MW 401(k) plans lack one benefit that would make a big difference in retirement
By Olivia S. Mitchell
The missing link in most company retirement plans: a monthly paycheck for life
Here's how to help retirees avoid outliving their old-age savings.
While the U.S. retirement system relies on employer-provided 401(k) plans to help most workers save and invest for their golden years, few of these plans help retirees avoid outliving their old-age savings.
The reality is that the only way to do so is to give retirees access to lifetime annuity products, offered by insurance companies providing them with a monthly paycheck for life. Today just one in 10 defined-contribution plan retirees have access to guaranteed monthly income payouts using their retirement-plan assets.
Fortunately, things are starting to change for the better, with several new players joining the pool in the recent past. This trend will help millions of retirees by providing them with a monthly paycheck so they won't run out of money in their later years.
Why the past reluctance?
One reason that few employers included income annuities in their plan menus in the past was the programs' cost and complexity. In fact, a recent study concluded that a majority of employers offering 401(k) plans believed that including annuities in the plan menus was simply too complicated. But this is starting to change quickly, and for the better, in the U.S.
Another factor holding employers back from adding retirement-income annuities was that they feared being held liable if the insurer paying the benefit checks went bust. This doesn't happen often in the U.S., but some of us may recall the 1991 Executive Life Insurance Co. bankruptcy due to the firm's massive losses on junk-bond investments. In that case, state reinsurance agencies did manage to make retirees whole, while other insurers and investors took a hit. Today, state Guaranty Associations promise to pay annuity holders; coverage differs by state, but most guarantee up to $250,000 per contract.
Many people greatly underestimate their longevity.
A third reason payout annuities have taken a while to permeate the retirement marketplace is that many people greatly underestimate their longevity. This means they focus too much on the average life expectancy, or how long people of their age and sex will live on average, rather than their own personal chances of living to a very old age.
My research shows, for instance, that providing people with longevity information can powerfully shape their financial decision-making. Middle-aged and older women, in particular, underestimate their chances of living to 85 or 95, meaning that they are simply unaware of the risk of running out of money in late life.
For those wanting more information on their chance of living to 80, 90 or 100, this actuarial website presents the alternatives in several interesting ways. For instance, for a woman aged 40 and her 44-year-old spouse, both nonsmokers and in average health, the model predicts that each one has almost a 60% chance of living to age 90:
Build it and they will come
When asked, three-quarters of retirement savers reported that they want a guaranteed lifetime income paycheck that continues for as long as they live. Even more impressive is that two-thirds of survey respondents in 2024 were more fearful of running out of money in retirement than dying.
Financial advisers are often unwilling to help their clients protect against longevity risk.
Solving the demand has been complicated by the reality that people seeking to buy a lifetime income paycheck just don't know or where to access such a benefit. This isn't helped by the evidence that financial advisers are often unwilling to help their clients protect against longevity risk. This is because they are conflicted about recommending annuities, since buying them can reduce the agents' fees and commissions.
Fortunately for those seeking longevity protection, Congress recently acted to make lifetime incomes easier for people to access by passing the Setting Every Community Up for Retirement Enhancement (SECURE 2.0) Act. This new law helps by allowing firms to include payout annuities in their defined contribution plan and Individual Retirement Account menus. An important element of the employer's decision process must include an "objective, thorough and analytical" evaluation of the products and the sponsoring insurer's financial stability.
Of course, both retirement-plan sponsors and employees will need further financial education before committing to any specific product. Employers, knowing that many people will underestimate their chances of living a long time, would do well to provide the kind of information that helps employees properly value the longevity risk they face. Understanding how long one might live can greatly reduce the chance of feeling financial regret in later life.
Next steps
A recent survey of retirement-plan sponsors concluded that in-plan annuities were facing a "tipping point," with a majority of employers considering such a change this year. Also encouraging is that many industry partners are flocking to provide the missing retirement paychecks so needed by our rapidly aging population. This will surely assist retirees, particularly the one-third likely to run out of money late in life.
The next key question is "how much" of peoples' retirement nest eggs should be converted into a lifetime paycheck, and whether employers can automatically enroll their retirees into such a product. My research shows that putting just 10% of retirees' 401(k) assets into a deferred lifetime annuity, payable from age 80 onward, is a reasonable and attractive way to enhance retirement security, making most retirees significantly better off. (Note that a retiree with a very low savings balance, under $65,000, is probably better off not annuitizing, as he or she cannot buy a substantial income stream with so little.)
Another advantage of an automatic annuity is that tax rules permit retirees who buy such qualified deferred income contracts (QLACs) to reduce the amount of money they must withdraw from their retirement plans due to required minimum distribution $(RMD)$ regulations.
Giving retirees the chance to buy a lifetime paycheck will benefit millions of American workers, helping protect them from running out of money in their golden years.
Olivia S. Mitchell is a professor of business economics and public policy at the Wharton School of the University of Pennsylvania. An expert in public and private pensions, she is Executive Director of Wharton's Pension Research Council.
More: When is the best time to convert your IRA to a Roth IRA?
Also read: Is your financial adviser on your side? There are new rules for managing retirement savings - why investors should care.
-Olivia S. Mitchell
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May 04, 2024 14:56 ET (18:56 GMT)
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