Workers contemplating retirement face significant financial risks. Inflation, an uncertain rate of return on investments, the insolvency of a former employer or financial provider – all these external factors can deplete retirees’ assets and income. Personal risks such as unemployment, illness, disability, and even life span can lower earning capacity or raise financial need.
A long life, a blessing in so many ways, is especially hard to manage. Some underestimate how long they will live or neglect to plan for the possibility of many years in retirement. Many find it difficult to devise and adhere to a plan for managing retirement assets over an uncertain, and potentially long, time horizon.
Americans’ financial prospects for retirement naturally depend on how much money they have saved during their working years. Equally important, but often an afterthought, is how they use it.
Traditionally, the most complete solution to this problem has been to protect retirees from outliving their assets through the use of guaranteed lifetime income, such as an annuity. Annuities and other lifetime-income arrangements undertake to make predictable payments for as long as annuitants are alive.
Yet in recent years annuitization rates have fallen. Defined benefit pension plans at the workplace, a traditional source of low-cost annuity income, have increasingly offered and made lump-sum (single cash) payments, either by adding a lump-sum option to the plan’s array of payout options or by converting the entire plan to a different, lump-sum-oriented format known as a hybrid. “Cash-balance” plans are the most common kind of hybrid. Many other employers have replaced their defined benefit plans with 401(k) plans, whose accumulated wealth is typically returned to workers upon retirement as a lump sum rather than as monthly payments for the duration of retirement. Only about 2 percent of 401(k) participants choose to convert their savings into annuities upon retirement.
Despite these trends, the need for stable and assured income has increased along with longer life expectancies and retirement periods. The choice between an annuity and a lump-sum distribution may be one of the most important financial decisions a person ever makes. Why more people do not choose annuities has been something of a puzzle within the economics literature and for policy analysts. There are three broad classes of explanations:
- Annuities may not inspire confidence because they are not sufficiently transparent or simple to understand. Consumers find themselves mystified by annuities’ complex provisions and worry (based partly on warnings in the personal finance and consumer protection literature) that insurance companies are pricing their products unfairly. Comparison shopping between annuities, let alone between annuities and lump-sum options, can be a lot more complicated than contrasting a Toyota to a Ford in an automobile showroom.
- Annuities may appear to be a risky, high-stakes gamble with insurance companies about how long the retiree will live. Retirees who die young are deprived not only of years of their life but also of years of annuity payments.
- Annuities may preclude important alternative uses of retirement savings.