Are you saving enough money for retirement? If you’re like most Americans, the short answer is probably no. A 2017 government report found that the median retirement savings for Americans between ages 55 and 64 was $107,000, which amounts to a monthly payment of about $310. The federal government recently changed the rules to allow deferred longevity income annuities to be included in pension plan menus as a default payout solution. It’s a move designed to provide a lifetime benefit stream of payouts, especially as people are living longer. But is this action beneficial? That’s the focus of new research from Olivia S. Mitchell, a Wharton professor of business economics and public policy, and the executive direction of the Pension Research Council. “Putting the Pension Back in 401(k) Retirement Plans: Optimal versus Default Longevity Income Annuity” is the title of the paper written by Mitchell and co-authors Vanya Horneff and Raimond Maurer, both in the finance department at Goethe University in Frankfurt, Germany. Mitchell joined Knowledge at Wharton to talk about her research. (Listen to the podcast at the top of this page).
An edited transcript of the conversation follows.
Knowledge at Wharton: Can you start by defining an annuity in this context?
Olivia S. Mitchell: In the old days, people who had pension plans tended to have defined benefit plans. In a defined benefit plan, from retirement on, you get a paycheck per month and you never run out, assuming the company that has put together the plan stays in business.
Now, we have 90 million participants with defined contribution plans — 401(k) plans, 403(b) plans. Typically, they have no access to any kind of payout scheme at retirement. Instead, what a lot of advisers will tell people is, “Roll your money out into an IRA account, and then we’ll help you manage it.” But they mostly never come back and say, “We want to help you make sure you won’t run short.”
In 2014, the U.S. Treasury decided to help encourage lifetime income protection. The way they did it was they said, “We will encourage you to take some of your money — not all of it — in your 401(k) plan and put it into a deferred income annuity.” This would be a product where it would pay you lifetime benefits, say, from age 85 on. If you do that — and this is something attractive to people who are in middle and higher tax brackets — that amount of money will not be counted against you when it comes to the required minimum distributions. The IRS forces you take out these so-called RMDs once you’re age 70-1/2. But if you set aside up to a quarter of your money in these deferred annuities, that’s not counted against you. So, it’s a way to both guarantee your longevity protection and reduce taxes.
Knowledge at Wharton: The reputation of annuities has taken a hit because of high fees, and that hasn’t really cleared up as better products have come out. Would you agree?
Mitchell: I think there are a couple of problems with the public’s perception of annuities, and one is that the insurance industry has put a lot of bells and whistles on these products. You can understand why they do. People don’t want to buy a lifetime annuity and then worry about being hit by a bus the moment they leave the insurance office because then they’ll say, “Oh, all my money went for naught.” Of course, that’s the way that insurance is supposed to work. If your house doesn’t burn down, you don’t get any money from the insurance company. You were protected. But I think people don’t really understand insurance, and annuities are a component of that.
The other thing is that people suffer from lump-sum illusion. They think, “Oh, I’m rich. I have $100,000 in my 401(k) account, not realizing that if they were to convert it into a product that would pay you the rest of your life, if you’re male, you’d probably get $6,600 a year. If you’re female, you’d probably get $6,300, because women live longer than men. They see the $100,000 and don’t understand that it really needs to support them for quite a long time in retirement.
Knowledge at Wharton: What were some of the main findings in your paper?
Mitchell: We were interested in trying to think about what an optimal default might be. What we’re looking for is the right sweet spot. How much should employers encourage their retirees to put into these deferred annuities such that it would provide them that longevity protection and make a meaningful difference in old age?
Under these treasury rules, you can defer the annuity at maximum to age 85. That was the first example that we studied in our model. If you did that, what we found is that people would optimally put between 5% and 15% of their nest eggs into these deferred annuities, payable at age 85, and this would improve their well-being by 6% to 14%.
Knowledge at Wharton: How would it improve their well-being?
Mitchell: Because they would be able to consume more in old age by virtue of the fact that they had not run out of money. It’s peace of mind in that if you just draw down your retirement account, say, according to the 4% per year rule of thumb, you could well run out, depending on how long you live and what you invest your money in. Whereas if you put just a small portion of this account in the deferred annuity, then you still have the rest of your money, which you can do with as you deem useful. But you will be protected against longevity risk.
