This op-ed was originally published in MarketWatch on July 15, 2019.
In an unusual bipartisan effort, Congress is close to passing the SECURE Act (Setting Every Community Up for Retirement Enhancement). In a key provision, the Act encourages employers sponsoring 401(k) plans to offer retirees the chance to convert their plan balances into annuities with monthly payments for the rest of their lives.
In specific, the Act establishes a safe harbor protecting plan sponsors from future liability if they reasonably select an insurance company to offer annuities to their retirees and that company later fails to make the scheduled monthly payments.
Congress is adopting this safe harbor because fixed annuities offer significant financial benefits to workers about to retire. Fixed annuities provide pre-set monthly payments for the life of retirees so they will not outlive their savings. Moreover, fixed annuities allow retirees to avoid difficult decisions about how to invest their savings after retirement. And fixed annuities have certain tax advantages — retirees are not taxed until they actually receive their monthly payments.
Yet, despite the benefits, retirees are reluctant to convert their retirement savings into annuities. This article reviews the three main arguments against annuities and suggests strategic responses by plan sponsors to these arguments. Unless plan sponsors implement these strategies, the Act will not lead to a substantial increase in the take-up of retirement annuities.
Give cheaper and simpler choices
First, many annuity policies sold to retirees in the retail market are quite expensive — including mortality charges, administrative fees and sales commissions can be as high as 5%. These commissions go to pay a salesperson to explain how annuities work and why they would be appropriate to the particular retiree.
Annuity policies can also be complex. For example, a popular annuity policy has variable monthly payouts based on the performance of the S&P500 SPX, -0.63%, subject to caps and other conditions.
To avoid these problems, plan sponsors should find a low-cost source of annuities and arrange for direct purchases from that insurance company — without the deployment of a sales force. Instead, the plan sponsor could provide retiring participants with seminars, which would objectively review the pros and cons of annuities. Importantly, the plan sponsor should work with the insurer to offer a simple form of a fixed annuity, with pre-set monthly payments for the life of retirees (and possibly the life of their spouses).
Second, most retirees do not want to use all of their retirement savings to buy annuities, because they put a high value on maximizing their financial options during their remaining years. For instance, most retirees want to retain the option of withdrawing a lump sum from their savings in the event of a major medical emergency for themselves or their families. Alternatively, if things go well financially for retirees, they usually want the option of leaving part of their savings to their children and grandchildren.
In response, plan sponsors should offer retirees the chance to use 25% or 50% of their retirement savings to buy annuities with fixed monthly payments. The rest of their retirement savings could be rolled over tax free to an individual retirement account (IRA) at a qualified financial firm. Then retirees would have a monthly payment from their annuity to supplement their Social Security check, while retaining the option to make bequests or emergency withdrawals from their rollover IRA.
Third, retirees have different expectations about how long they will live — which materially influence their receptivity to annuities. Some retirees are concerned about their near-term mortality, due to current illnesses or adverse genetics, so they will be reluctant to buy a stream of monthly payments based on average life expectancy. Other retirees are worried primarily about outliving their savings. While they may have a solid financial plan if they live until 80, they’re not sure what would happen if they live until 90 or 100.
Consider longevity annuities
To deal with the financial risk associated with living so long, plan sponsors should offer what are called longevity annuities, as well as the standard annuities with immediate monthly payments at retirement. Longevity annuities do not start making monthly payments until retirees reach the age of 80 or even older, and then continue for the rest of their lives. Since longevity annuities defer payment for so many years, they can be purchased by retirees in their 60’s at relatively low prices. Some longevity annuities will even return the purchase price to the heirs of a retiree who dies before age 80.
Here’s an example: Suppose a male at age 65 wanted to purchase an annuity policy paying $1,000 per month for the rest of his life. According to Fidelity Investments’ Guaranteed Income Estimator online tool, if he agreed that the monthly payments would not start until he reached age 80, he would invest $70,313 at age 65. If he died before 80, his heirs would get back his original investment. If he died within a decade or so after age 80, his heirs would get back his original investment minus the total of the monthly payments he had already received.
By contrast, if the same male at age 65 wanted to purchase an annuity policy paying $1,000 per month for the rest of his life starting immediately, he would have to invest $211,280. In addition, these monthly payments would be guaranteed for 20 years from his start date; in other words, if he died before age 85, his heirs would still receive $1,000 per month until the date when he would have reached age 85.
In short, the SECURE Act would be a good start toward increasing the use of 401(k) balances by retirees to purchase lifetime annuities. These annuities can be a useful component of the financial plans for many 401(k) participants. However, to be attractive to these participants, plan sponsors must allow retirees to use only part of their account balances to purchase fixed annuities at low cost — with a choice between monthly payments that start immediately at retirement and those that are deferred until age 80.