Why the Government Should Not Issue Annuities

Filed Under (Retirement Policy) by Jeffrey Brown on Mar 1, 2011

In Sunday’s New York Times, Professors Hu and Odean published an op-ed entitled “Paying for Old Age.” After reading it, I concluded that it needs a response, as I am afraid that the authors have misdiagnosed the main problem.

First, let me say that I am a big fan of Odean’s academic work, including that which uses proprietary brokerage data to provide insights into individual investor behavior.  And Henry Hu is also a highly respected law and finance scholar who is well-known for his work on financial risk.  I am delighted to have more super smart academics taking an interest in the important issue of guaranteed lifetime income (and I don’t mean to imply by “more super smart academics” that I consider myself super smart!  Rather, this is a topic that has been researched by some of the brightest economic minds of the last 25 years, including Nobel Laureates Peter Diamond and Franco Modigliani, as well as other leading economists such as Jim Poterba, Doug Bernheim, Amy Finkelstein, Olivia Mitchell, and many others.)

In essence, Hu and Odean are suggesting that the U.S. government should issue inflation indexed life annuities directly to the public.  They are not the first to propose this – the Aspen Institute had a similar proposal several years ago.

I understand the motivation of their proposal.  After all, we know that counter-party risk is one reason that individuals may be concerned about entering into long-term annuity contracts with insurers, and this is especially true after the recent financial crisis that witnessed the disappearance of venerable financial institutions.  Perhaps even more importantly, we know that many 401(k) plan sponsors have concerns about fiduciary liability when it comes to choosing an annuity provider.  Having the government provide the annuities directly is meant to address this concern.  So it is fairly straightforward to write down a simple economic model in which I can show that optimally structured government intervention appears to make people better off.

Even so, I think the proposal is off base, for several reasons.

First, I think they have misdiagnosed the reason people do not buy annuities.  While concerns about counter-party risk are certainly heightened today, the demand for annuities was ridiculously low even a decade ago when most consumers were not even thinking about the issue.  Nor is there much evidence that the lack of inflation protection or high prices are the primary reasons for limited demand.  While these probably contribute a bit on the margin, they are only three items on a very long list of reasons that demand for annuities is limited, which I have discussed at length elsewhere.

Second, I have no confidence in the government’s ability to run this program effectively.  The same holds true for the idea of the government providing a government backstop for private annuity providers.  Last year I published a book (a collection of papers from an AEI conference that I organized two years ago) that includes analyses of 6 major government insurance or reinsurance programs, including programs to insure DB pensions (PBGC), bank deposits (FDIC), crops, terrorism, floods and natural catastrophes.  As I discuss in my intro chapter to that book, one of the themes that came out of these analyses is that the U.S. government simply does not seem to be capable of structuring insurance programs in a manner consistent with basic economic principles.  They almost universally fail to charge appropriate prices for the insurance (in two ways – premiums are too low on average, and they are not properly risk-adjusted), which distorts incentives and leads in some cases to excessive risk-taking (a form of moral hazard).  They tend to create large unfunded liabilities that put taxpayer funds at risk.  There are other problems as well (which you can read about if you read the book!)

So while an optimally-designed government backstop would have real value, the U.S. government has an abysmal record of optimally designing such systems.  So we are immediately thrust into the world of “second best” policies where it becomes difficult to ascertain whether a poorly designed program is really better than none at all.  I am extremely reluctant to run the “experiment” because, to paraphrase Milton Friedman, “there is nothing so permanent as a temporary government program.”

Third, despite the authors’ attempt to sell this as an “everybody wins” idea, I think it is pretty clear that this would crowd-out private annuity provision, and all the future innovation that may come out of it.  (Disclosure: I am a trustee for TIAA, one of the world’s largest annuity providers.  I have also done work over the years for many other life insurance companies. )

Finally, I believe that other market-based solutions are emerging.  There has recently been a lot of discussion, and some activity, of “multi-insurer solutions,” in which a plan sponsor enters into an agreement with multiple insurers who essentially each agree to kick in to cover one another in the event that one provider experiences financial distress (of course, this does not help if the whole industry goes down.)  The idea is still young and new, and I would hate to kill the innovation by starting yet another government program.

In essence, I do not think that direct government provision of annuities is necessary or desirable.  The problem in the private market is not that the products do not exist, it is that people do not buy them.  Nothing in this proposal will change that.  We would be better off focusing our efforts on policies such as reducing fiduciary risk to plan sponsors that would like to provide annuity options to employees.  Or reforming our minimum distribution requirements so that they no longer discourage annuities.

Bottomline – rather than having the government provide annuities, I would like to see the government stop discouraging the use of annuities that private providers would be happy to make available.

