Annuitizing 401(k) Plans: Class Warfare, or Just Good Economics?

Filed Under (Uncategorized) by Jeffrey Brown on Mar 16, 2010

Last month the Departments of Labor and Treasury issued a Request for Information in order to solicit public comment on ideas related to converting 401(k) account balances into annuities or other guaranteed retirement income streams.  This is a topic about which I have given a lot of thought – indeed, I even wrote a paper recommending that annuities become the “default option” for distributing from 401(k) plans.  (Click HERE to see the paper).

 As I see it, there is a good case to be made for thinking about guaranteed lifelong income as the default distribution option.  My primary motivation is to ensure that individuals have the private sector financial tools available to optimally manage their retirement portfolios in the presence of uncertainty about how long they will live.  Annuities solve this problem by allow one to trade a lump sum of wealth for an income stream that will last as long as you (and possibly a spouse) live.  There are mountains of academic research suggesting that annuities can make people better off by offering a higher level of sustainable consumption, insuring against longevity risk, and so on.

Enter stage right, Newt Gingrich and Peter Ferrara.  In a piece on Investor Business Daily’s website (read it here), they wrote an article entitled “Class Warfare’s Next Target: 401(k) Saving.”  In it, they essentially argue that treating annuities as the default distribution option is somehow a left-wing conspiracy to tax your retirement, force people to buy government bonds, and do other evil things in the name of “class warfare.”  (You can also find it on the AEI webpage and a related post on the conservative blog watch.)

 

I am extremely puzzled by their hostility towards the general idea.  But before I point out what I do not like, let me point out some valid points they raise:

 

First, they correctly point out one longer-term risk of a government program that starts out as optional – which is that they can, through the political process, end up paving the way toward a mandate.  There is no question that mandated annuitization would be a bad thing on many levels – it would interfere with individual liberty and choice, it would effectively redistribute resources from the poor (who don’t live as long) to the rich (who tend to live longer), and so on.  So they are right to be concerned about where an optional program will ultimately lead in a political environment – a point that academic economists too often overlook when thinking about optimal policy designs.

 Second, I completely agree with their general dislike of the Ghilarducci proposal to invest in a guaranteed retirement account administered by the Social Security Administration.  Indeed, I could write 20 blogs on all the things I dislike about this proposal, whether it be the absurdly high return that Ghilarducci proposes to guarantee at taxpayer expense (without appropriately accounting for the true economic cost) or the very idea that the under-resourced, overly-bureaucratic Social Security Administration should be expanded into an area that the private sector can run perfectly fine.  

 Third, I certainly cannot quibble with their general ideological distaste for policies that keep “punishing responsibility and rewarding failure.”  As readers of this blog can probably tell, I am an advocate of free market capitalism, and I generally distrust over-reaching government regulation.  

Given all of this, why do I support annuities as a default option?  And why do I disagree with the Gingrich/Ferrara critique?  Here are a few reasons.  I will keep it short so this post does not grow monstrous in size, but perhaps I will return later:

Part of the goal here is to do what conservatives like me generally like – to provide people with more choice, not less.  The idea is to get more plan sponsors to offer annuities as a distribution option from their 401(k) and other DC plans.  Right now, few do so, and so individual participants who want annuity income are forced into the individual market where they don’t get as good of a deal (due to concerns about adverse selection, etc.)

  1. We already have a default distribution option from 401(k) plans – in most cases it is to take a lump-sum distribution.  The question is about what type of default option makes the most sense for the most people.  I think the research is pretty clear that most individuals do not have adequate sources of guaranteed retirement income, and that a product that provides guaranteed lifetime income would make them better off.  A lump-sum strikes me as precisely the wrong default option for a retirement plan.
  2. What I favor is an optional program.  As I have outlined in my proposal, people would have plenty of opportunity to take an alternative distribution if they want it.  Those who (like me) place a high premium on individual liberty should take comfort in the fact that my proposal would place no restrictions on an individual’s ability to opt out of the annuity if they want.
  3. There is nothing in my proposal that forces people to hold treasury bonds or subject themselves to inflation risk, as implied by Gingrich and Ferrara.  Indeed, I am a big advocate of inflation-indexed annuities and/or variable payout life annuities in which the lifetime payouts are linked to an underlying portfolio like those offered by TIAA CREF (disclosure: I am a Trustee for TIAA.)  Plus, an annuity provides what some call a “mortality premium,” which is an extra rate of return in exchange for making the benefits life-contingent.
  4. Under my proposal – and under most of the serious proposals I have heard so far – the government (whether it be Social Security Administration or some other agency) would NOT be the administrator of this program.  Rather, plan sponsors could contract with private sector annuity providers – and there is a nice, active, competitive market for such products.

Yes, I am a big fan of free markets.  But only a fool would think that the existing 401(k) system looks like it does because of pure free market forces.  The complicated system we have in place today is as much a creature of government regulation as any program we have.  Indeed, the name “401(k)” itself refers to a section in the Internal Revenue Code! 

As long as we are operating in a world in which government rules largely drive plan sponsor decisions about what kind of retirement plan to offer – and as long as plan design influences participant behavior – and as long as participant behavior drives how well off these participants will be when they retire – then does it not at least make sense to ensure that the basic set of rules be ones that make people’s retirement more secure rather than less?  Especially if we can do it in a way that preserves individual choice?

I respect Gingrich/Ferrara’s healthy skepticism of government.  But sometimes ideology can get in the way of a good idea.  

