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Automatic Lifetime Income as a Path to Retirement Income Security

Automatic Lifetime Income as a Path to Retirement Income Security. Jeffrey R. Brown William G. Karnes Professor of Finance and Director, Center for Business and Public Policy University of Illinois at Urbana-Champaign Associate Director, Retirement Research Center and Research Associate

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Automatic Lifetime Income as a Path to Retirement Income Security

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  1. Automatic Lifetime Income as a Path to Retirement Income Security Jeffrey R. Brown William G. Karnes Professor of Finance and Director, Center for Business and Public Policy University of Illinois at Urbana-Champaign Associate Director, Retirement Research Center and Research Associate National Bureau of Economic Research brownjr@illinois.edu

  2. Retirement Income Security as a Goal • The DC / 401(k) system has systematically emphasized wealth accumulation • Having tools to convert wealth into guaranteed lifelong income is equally important for retirement income security • Large economics literature on the benefits of annuities • Unfortunately, annuities have been largely ignored in plan design: only one in five 401(k) plans offer annuities • This paper argues that it is time to encourage income security via “auto annuitization”

  3. The Proposal • Congress should encourage plan sponsors to use life annuities as the default distribution option • Issues that I will address today: • What are the objectives of an auto-annuitization program? • How might public policy encourage this outcome? • How would auto-annuitization work? • Note: In addition to providing more detail on these questions, the paper discusses why such a policy is needed, reviews the literature on defaults and annuitization, and answers a number of more specific design questions

  4. Objectives of Auto Annuity Program • Make annuities available to DC plan participants • “Change the conversation” • Preserve individual choice • Keep it simple, while encouraging innovation • Avoid irreversible participant mistakes • Minimize the burden for plan sponsors

  5. Suggested Policymaker Actions • Provide default annuity fiduciary relief • Plan sponsors who adopt auto-annuitization should receive fiduciary relief similar to that offered under QDIA rules • With sufficient notice and effective opportunity to elect otherwise, the participant – and not the plan sponsor – would be deemed to have selected the annuity • Illustrate DC benefits as annuity payments • Research has found that consumers find annuities more attractive when presented in a “consumption” frame rather than in an “investment” frame • Content requirements under ERISA quarterly benefit statement rules should be expanded to include an illustration of monthly income • Provide QJSA administration relief • These rules add complexity and liabilities to plan sponsors that are most easily avoided by excluding annuities • Change 1: Modify ERISA to allow plan sponsors to shift QJSA administration and liabilities to an annuity administrator • Change 2: Modify ERISA to permit greater use of electronic means of administering the QJSA rules

  6. How Design the Auto Annuity Plan? • Triggered upon request by employee for non-hardship withdrawal • At time of request, the account is divided 50/50 into: • “Cash Account” and • “Annuity Account” • Annuity account (if not already in annuitized form) would be converted to an annuity, including: • Immediate life annuity, OR • At least 20% of the annuity account used to purchase the first of five “laddered annuities” over 5 years

  7. How Design the Auto Annuity Plan? • If more than 25% of annuity account (1/8 of total DC balance) is annuitized in any 6-month period, then the annuity contract would be subject to a “trial period” of 3 to 24 months. • During this period, annuitant may seek a refund of the premium minus the value of payments already received. • Note: The auto annuity program proposed by the Retirement Security Project (Gale, et al) would qualify • The participant must be able to opt out of the default. In the case of a married participant, the spouse must provide consent.

  8. How Design the Auto Annuity Plan? • The default annuity must be joint-and-full survivor for married couples, or single life annuity for single individuals. No credit given for non-life-contingent features (e.g., period certain, refund options, etc.) • The default annuity must be escalating at rate of 2-5% annually, OR indexed for inflation • Plan sponsors would be permitted to impose a minimum “annuity account” size of no greater than $20,000

  9. How Design the Auto Annuity Plan? • Credit for “in-plan” annuities: • For plans that enter participants into deferred annuity contracts during the accumulation phase, the actuarial value of the life-contingent portion would “count” toward the minimum annuitization requirement • Meant to include / encourage a number of innovative approaches for incorporating income into the accumulation phase, for example: • Lifecycle funds that gradually convert into annuities • Plans that place employer match into annuity contracts • Deferred life annuity contracts as an alternative to fixed income investment options

  10. Example 1 • Gale, Iwry, John and Walker (2008) • Individuals defaulted into 2-year “trial income product.” • Unless individual opts out, she would receive 24 months of payment. • At end of the trial, the individual can then choose alternative distribution option or be defaulted into permanent annuitization.

