Encouraging lifetime income in 401(k) plans

The U.S. private pension system is growing, now totaling roughly $28 trillion in assets.  But just as steadily, the system has been delivering less of its traditional product: pensions. With the shift from defined benefit (DB) to retirement saving accounts like 401(k)s and IRAs, traditional retirement income guaranteed to last a lifetime is increasingly replaced by single-sum cash payments.  This imposes new risks and tasks on individuals. Unlike in DB plans, 401(k) and IRA participants are responsible for making choices both while saving and while spending their savings during retirement.

In particular, as I discuss with Bill Gale, David John, and Victoria Johnson in a new paper and policy brief, retirees confront a central dilemma: how to reliably manage the “longevity risk” of outliving their savings without unnecessarily sacrificing their standard of living.  And because individuals generally can’t predict how long they will live, planning based only on average life expectancy entails a 50 percent “risk” of living longer.

One answer is to buy a commercial annuity guaranteeing income for life.  However, that market is small: only 2 percent of U.S. retirement assets are held as fixed annuity reserves.  The annuity industry, including its extensive distribution networks of agents, brokers, and other intermediaries, increasingly pursues higher profits through variable and other products emphasizing tax-favored investing and asset accumulation over basic insurance and guaranteed lifetime income.  As annuities become more complex, less transparent, and higher-priced, retail consumers are hard pressed to understand and compare product features and prices.  To this, we propose a partial solution: legislation encouraging 401(k) plans to offer retirement income using consumer-protective annuities. Through group purchasing, plans can leverage economies of scale to obtain institutional pricing. They also can employ defaults and other behavioral strategies to encourage employees to select annuities.

Unfortunately, many plan sponsors hesitate to offer annuities, largely for fear of long-term legal liability if the insurer they choose ultimately goes insolvent and can’t make its annuity payments.  To allay these concerns, we propose a fiduciary “safe harbor” protecting plan sponsors from liability if they select annuity providers that receive high financial strength ratings from multiple rating agencies.  These ratings are based on the kind of full financial analysis that would be inefficient for each plan sponsor to perform, or engage experts to perform, separately.  Recognizing, though, that rating agencies historically have not been completely independent or reliable, we also suggest consideration of a strictly independent, expert, non-profit fiduciary entity to perform or supervise this rating function on a centralized basis for all interested plans.

Another concern holding plans back from offering annuities is their relative lack of portability. If a plan stops offering in-plan annuities, annuity benefit accumulation will be interrupted, and employees might face liquidation or surrender charges unless they transfer the annuity to another plan or IRA.  We therefore propose a legislative exception to the 401(k) rules currently preventing employees from withdrawing and directly rolling over annuities to IRAs or other plans.

Retirees’ challenge also includes complying with the “required minimum distribution” (RMD) rules, generally requiring them to begin annually withdrawing retirement savings from plans and IRAs after age 70½. RMDs’ main purpose is to prevent retirement tax advantages from being used for estate planning (by deferring taxes until after death) rather than for financial support in retirement. But retirees with moderate-sized savings have little interest in estate planning; they generally spend their savings during retirement.  Accordingly, we propose to completely exempt from RMDs all retirees with total retirement balances below $100,000. Together with other RMD reforms, we would pay for the revenue cost of this exemption by closing a gap in the RMD regime that lets wealthy retirees stretch out and reduce taxes by leaving their retirement savings to be paid after their death to young heirs over the heirs’ entire life expectancies.  Instead, we would generally require distributions to be completed within five years after the retiree’s death.

Appropriate annuity options in 401(k) plans would help address retirees’ decumulation dilemma and provide an important start toward restoring the pension to our private pension system.