The Laws of Arithmetic and Illinois Pensions

Filed Under (Retirement Policy) by Jeffrey Brown on May 17, 2010

An article on Saturday in the Tribune pointed out the obvious – that there are no easy solutions to Illinois state budget woes.  Lawmakers are not even thinking about how to backfill the enormous pension funding gap that already exists.  Rather, they are spending all their energy trying to figure out how to deal with one piece of it – namely, the $4 billion or so that is due this year.

It reminds me, once again, of former Fed Chairman Greenspan’s remark about Social Security options, and how we only have three options – raise taxes, reduce benefits, or repeal the laws of arithmetic.

The same three options are the only ones on the table for Illinois.  Our ability to reduce benefits is limited.  And as many have pointed out in comments on my prior posts, one can hardly lay the blame for this problem at the feet of the pension participants who paid their share along the way.  That leaves tax increase or borrowing.  But I would hasten to add that borrowing is just a tax increase on future generations of taxpayers.  This being gubernatorial election year in Illinois, I suspect that lawmakers will once again kick this fiscal can down the road …

Misguided Reform Rhetoric Around Illinois Pensions

Filed Under (Retirement Policy) by Jeffrey Brown on Mar 31, 2010

Illinois pensions are in the news yet again.  Last month, the Pew Center on the States reported that Illinois was once again the poster child for everything wrong with the funding of state pensions, noting that we had the worst funding ratio of any state in the country.

 

Last week, Illinois House Speaker Michael Madigan decided – finally – to take some action.  He secured a House vote to change pension benefits for future Illinois state workers.  Specifically, this proposal would raise the full benefit age to 67, cap the maximum pension income at a bit over $100,000, limit cost-of-living increases, and so on.  In short, the package amounts to benefit reductions for not-yet-hired future state workers.  

 

Why this option?  To put it simply, there are only two options for fixing the funding problem. 

 

Option one is increase revenue to the system.  In other words, make additional contributions.  But this would require that Illinois lawmakers raise taxes or cut other state spending, neither of which is politically popular.  

 

Option two is to reduce the liabilities.  But as I have written before, the impairment clause in the state constitution prohibits benefit reductions to existing retirees and existing employees.  So the only way to reduce liabilities is to cut benefits for future workers – those that have not yet joined the system.  And that is precisely what Madigan pushed through the House.

 

[By the way, the only “option three” is to, in the words of Alan Greenspan when discussing Social Security, is to “repeal the laws of arithmetic.”  I am pretty sure that most state governments would choose this option if they could!]    

 

As a fiscal conservative, I have no real objection to the decision to reduce future liabilities in the way that the House has chosen to do.  But two issues that have come up in the debate that I think are worth a bit of analytical clarity.  

 

First, estimates of future savings are almost surely inflated.  There are two reasons for this.  One is that some of the estimates appear to have simply looked at undiscounted dollar flows, which implicitly assumes a dollar saved in 2050 is the same as a dollar saved in 2020.  This is obviously not the case, since a dollar saved earlier has a much higher present value.  A second reasons is that – as I have written before – pensions are part of the overall compensation package.  If we reduce future retirement benefits, our ability to attract top faculty members, for example, will be reduced unless we increase compensation in some other way.  None of the cost savings estimates account for this.    

 

Second, there is clear confusion about the source of the funding problem.  Much of the rhetoric around this legislation focused on the level of benefits.  The Champaign News-Gazette is a typical example, stating:

“A big part of Illinois’ horrendous budget problems can be traced to the high costs for the lavish pensions many public employees enjoy. They are far more generous than those available to workers in the private sector, and that’s a big reason why state public pensions are underfunded to the tune of an estimated $80 billion.”

This is wrong for several reasons.

First, the real source of the funding problem is not level of benefits.  It is the fact the Illinois legislature has consistently failed to make the annual contributions that are called for under standard funding formulas.  My colleague Fred Giertz has done some calculations suggesting that if the legislature had made its required contributions every year, the Illinois system would be slightly over-funded, not under-funded.  In short, don’t blame the pensioners for the lack of fiscal discipline on the part of our politicians.

Second, the comparison of public pensions to private pensions is misleading.  One reason is that the public pension replaces both Social Security and a private pension.  Social Security costs roughly 12% of payroll today.  Private employers who offer pensions typically contribute several percent more.  On that basis, Illinois public pensions are not “lavish.”  A second reason is that – yes, I am repeating myself – this is part of an overall compensation package.  So any comparison needs to account for the value of all salary and benefits, not just a single piece of it.

 

 

 

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.  

Do Illinois Pensioners and Taxpayers Know the True Value of Public Pensions?

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Sep 28, 2009

Last week I wrote about the (often misguided) debate over the generosity of public pensions in the state of Illinois.  I ended by noting that it was important to further examine how my previous analysis would change once we account for two under-appreciated facts about the Illinois pension system.    

 

The first under-appreciated fact is that Illinois is one of a small number of states that provides an explicit constitutional guarantee against the impairment of pension benefits.  Specifically, Article XIII section 5 of the Illinois State constitution states that: “Membership in any pension or retirement system of the State … shall be an enforceable contractual relationship, the benefits of which shall not be diminished or impaired.”

