity with a COLA, my colleague concluded that the couple would be best off holding onto their cash. Thus, even with professional advice, but absent a crystal ball, buying an annuity is a hard decision to make.
There also are valid non-financial factors that for some participants trump the economically wise and prudent decision to purchase an annuity with part of their 401(k) account. Both a financially unsophisticated retiree going on intuition and a knowledgeable, well-advised retiree who's done the math may rationally decide to front-load their retirement spending. These folks may prefer the certain pleasure of the additional spending during their earlier (and healthier) retirement years and willingly accept the risk of penury in their final days, when their quality of life is likely to be severely compromised anyway.
I consider an annuity to be a generally sensible approach to managing investment and mortality risks for retirees with significant accumulations in their 401(k) accounts. But neither I nor anyone in Washington has a right to make that decision for other people. Any mandate on employers and/or employees would likely increase costs, discourage savings, and thwart the wishes of many retirees. Instead, our newly elected President and Congress should create effective incentives for employers to offer, and participants to elect, annuity payouts. They might increase fiduciary protection for offering participants the "wrong" annuity, provide a tax break on annuity distributions, or find another avenue that would make annuities less expensive and more user-friendly. It would then be left to retirees to decide what is in their own best interests.
Originally published in the Benefits Law Journal, Vol. 21. No. 4
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