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You get what you pay for: Guaranteed returns in retirement saving accounts

William G. Gale, David C. John, and Bryan Kim

The sharp downturn in the value of financial assets between 2007 and 2009 serves as a pointed example of how risky assets can quickly lose significant value. This experience, coupled with continuing concerns about retirement security, has generated new interest in the idea of having the government provide minimum rate-of-return guarantees for retirement savings accounts.

Guaranteed returns are not a new concept. Defined contributions plans in several countries provide minimum rate-of-return guarantees, as do some defined contributions plans in the United States. TIAA-CREF’s “Traditional Annuity” provides a prominent example of an account with a guaranteed minimum return. Cash balance plans offer savers a fixed rate of return—thus, the guaranteed minimum return is equal to the ceiling on returns that the saver can receive. Many 401(k) or mutual funds offer “stable value” options that guarantee return of principal.

A variety of recent proposals would offer guarantees for new types of savings plans including some state-sponsored retirement savings plans for small businesses. State governments in California and Connecticut recently decided against requiring guarantees.

The key economic issues are the level of costs and benefits associated with a government-provided guarantee and who would bear the costs. Guarantees are a classic example of the economics dictum that it is impossible to get something for nothing. In principle, rate-of-return guarantees are simple: they could protect savers from losses and ensure that they receive at least a minimum return on their investments. In practice, they raise a variety of complex issues and are more costly than meets the eye. First, someone—the saver, the plan sponsor, or the taxpayers—has to pay for the guarantee. When the government pays the costs, budget documents tend to severely underreport the economic costs associated with the guarantees. Those costs are resources that have to be forgone in order to finance the promises. When private insurers offer guarantees, the costs, reflecting true economic costs more accurately, are often quite high. Second, the net benefits may not be as obvious as they seem, since markets often respond quickly and since for most people social security, Medicare, and housing are the source of the vast bulk of retirement resources.

The economic costs are a measure of the value of the foregone resources used to implement the guarantee. This value is independent of whether the government or the private sector provides the guarantee. Ultimately, the level of economic costs and value associated with a guarantee depend on how high a rate-of-return is being guaranteed and what time period is covered. The allocation of those costs – to savers, plan sponsors, or taxpayers – depends on how the guarantee is financed.

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