We Need a New Retirement System

Filed Under (Health Care, Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Oct 20, 2009

The past year has not been good for 401(k)s and other retirement plans.  Among many implications of the financial crisis and deep recession, we have seen the dramatic, correlated losses across nearly every major asset class underscore the fragility of a 401(k) system that is focused predominantly on wealth accumulation rather than secure retirement income.  In essence, the 401(k) system was exposed for what it truly is – a promising supplemental savings plan, but an inadequate vehicle for ensuring a secure retirement.  

 

I’m not alone in this view.  I spend much of my time interacting with people who specialize in thinking about retirement income security – academic researchers, policymakers on both sides of the political aisle, insurance companies, financial advisors, consultants and consumers.  Over the past 12 months I have noticed a striking degree of commonality in their thinking around the fact that we need a better retirement system in the U.S.  This is not to say there are not still important areas of disagreement – for example, I find proposals to increase Social Security benefits, to return to a defined benefit system, and/or to have the government guarantee retirement income to be a combination of naive, reckless and fiscally irresponsible.  But when it comes to the future of private sector retirement plans, I believe there are a number of common themes emerging that make very good sense.

 

Yesterday, I had the opportunity to speak at the annual conference of the American Council of Life Insurers (www.acli.com) about my proposal for encouraging plan sponsors to use guaranteed lifetime income products as the default distribution option.  Before my session, I had the privilege of hearing Dr. Roger Ferguson, President and CEO of TIAA-CREF – one of the largest providers of retirement income in the world – speak on this issue.  (In the interest of full disclosure, I should note that I am a trustee of TIAA). 

 

Dr. Ferguson outlined 5 areas that need improvement in our system.  (I should note that I am paraphrasing here and including some of my own thoughts – so please do not interpret this as an exact representation of his remarks!)

 

  1. We need to return to a focus on providing guaranteed income.  During the shift from Defined Benefit (DB) pension plans to Defined Contribution (DC) pension plans like the 401(k) and 403(b), we somehow lost sight of the fact that the point of saving for retirement is to provide income security.  We need to get the focus back on annuitized, lifetime income.  This does not mean a return to the old style DB systems.  It does mean looking for innovative ways to convert 401(k) and 403(b) wealth into income before, during, and after retirement.
  2. We need to broaden coverage.  Millions of households do not have access to any employer sponsored retirement plan.  Somehow, someway, we need to fix this.  While it is true that individuals can save on their own, the evidence is overwhelming that “employers matter” in promoting saving.  Social Security alone is sufficient to replace adequate income for only a minority of households.  Indeed, given the poor fiscal trajectory of the program, the rising normal retirement age that will reduce benefits for those who claim at earlier ages, and rising Medicare premiums, its adequacy will only diminish further.    
  3. We need to ensure that individuals are broadly diversified.  I, personally, would love to see us put together individualized retirement plans that include a life cycle portfolio trajectory that gradually converts into annuitized income the closer one gets to retirement.  The investment options need to include not just stocks and bonds, but also real estate and other asset classes.  
  4. We need to ensure that individuals have access to good information and advice.  Our current regulatory structure – designed to protect consumers from tainted advice by those who might have a conflict of interest – has had the unfortunate effect of making plan sponsors go through a torturous and administratively complex route to provide good advice to participants.  We need to find sensible ways to streamline this process. 
  5. We need to provide vehicles for individuals to be able to save for retiree health care expenses.  Health Savings Accounts and other similar tools have a useful role to play here.

 

To get there from here, we do need some regulatory and policy changes.  I suspect that we may see this discussion rise closer to the top of the agenda after health care reform is behind us …

So you don’t know how long you will live? Perhaps its time for an “auto-annuity”

Filed Under (Retirement Policy) by Jeffrey Brown on Sep 14, 2009

I don’t know about you, but I have no idea how long I will live.  In most ways, this is a blessing – given how much I like to quantify things, I don’t think I could help myself from starting the grand count-down if I knew my death date for certain.  But in at least one respect – financial planning for retirement – this uncertainty is a real nuisance. 

Fortunately, there are financial products – known by the unsexy name of “life annuities” – that help solve this problem by converting  wealth into a stream of income that will last as long as you do.   There is plenty of research out there showing why annuitization can improve individual well-being by providing a higher level of consumption in retirement.  The problem is that most 401(k) plan sponsors don’t offer them in their plans, and thus most retirees or soon-to-be-retirees don’t have the option to convert their wealth into a guaranteed income stream.

Last Friday, I presented a new policy proposal at a conference sponsored by the American Council of Life Insurers, the AARP, the American Benefits Council, and WISER (apologies if I missed any sponsors!)  The gist of the proposal is to encourage 401(k) and 403(b) plan sponsors to adopt life annuities as the default distribution option from their plans.  The policy steps suggested to encourage it include fiduciary relief and the easing of some administrative burdens associated with qualified joint and survivor annuity rules.  If I may say so myself, the proposal was very well received – including by officials at Treasury, Labor and most of the Congressional staffers present.

Using “automatic enrollment” has proven very successful at increasing 401(k) participation rates, and I believe that “automatic annuitization” could help do the same for increasing annuitization in the payout phase.  This seems a worthwhile goal.  After all, saving assets is not enough to ensure retirement security – you also need a way to ensure that you have enough to live on no matter how long you live. 

I know that this will not make the most scintillating reading for the masses, but you might want to check out the paper anyway.  Whether or not this proposal is ever enacted, I am pretty confident that the future of private sector retirement plans in this country is going to include a greater role for annuitization.  So you may as well start learning about it now … here is the link to the paper.