 

While Illinois is not alone in providing this guarantee – similar language is included in the constitutions of Alaska, Arizona, Hawaii, Louisiana, Michigan and New York – it should be noted that not all states provide such a guarantee.  In Indiana, for example, the Indiana Court of Appeals (in Haverstock v. State Public Employees Retirement Fund” stated that “pensions are mere gratuities springing from the appreciation and graciousness of the state.”

 

In a paper that I wrote with David Wilcox in the May 2009 American Economic Review, we discuss just how powerful these guarantees have proven to be over the years.  On the basis of that analysis, I am highly confident that Illinois pensioners will receive their benefits.  Unfortunately, with Illinois having one of the worst records of effective governance in the U.S., most other pensioners and participants are not quite so confident.  One way or another, most of them think, the politicians in this state will find some way to renege (at least partially) on these benefits.  (As an aside, what public servants really have reason to be afraid of is that retiree health benefits will disappear – those are not covered by the impairment clause.) 

 

The second underappreciated fact is that the public defined benefit pension plans in Illinois are far too complex for the average (or even the highly sophisticated) participant, taxpayer or legislator to properly value.  There are many reasons for this, but mainly it boils down to the fact that the ultimate benefit depends on a lot of variables that will only be known with certainty many years in the future, such as one’s final average salary.  If that were not complex enough, the legislature has made it even more complicated by having multiple benefit formulas in place.  For example, in the “Traditional” defined benefit plan under the State Universities Retirement System (SURS), participants who joined the system prior to July 2005 received a benefit that was the higher of two approaches.  The first was the standard formula (2.2% times years of service times final average compensation).  The second was a “money purchase” option that essentially kept track of the individual’s contributions, matched them with a state match (at least on paper – we already know the state did not really provide the money), and then credited them with an “Effective Rate of Interest,” or ERI.  Then, at retirement, the “balance” in this largely fictitious account was converted to an annuity using an annuity table that used a rate quite close to the ERI.  If the resulting number was higher than the standard formula, the annuitant gets this higher amount instead. 

 

Confused yet?  If you answered “yes,” don’t feel bad.  Most participants don’t understand all these details.  It is complex stuff that requires a high degree of financial sophistication to truly follow.  If you answer “no,” then let me ask a few extra credit questions.  First, do you know what mean, standard deviation and range the ERI has been in for the last 25 years?  And do you know how the annuity conversion factor compares to market rates?

 

By this point, I suspect very few people know the answer.  Again, don’t feel bad.  I study pensions for a living, and it took me a lot of time and research to find these answers (and, alas, it was too late – by the time I understood all the details, I had already made a sub-optimal pension choice – and it was unfortunately a lifetime irrevocable one!) 

 

Without boring you with details, let me give you a flavor of what I have since learned.  The way the SURS board has historically set the ERI, participants in the DB plan were getting an enormously high return (roughly 8-9%) relative to the risk (as measured by the standard deviation in the ERI, which was tiny over the past 25 years), and this high return was being implicitly guaranteed by the taxpayer.  And the annuity rate?  It is substantially more favorable than even the most attractive private market annuity prices – I’m talking in the range of 50% or more benefits per dollar in the “account,” and in some cases, far more.  These two factors explain why most people retiring from SURS in recent years actually received a higher benefit from the money purchase calculation than the basic formula.

 

What do these two points – the constitutional guarantee and the complexity of the benefit formula – have to do with each other?  Put simply, they have conspired to put an enormous pension funding burden on taxpayers without providing commensurate perceived value to state workers!

 

Let me explain.  As a result of a complex benefit formula that hides the true value of the pensions – combined with the fact that most participants view the DB pension promises as being at some risk of not being honored – means that most public pension participants do not value the pensions at their full economic value.  This fact partially mitigates the point I made last time because this means the “compensating wage differential” will not be dollar-for-dollar. 

 

However, the fact that participants discount their benefits in this way does NOT mean that the state is not actually incurring the full economic costs.  Indeed, the constitutional guarantee means that the states’ taxpayers ARE on the hook for the full economic cost of these benefits.

 

In essence, we have the worst of both worlds.  Public employees are earning a valuable benefit, but because our legislators have (i) created a needlessly complex system, (ii) created a complete lack of confidence in the security of these promises, and (iii) have provided us with a constitutional guarantee that the benefits will be paid, the participants don’t fully value the benefits even though the state bears the full costs.

 

If any private company did this – providing a costly benefit that was valued by employees at less than the true cost to the employer – that company would soon be bankrupt.  But this is Illinois state government.  So, instead, we continue to build up enormous funding liabilities that will simply be passed on to the next generation of Illinois taxpayers.  It may be “business as usual” in Illinois.  But it’s also a real shame.

 

Public servants and taxpayers of Illinois deserve better.