Posted by Jeffrey Brown on Feb 7, 2012
Filed Under (Retirement Policy, U.S. Fiscal Policy)
With nearly 80 million baby boomers starting their march into retirement, many policy-makers have begun to focus on how to provide secure retirement income in a fiscally sustainable way. This is no small challenge in an era of enormous deficits.
Although Social Security plays an important role in providing income that retirees cannot outlive, the benefits provided by Social Security are insufficient to ensure that most retirees can maintain their pre-retirement living standards. However, increasing these benefits would be horrible fiscal policy: because the pay-as-you-go nature of Social Security has collided with an aging population, this program faces enormous fiscal problems that are going to require reductions – not increases – in the rate at which benefits grow.
Thus we have two opposing forces: a need for more retirement income, and a need to cut government spending on entitlement programs like Social Security. What can be done?
Fortunately, the private sector can play an important role here, but only if the regulatory environment allows for it. Presently, the regulatory landscape surrounding employer sponsorship of retirement plans is burdensome and enormously complex. In many cases, the best thing the government can do to promote a greater role for the private sector in providing guaranteed retirement income is to “get out of the way.” Ironically, however, there are other instances in which the best way the government can promote private sector solutions is to get more involved – if only by providing guidance on how plan sponsors can improve their plans without running afoul of existing regulations. Getting guaranteed income options into 401(k)’s and other retirement plans is one such case.
In recent years, the financial services industry has increasingly focused on how to provide plan sponsors and plan participants with products that help to provide guaranteed lifetime income. The resulting innovation over the past decade has been impressive, as companies have introduced a wide range of insurance and investment products that provide individuals with lifetime income.
However, employers that sponsor 401(k) plans have been slow to adopt. As a result, most 401(k) participants in the U.S. still do not have access to annuities or other income products in their plans. Although there are many reasons for this, there is little question that part of the reluctance of plan sponsors to provide annuities is that they have been scared off by regulatory and fiduciary concerns.
Last week, the Treasury Department proposed guidance to help address a few of the many issues that stand in the way of better private sector retirement plans.
In a nutshell, the proposed guidance does three things:
First, it makes it easier for plan sponsors to allow retirees to have a mix of lump-sum and annuity choices. Put simply, it makes very little sense for most retirees to annuitize either 0% or 100% of their retirement assets. Annuities provide guaranteed income, help to protect against out-living one’s assets, and help to guard against market volatility. On the other hand, having some non-annuitized wealth available is extremely valuable when faced with uncertain expenses such as for long-term care. Given that the optimal financial plan for most individuals would be to have some of both (e.g., annuities and a lump-sum), it only makes sense for our regulatory infrastructure to encourage this.
Second, a number of academic papers have established the potential value of annuity products that have a deferred payoff structure. That is, with a small fraction of one’s wealth at, say, age 65, one can buy a product that will start paying income at age 85. In the industry, these are sometimes called “longevity insurance” (although the name is very unfortunate, because all life annuities – whether they are deferred or not – are providing insurance against the financial costs of longevity). The proposed regulatory guidance would help ensure that these products are more easily available.
Third, Treasury issued two “revenue rulings” that clarify how rules designed to protect employees and their spouses apply when a plan offers an income option.
These rules are useful, but far from sufficient. Looking ahead, plan sponsors and participants would be better off if policymakers also took at least three additional steps.
First, the Department of Labor needs to provide much greater clarity about how plan sponsors who wish to provide lifetime income options can do so while protecting themselves from fiduciary risk. This could include providing a “safe harbor” rule for the selection of the annuity provider. Too many plan sponsors continue to be spooked off by the specter of fiduciary liability if they choose an annuity provider that runs into financial distress in the future.
Second, Congress should reform the Required Minimum Distribution rules to eliminate the various implicit and explicit barriers to lifetime income. These rules were written by tax lawyers to ensure that the IRS could eventually get its hands on tax-deferred savings. If these rules were instead written with an eye towards retirement income security, they would look quite different.
Third, we should encourage plan sponsors to report 401(k) and other defined contribution (DC) balances in terms of the monthly income the plan will provide, rather than simply as an account balance. The Lifetime Income Disclosure Act that received bipartisan sponsorship in the U.S. Senate last year would be a positive step in this direction. (My Senate testimony on this Act can be found by clicking here).
This need not be a partisan issue. Republicans should recognize that strengthening retirement income security in our private pension system will give us more freedom to address our burgeoning Social Security deficits. Democrats should view this as an opportunity to ensure that employers “do the right thing” by providing retirement plans to employees that actually succeed in providing a secure retirement.