Automatic Lifetime Income as a Path to Retirement Income Security

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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_at_illinois.edu

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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

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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

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Objectives of Auto Annuity Program

1. Make annuities available to DC plan participants
2. Change the conversation
3. Preserve individual choice
4. Keep it simple, while encouraging innovation
5. Avoid irreversible participant mistakes
6. Minimize the burden for plan sponsors

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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

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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

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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.

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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

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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

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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.

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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.

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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

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Some Questions and Answers

• Question Why do we need policy intervention?
• Answer We are stuck in a bad equilibrium.
  Plan sponsors wont 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 dont have a reason to educate
  themselves about it.

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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.

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Some Questions and Answers

• Question Isnt 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.

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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.

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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.

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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.

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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.

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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.

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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.

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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 participants 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.

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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.

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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.

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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.

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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