In 2014, the Bipartisan Policy Center (BPC) launched the Commission on Retirement Security and Personal Savings, led by former Senator Kent Conrad and WL Ross & Co. Vice Chairman Jim Lockhart. The commission will consider and make recommendations regarding Social Security, pensions, defined contribution (DC) savings vehicles, strategies to generate lifetime income and other factors that affect retirement security.
This BPC-staff authored post is the fourth in a series that will outline the state of retirement in America and provide a sense of the challenges that the commission seeks to address in its 2015 report.
Most of the public discourse on retirement planning revolves around how much people should save during their working years and what is the best means by which to do so. Just as important to retirement security, however, is what individuals do after they reach retirement and how they make their savings last for the possibility of living two, three, or more decades beyond their working careers. This is one of the biggest challenges facing the U.S. retirement system today.
What’s the Current Status?
Defined benefit (DB) pensions were originally designed around the concept of lifetime income – the provision of a set monthly benefit (usually a percentage of terminal salary) through the end of the worker’s life and their spouse’s. In this approach, the worker is protected from what’s known as the longevity risk – the risk that an individual would outlive the savings they accrued.
Many DB plans, especially in the private sector, now allow participants to choose between a lifetime, monthly benefit or a lump-sum distribution, which is a large, up-front cash payment that reflects the present value of the lifetime benefit. Among workers in DB plans with this choice, most choose the lump-sum distribution, at which point the account holder is responsible for managing the investments and withdrawal schedule (often through an Individual Retirement Arrangement (IRA)).
Similarly, participants in defined contribution (DC) retirement plans have an account balance that they are responsible for managing. Even workers who retire with large DC account balances risk running short of money in old age if they live an unexpectedly long life, face poor investment returns or have unexpected expenses.1
These changes to DB plans and the rise of DC plans mean that in today’s system, participants themselves are more often responsible for managing longevity risk. DB participants who opt for a lump-sum distribution (instead of a monthly benefit) at retirement and all DC participants face the challenge of ensuring that their accumulated savings are sufficient to last through the end of their lives.
Lifetime Annuities in DC Plans Can Help Mitigate Risk
An alternative to managing withdrawals on a year-to-year basis – and one that mitigates longevity risk – is purchasing a lifetime annuity (through either a lump-sum or periodic payment), in which an insurance company provides a stream of monthly payments that are guaranteed for life (and potentially also the life of a surviving spouse). Retirees with an employer DC plan or an IRA can use some or all of the balance to purchase a lifetime annuity, but few do so in practice – more on that below.
Retirees who own annuities or have taken lifetime, monthly benefits from a DB pension effectively transfer the longevity risk, as well as the risk of poor investment returns, to whomever is paying out the benefits.2
Many Types of Annuities
|Type of Annuity||Description|
|Fixed Lifetime Annuity||Annuity for which monthly benefit is set at purchase and continues for the life of the policyholder (and the death of a surviving spouse, in the case of a joint-and-survivor annuity). May grow at a predetermined rate (e.g., 1 percent per year or with inflation). No cash value if annuity-holder decides they no longer wish to receive regular benefits, but may include a death benefit. Fixed, lifetime annuities may be either:|
|Variable Annuity||Annuity for which monthly benefit rises or falls with performance of underlying assets. Usually have a cash value and can be very complex.|
There are many reasons for why take-up of annuities from DC plan participants has been low, including:
- High Interest Rates: Fixed annuity payments are very sensitive to the interest rate at the time that they are purchased and can vary by as much as 20 percent or more from one year to the next.3 When interest rates drop for the same initial purchase price, the monthly payment from an annuity will be lower. The current low-interest-rate environment has discouraged many workers who might benefit from protection against longevity risk from purchasing annuities.
- Adverse Selection: annuity prices are driven up because people who think that they are likely to live longer are more likely to purchase them – an effect known as adverse selection. If a broader selection of retirees purchased annuities, the prices would probably become more attractive.
- Complexity of the Purchasing Process and Fees: Purchasing an annuity is usually not as easy as purchasing a mutual fund in a 401(k). Annuities are typically sold through brokers, who often charge high commissions.4 Complex variable annuity products, which are more common than immediate fixed annuities – perhaps because brokers receive larger commissions on them and thus have more incentive to sell them – have particularly high associated fees. While simpler, lower-fee lifetime annuity products could be offered directly by employer DC plans, most plan sponsors do not because they are concerned about potential liability should the annuity provider fail to make payments.
- Concern over Parting with a Large Sum of Money at Once.
In an effort to help more Americans access lifetime income, the Treasury Department issued a new rule in July 2014. Previously, purchase of deferred lifetime annuities – which begin payment some years in the future and continue for life – did not satisfy the required minimum distribution rules (RMD).5 In some cases, this has discouraged DC plan participants from purchasing them. Under the new rule, however, participants can use up to 25 percent of their account balance (or $125,000, whichever is lower) to purchase a deferred lifetime annuity that starts no later than age 85 and be exempted from RMDs for the amount of the purchase, just as they would for an immediate annuity. The new rule should make deferred annuities more attractive for workers to purchase with some portion of their accumulated DC wealth.
The Bottom Line
While there are tools available to retirees to manage longevity risk, such as commercial annuities and DB plan benefits in the form of monthly, lifetime payments, infrequent use of these options means that many retirees have no protection against this risk. Treasury’s new deferred annuity rules are one attempt to expand the options available to retirees in hopes that take-up will improve. Work remains to be done, however, in helping both DC and DB plan participants manage their savings in retirement, and BPC’s commission will be examining policy options to do so.
Longevity risk also needs to be considered alongside other challenges – such as need for long-term care, poor investment decisions, and pre-retirement account leakage – that can adversely affect retirement security. Because there is a diversity of risks depending upon an individual’s personal and financial situation, there is no one-size-fits-all policy solution. For more on these issues, look out for BPC’s upcoming white paper A Diversity of Risks: The Challenge of Retirement Preparedness in America.
Alex Gold contributed to this post.
View all posts in BPC’s Retirement in America series under Related Stories below.
1 Vanguard recommends that individuals withdraw at annual rates no greater than 3 to 5 percent of the accrued savings at the beginning of retirement. Others argue that even a 4 percent initial withdrawal rate runs the risk of outliving savings in a low-interest-rate environment.
2 In these cases, the DB plan or the insurance company is responsible for selecting investments and creating a mortality pool in which income is effectively redistributed from those who live shorter lives to those who live longer. Some annuities offer additional benefits such as a certain amount of life insurance coverage.
3 Warshawsky, Mark. Retirement Income: Risks and Strategies. 2012, Pp. 8-9.
4 Some retirement account servicers have negotiated discounted commissions for annuities from certain providers.
5 DC account participants aged 70 ½ and above must take Required Minimum Distributions (RMDs) each year; this usually starts at 3.65 percent of the account balance at age 70 and increases annually.
KEYWORDS: 401(K)S, DEFINED BENEFIT PENSION PLANS, INDIVIDUAL RETIREMENT ARRANGEMENTS, COMMISSION ON RETIREMENT SECURITY AND PERSONAL SAVINGS, REQUIRED MINIMUM DISTRIBUTION RULES, RETIREMENT IN AMERICA