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What Do People Have Against Retirement Income?

Geplaatst op feb 26, 2014 in News

Over the past few years, economists have expended a lot of time and energy attempting to explain what they call “the annuity puzzle.” The puzzle is this: A guaranteed lifetime income is a valuable thing (especially if it comes with regular cost-of-living adjustments), and people who receive one through a traditional state or corporate pension are generally very happy with it. So why is it that those with the self-directed “defined contribution” retirement plans that have become standard in the U.S. — 401(k)s, 403(b)s, IRAs, and the like — so rarely convert the money they’ve saved into pension-like life annuities that guarantee a monthly check until they die?

Part of the explanation is that only 6% of corporate 401(k) plans even offer an annuity option at retirement (you instead have to roll the money over into an IRA and then shop for an annuity). But even among those with traditional defined-benefit pensions that offer a choice between a lifetime income and a lump sum, the majority chooses the lump sum. And new research from economists Daniel G. Goldstein, Hal E. Hershfield, and Shlomo Benartzi seems to indicate that most of these people don’t fully understand the choice they’re making.

As a big fan of the all-annuity Dutch retirement system, generally considered the world’s best, I tend to read such findings and harrumph in dismay. A couple of years ago I was invited to speak about “Investment Advice in a Turbulent Economy” at a college reunion. Everybody else on my panel was a money manager with tips on what to buy; I instead subjected my fellow alumni to a harangue about how ridiculous it was that American retirees had to spend so much time thinking about their investments, and how much better off most people would be with lifetime annuities. I think the audience appreciated that I at least had something different to say, but I could also see eyes glazing over every time I said the word “annuity.”

I don’t really know how to undo the narcotic properties of the letters A-N-N-U-I-T-Y. But rather than launching straight into another harangue, I thought it might be helpful to run the annuity puzzle by someone with a lot of hands-on experience, Harvard Business School senior lecturer Bob Pozen. Over the past four decades, Pozen has seen the U.S. retirement-savings system from the perspective of SEC lawyer, top executive at two giant mutual fund companies, Social Security reform commission member, and not-really-retired retiree. “It is interesting,” Pozen says. “Almost every economist you ever speak to says that’s what you want to do — have your money in a life annuity with survivorship benefits. But no one ever wants to do that.”

This unwillingness isn’t entirely a puzzle, though. Here, with an assist from Pozen, are the main pros and cons of annuitizing retirement income:

The big advantage for the individual is that you don’t run out of money before you die, which lots of Baby Boomers are currently on track to do. The downside is that you’re locked in. If all your money is in a life annuity, you can’t leave any to your grandchildren and you may not have enough cushion to deal with unexpected medical bills. “People want optionality,” Pozen says. Also, there’s always the risk that your annuity provider will fail to pay up — which is mitigated in the U.S. by pension and insurance backstop funds, but certainly isn’t zero. Just ask the current and retired city employees of Detroit.

For society, the attraction of a fully annuitized system is that it’s much cheaper than having every last person save up and manage her retirement money on her own. An individual retirement saver who doesn’t want to risk going broke at age 95 needs to put aside a lot more money than a pension plan or insurance company has to in order to guarantee somebody a lifetime income. That’s because, in a life-annuity system, those who die in their 60s end up subsidizing those who live to 95. It’s sort of the opposite of what happens in health insurance, where the healthy subsidize the sickly. The downside with retirement annuities is distributional — the affluent are healthier and live longer than the poor. Pozen points out that this life-expectancy gap already nullifies much of the progressivity built into Social Security, and will probably grow larger in coming years.

Still, even Pozen thinks the economists are right that Americans ought to be annuitizing more of their retirement savings. One key, he thinks, is making annuitization less of an all-or-nothing choice. This argument is backed up by recent research by economists John Beshears, James J. Choi, David Laibson, Brigitte C. Madrian, and Stephen Zeldes, who found that people are much more amenable to annuitizating part of their retirement savings rather than all of it (something that the IRS is currently proposing to make easier for pension plans to offer). Pozen also suggests that the best kind of annuity for most people might be a deferred one that you buy at age 65 but doesn’t start providing income until age 80. “People usually have a good idea when they retire at 65 what’s going to happen for next 10 or 15 years,” he says. “But they have no idea if you go further out.” A deferred annuity amounts to relatively cheap insurance against what might happen “further out.”

Such products exist — they’re called Advanced Life Deferred Annuities — but I don’t get the sense that they’re common or easy to find or understand. The private annuities market in general is maddeningly complex, and the products that get pushed the hardest by insurers are often a bad deal for consumers. The oft-criticized variable annuities are the worst offenders, but even in fixed annuities the focus all seems to be on products that aren’t indexed for inflation — and thus don’t really insure that you’ll have enough money when you’re 90. Then again, this is partly because the insurance companies are operating at an information disadvantage of their own: The people who buy annuities, especially inflation-linked ones, tend to have good reason to believe that they’re going to live a long time. And those who don’t buy them often have good reason to suspect they won’t be around all that long.

This is what’s called an adverse selection problem, similar to the one that motivated the individual mandate in Obamacare. So does the U.S. need a retirement-annuity mandate? Well, we actually already have a partial one, and it’s called Social Security. This aspect of Social Security has in the past been cause for complaint. “Compulsory purchase of annuities has … imposed large costs for little gain,” economist Milton Friedman argued back in 1962. “It has deprived all of us of control over a sizable fraction of our income, requiring us to devote it to a particular purpose, purchase of a retirement annuity, in a particular way, by buying it from a government concern.” In a world beset by annuity puzzles, though, Social Security’s structure makes a lot more sense. “The most important annuitization we have is Social Security,” Pozen says. “So we ought to make sure we really have it.”

The sustainability of Social Security is a topic for another day. When it comes to annuity puzzles, though, there’s one more factor worth mentioning. In the Palliser novels of Anthony Trollope, which have constituted most of my bedtime reading for the past month, there’s endless discussion of how much money people have. These 19th century fortunes, however, are almost always described in terms of the annual income they produce, not the lump sum.

Hardly anybody talks about investments that way now. Part of it is just that most of us expect to live from our jobs, not the inherited wealth still so crucial in Trollope’s world (and even more so in Jane Austen’s half a century earlier) — so whatever fortune we may have built or inherited isn’t expected to produce income just yet. But I also wonder if asset values have come to play such a big role in modern economic life that we’ve forgotten what those assets are for. In countless ways, financial discourse in the Western world in general and the U.S. in particular has shifted from a focus on income to a focus on assets or net worth. CEOs and financial-sector stars make the vast majority of their money in asset-price-linked jackpots, not annual paychecks. Accounting has moved from a basis in history and income to one in which prices are marked to market. Investors once bought stocks purely for the dividends; now dividends are usually an afterthought, with price appreciation the main goal.

In an apparent attempt to buck that trend, the Labor Department is considering a new rule for providers of 401(k)s, IRAs, and other retirement accounts that would “require a participant’s accrued benefits to be expressed on his pension benefit statement as an estimated lifetime stream of payments, in addition to being presented as an account balance.” A similar bill has been floating around Congress (but not really making any progress) for the past couple of years. It might seem like a petty little requirement. But maybe it’s a petty little requirement we need.

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