Part of our story also analyzed what would be a nice, middle-ground default number? For example, if all U.S. employers with defined contributions plans defaulted workers into deferred annuities worth about 10% of their retirement account, they would be a lot better off. I’d caveat that with the observation that if someone only has $5,000 in his 401(k) plan, it doesn’t make sense to annuitize because it’s not going to last very long.
What we estimated was that if you had at least $65,000 in your 401(k) plan or more, then all you would need to do is put 10% of that amount into a deferred annuity, and you would be better off by doing so.
Knowledge at Wharton: There have been some other developments in this idea of default and how employers handle retirement funds for their employees, which you say has benefited employees because it’s helping them to make a decision that down the road that they will be glad to have made. Could you explain that whole idea of default?
Mitchell: There has been a large body of research around how to help employees save better for retirement. It’s a behavioral story. Many employers have put in place 401(k) plans but left it up to the worker to decide. Do I want to participate? How much do I want to do? Where do I want to invest it? People get fazed by that big series of complex questions. In fact, my own two daughters recently started working, and they called me up and said, “Mom, how much should I save and where should I put it?”
“I think there are a couple of problems with the public’s perception of annuities, and one is that the insurance industry has put a lot of bells and whistles on these products.”
In the real world, most U.S. employers are now using a default saving rate. They’re also increasingly using auto-escalation. If I default you into your retirement saving plan at 5%, then maybe next year it’ll be 6%, unless you opt out, 7%. Maybe I’ll do it by a percent, and you won’t notice it, and you’ll be saving more for retirement. Our proposal is looking at defaults on the payout side, which nobody has really focused on yet.
Knowledge at Wharton: On that payout side, we’re talking about annuities and rules that have blocked them in the past but are now gone. It’s just that people and maybe some advisers haven’t caught up with that reality.
Mitchell: I think there are two issues. One is that individuals in the population are still often misled or misinformed about annuities. Another key point is that many employers have been reluctant to automatically plug workers into annuity products because they worry about their own fiduciary liability.
For instance, if I pick insurance company X as the annuity provider for you and all my other employees, what happens if the insurance company goes bust? I might worry that I would bear liability downstream. What’s interesting now is that there are two bills before Congress exactly focused on this point, allowing what we call a “safe harbor” set of circumstances. If an employer wants to offer a deferred annuity, then as long as you make sure it’s a well-regarded insurance company with the proper characteristics and so on, that employer would be held harmless for instituting those annuities in the plans. I think it’s probably going to pass.
Knowledge at Wharton: You do an interesting experiment in the paper with two people aged 66, the first having an opportunity to buy deferred longevity income annuities, and the second not. Could you tell us how that turned out?
Mitchell: We build what we call a “dynamic stochastic lifecycle model,” and we show for a series of simulations what would happen to someone who had no protection against longevity shocks versus someone who does have protection. Now, these are complex models because not only do you not know when you’re going to live until, but you also don’t know what your earning stream will look like. It could go up or down. The capital market returns better in some periods than in others. All that is taken into account in this model.
We do the analyses for people with and without access to the annuities. The bottom line is that people with the access to the deferred annuities are substantially better off, especially in the latter part of their lifetime from, say, age 85 or 90 on. Of course, we don’t often want to think about how long we’re going to live, much less think about when we’re going to die. But it’s completely incorrect to just assume you’re going to live your life expectancy. Fifty percent of the people live longer than their life expectancy — it’s a mean. And if you do happen to be around at age 95 or 98 or 100 or 104, you’re going to need something to consume. It’s that protection that’s so valuable.
Knowledge at Wharton: It sounds like it works kind of like Social Security.
Mitchell: Absolutely. Social Security is a lifetime annuity, and that’s one of the beauties of the system. However, it only annuitizes a portion of your retirement income. If you want to be protected against living too long, and your Social Security benefit is $15,000 a year, then you’re probably going to need to have more to live on.
Knowledge at Wharton: How would you sum up the key takeaways from your research?
Mitchell: I think the key takeaways are that longevity protection is extremely important, especially for people who have a lump of money in their 401(k) plans and hope to make it last their lifetimes. They may be able to, they may not.
We’ve talked about the fact that you don’t know how long you’re going to live. There’s also the fact that, increasingly, people at older ages run into financial problems because of cognitive aging, dementia and whatnot. I know in my own case, when my elderly mother hit her 90s, I wished she had a life annuity so that I didn’t have to try to manage her remaining pennies so they didn’t run out. It helps not only the retiring generation but the next generation as well.
