Alicia Munnell, the director of the Center for Retirement Research at Boston College, is a weekly contributor to “Encore.
The biggest problem with 401(k) plans is that people do not have enough money in them. Typical estimates of the median balances for people approaching retirement are under $100,000. The second biggest problem is that people have no idea how to draw down their $100,000.
Unlike traditional defined benefit plans that provide participants with steady benefits for as long as they live, 401(k) plans generally pay out benefits as lump sums. Lump-sum payments mean that retirees have to decide how much to withdraw each year. They face the risk of either spending too quickly and outliving their resources or spending too conservatively and consuming too little.
These risks could be eliminated through the purchase of annuities. Annuities are contracts offered by insurance companies that pay a stream of monthly payments in exchange for a premium. The annuity not only protects people from outliving their resources but also allows them to enjoy a higher level of consumption than they could provide on their own. The insurance company can provide this high guaranteed income because it pools the experience of a large group of people and pays benefits to those who live longer than expected out of the premiums paid by those who die early. That is, pooling creates a “mortality premium.”
The simplest annuity is the single-life, single-premium immediate annuity, which involves a one-time payment from the individual, and payments to the individual begin immediately. Other options are available. Annuities can cover both the husband and wife (joint and survivor), they can provide payments based on some underlying portfolio (inflation indexed or linked to stocks), or they can guarantee payments for a certain period, such as ten or twenty years. Or they can begin at a later date (deferred).
Economic theory suggests that people would be interested in buying annuities. Rational life-cycle consumers with no interest in leaving a bequest would always choose to annuitize 100 percent of their wealth. After all, they face a choice between a traditional investment with a market return or an annuity with a market return plus a “mortality premium.” The only cost to consumers is that the annuity payments stop at death. But if they place no value on wealth after death – that is, they have no bequest motive – the cost of the annuity is zero.
In fact, the market for annuities that are designed to protect against outliving one’s saving is tiny. Some of the reasons are irrational – people value piles of wealth more than flows of income and they simply don’t understand the advantages of the product. Other reasons are rational – people do care about leaving bequests; they already have a lot of annuitized wealth in the form of Social Security benefits, pension benefits, and the imputed rent from their house; they want cash to cover any large out-of-pocket health care expense; and the product is expensive for the average person because it is priced for the long lived and, being complicated, requires substantial marketing costs. Add to that list people’s concerns about the viability of insurance companies in the wake of the financial crisis, and the outlook for annuities is bleak.
Now some folks are starting to talk about a unique form of annuity – the Advanced Life Deferred Annuity (ALDA) – that might address many of people’s concerns about the traditional product. Next time!