  11. Example 2 • Laddered annuitization • Convert 1/5 of “annuity account” (1/10 of total account) into immediate annuity. • On each of 4 subsequent anniversary date, an additional 1/n of the account would be annuitized (where n = 5 minus number of contracts already purchased). • Individual can opt out at any time.

  12. Example 3 • In-plan annuity examples • Using deferred life annuities as an alternative to fixed income vehicles • Directing employer match into deferred payout annuities • Investment allocation gradually phased into annuities as one approaches retirement • Many, many other approaches

  13. Some Questions and Answers … Question: Why do we need policy intervention? Answer: We are stuck in a “bad equilibrium.” Plan sponsors won’t do it voluntarily because (i) it exposes them to fiduciary risk, and (ii) employees are not asking for it. Employees are not asking for it, in part, because (i) the DC plan “culture” does not emphasize it, and (ii) the lack of an annuity option means they don’t have a reason to educate themselves about it.

  14. Some Questions and Answers … Question: Why not make it part of plan qualification requirements? Answer: Ultimately, this may be desirable. But – so far –we have limited experience and limited empirical evidence to be fully confident of the effect of these provisions on plan sponsor and participant behavior. Encouraging plan sponsors to do it voluntarily will provide experience, data and knowledge.

  15. Some Questions and Answers … Question: Isn’t Social Security enough? Answer: While SS replacement rates average around 42%, they are higher for lower income HHs, and for these HHs, some researchers have suggested that SS may be sufficient. But for most HHs, Social Security is not adequate to maintain pre-retirement income levels.

  16. Some Questions and Answers … Question: Why Would the Default Apply to Only Half of the Account? Answer: Retirees face a mix of risks – some (e.g., longevity risk) best addressed by guaranteed income, while others (e.g., unexpected one-time expenses) are better addressed by a buffer stock of financial wealth. Our models are not sufficiently well developed to precisely estimate the optimal % annuitized, especially given heterogeneity of preferences, non-DC wealth, etc.

  17. Some Questions and Answers … Question: Why a Joint and Full Survivor Annuity? Answer: Cost of maintaining living standard for survivor is less than for couple. But many widows suffer significant drops upon death of spouse. Note that 100% of “annuity account” = 50% of total DC balance, and it is this roughly akin to 50% QJSA rule for DB plans.

  18. Some Questions and Answers … Question: Why an Escalating or Indexed Annuity? Answer: It is important to have adequate income at advanced ages. For someone retiring at 65, an annual average inflation rate of 3% will cut their real income in half by age 89.

  19. Some Questions and Answers … Question: Is the Opt-out Requirement Unduly Burdensome? Answer: Allow it to be done electronically. Some evidence suggests even current approach is not unduly burdensome: in a study by Mottola & Utkus (2007) of two large DB plans, 75% of married annuitants were able to opt-out of annuity.

  20. Some Questions and Answers … Question: How Should Small Accounts be Treated? Answer: If small account means limited resources, annuitization may be even more important! However, due to fixed costs of administering annuity contracts, most providers require minimum initial premium. This proposal suggests $20,000 in the annuity account as a reasonable cut-off.

  21. Some Questions and Answers … Question: How Should In-Plan Annuity Options be Treated? Answer: the actuarial value of any future annuity stream should be treated as if it is part of the “annuity account.” In essence, the life contingent portion of any such in-plan options will “count.”

  22. Some Questions and Answers … Question: When Should the Default Begin? Answer: Given heterogeneity of participants, the most sensible approach is to trigger this upon the participant’s first request. In practice, this will be after age 59½ or after separation from service if the separation occurs during/after calendar year in which employee reaches age 55. It will need to be integrated with required minimum distribution (RMD) rules.

  23. Some Questions and Answers … Question: Why Not IRAs? Answer: The rationale clearly extends to IRAs. But given the important role played by employers in plan design, it makes sense to start with employer sponsored plans. Because the auto-annuity is a default, and not a requirement, it is unlikely that individuals will roll into an IRA simply to avoid a default option.

  24. Some Questions and Answers … Question: Why is there a Trial Period for Some, But Not All, Options? Answer: Gale et al (2008) discuss rationale for trial period. This is desirable when a significant portion of the account is annuitized at once. With “laddered” annuitization, no more than 1/8 of the total account balance will be “irreversibly” annuitized.

  25. Some Questions and Answers … Question: What about Counter-Party Risk? Answer: Others have suggested PBGC-like backstop. I would prefer to limit risk through effective risk management, reinsurance, risk securitization, and possibly multi-provider solutions.

  26. Summary • Annuitization is a key component of retirement income security • Policy intervention is needed to encourage plan sponsors to provide it as an option • Defaults and “auto” options have proven effective in other aspects of retirement planning process, and they are likely to work here as well

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