Knowledge at Wharton: Was there anything that surprised you, or was this what you expected when you took this project on?
Mitchell: When we started the project, we picked age 85 as the age when your annuity would start. One reason we selected that is that’s what the law allowed. And No. 2, the longer you defer the annuity, the more buildup you have inside the product, so the better annuity you’re going to get when you eventually get there.
But what we found was, when we talked about this idea, a lot of people said, “Oh, I don’t think I’m going to live that long. Why don’t you propose age 80 instead?” It was just a gut-level heuristic. We’ve redone the analysis in a subsequent paper that we’re still finalizing, and it turns out age 80 is about the right age to do it at. That was surprising to us.
Knowledge at Wharton: You also note in the paper that it looks like annuities are ready to grow fast, according to industry projections. Could you talk a little bit about that? Are people catching on to these ideas?
Mitchell: I believe that’s the case, that annuities, especially in the insurance arena, have not been as popular as I think they could be and should be. To the extent that people are not already very annuitized, I think there’s going to be an increasing demand for them.
Let’s take the case of a low-wage worker. Such a worker probably is going to get a replacement rate from Social Security of 60%, 65%. It’s not obvious that you need, on top of Social Security, a whole lot more annuities. But a middle- or higher-wage worker might get 40% or 45%. That’s also the group that has the 401(k) plan, to be quite honest. So, I think that’s the group that (A) should be interested in mortality protection, longevity protection, and (B) that’s the group for whom Social Security is a relatively shorter leg of that three-legged stool. Then (C), of course, they’re going to be paying a lot of tax on it if they take it out according to the Treasury required minimum distribution rule. So, they can save some money as well.
“Many employers have been reluctant to automatically plug workers into annuity products because they worry about their own fiduciary liability.”
Knowledge at Wharton: What haven’t we talked about in regard to this paper that would be interesting for people to know?
Mitchell: One of the things that we did in this paper is to try to look at the relative attractiveness of deferred annuities for people of different educational and sex groups. We know that in the U.S., employers who offer benefit have to offer it non-discriminatorily by sex. You can’t pay a woman less in her pension just because she’s going to live longer on average. We tried to see what would be the differential appeal by different mortality tables by sex.
We also know in the U.S. that people who have less education tend to have shorter life spans. The richness of the paper focuses on, what about someone who only had a high school degree? Those people have higher mortality. Males with high school degrees live less long than average. Would they still benefit from a deferred annuity? What we found was that our rule of thumb about a 10% deferral still is quite attractive a threshold. You can’t go annuitizing people with $5,000.
Knowledge at Wharton: What will you look at next?
Mitchell: We always have a lot of projects that we’re cooking on. One related topic is called the Pan-European Pension Plan (PEPP). It’s a plan that’s being designed by the European Union to permit labor mobility across different countries in the EU. There has been a big obstacle to mobility until now because every country had people contributing to the pensions in those countries. But it wasn’t always easy to port those pension accumulations across nations. The EU is now putting in place something a lot like this. Probably it will have a portion of a deferred annuity included in it. That’s one project that we’re working on.
We also have a different project that’s related to different taxation structures for pensions. During the last budget scenario, the Trump administration at one point suggested “Rothifying” all pensions. What that means in English is that, instead of letting you put your contributions into a pension of a pre-tax basis and then taxing you later, the administration wants to tax your contributions earlier at the upfront point. Then you could take the money out after tax later without paying any more. The advantage from the administration’s point of view is that all the taxes that otherwise would occur in the future get levied right at the beginning. We know the federal government is in terrible arrears, so they need more tax revenue right away.
Knowledge at Wharton: But the federal government would have less revenue at the end.
Mitchell: Correct. The idea of Rothifying all the pension contributions really is kind of a tax gimmick, in the sense that you bring forward in time revenue that the government would have gotten otherwise. But then you get credit today.
There are some real effects, however. That’s really what we’re analyzing: Are people going to save more or less? Are people likely to save in different instruments? For example, if you know that you’re going to pay more tax later, maybe you’re going to invest riskily to take the chance on the upside, but not necessarily be suffering as much on the downside. But these are things that are still very much in progress.