Putting the Pension Back in 401(k) Retirement Plans: Optimal Versus Default Longevity Income Annuities

Key Points

  • A recent regulatory change makes it easier for people to use 401(k) and IRA money to buy Longevity Income Annuities (LIAs) that pay out a lifetime benefit starting no later than age 85.
  • The benefits of purchasing an LIA are positive for most people, but differ by sex, education, wealth and life expectancy. The benefit men receive from purchasing an LIA is more than double the benefit for women.
  • In a recent working paper, Wharton faculty member, Olivia Mitchell, and coauthors argue that using about 10% of 401(k) and IRA savings above a threshold to purchase LIAs would enhance wellbeing.

Putting the Pension Back in 401(k) Retirement Plans: Optimal Versus Default Longevity Income Annuities

Putting the Pension Back in 401(k) Plans: Optimal Versus Default Longevity Income Annuities studies the possible impact of a recent regulatory change that makes it easier for Americans to buy Longevity Income Annuities (LIA) with their retirement savings. Vanya Horneff, Raimond Maurer, and Olivia S. Mitchell (2017) examine who benefits the most from LIAs and if it would be beneficial for a portion of 401(k) plan and IRA assets to be automatically used to purchase an LIA.

Saving for Retirement

Researchers at the Federal Reserve estimate that between 60 and 70 percent of American families hold retirement savings. As of March 31, 2017, these assets totaled around $26 trillion. Almost 41 percent of that amount is held in traditional pension plans or annuities that pay a guaranteed benefit for life starting at retirement.

However, a growing portion is held in 401(k) plans and IRAs, which typically do not feature guaranteed benefits. More than 70 million Baby Boomers—people currently between the ages of 53 and 71—therefore must decide how to access retirement resources. If they have not saved enough or if they spend assets too quickly during retirement, they risk running out of money.

What if You Live Longer Than You Expected?

In 2014, the United States Treasury changed regulations to make it easier for employers and workers to purchase longevity income annuities (LIAs) while remaining in a 401(k) or IRA. The new regulation allows workers to use up to 25% of a 401(k) or IRA to purchase an LIA.

Longevity income annuities can help families insure against the risk of outliving their assets. LIAs are purchased at retirement. Unlike traditional annuities, though, these payments do not start right away. Instead, payments start no later than age 85 and continue for life. Because payments start when people are older, an LIA is cheaper to fund than the same monthly benefit from an annuity that starts at a younger age. The Social Security Administration reports that a man who is 65 today can expect to live to age 84.3, while a woman can expect to live to age 86.6. Essentially, LIAs are insurance against living longer than expected and, therefore, provide valuable longevity finance protection.

Who Benefits from LIAs?

Purchasing a longevity income annuity, though, may benefit some types of workers more than others. Workers with low lifetime earnings and expecting fewer years in retirement receive less benefit from LIAs, compared relative to other workers.

Figure 1 shows the benefits of LIAs by gender and education levels. Horneff et al., find that college-educated males have the highest potential welfare gains from investing in LIAs. For instance, a man with some college experience gains the most, generating $20,118 (250%) more in welfare gains than a college-educated woman. For people in the same education group, a man’s welfare gain from LIAs is often more than double that of a woman’s. However, unisex pricing would enhance the appeal of LIAs to female retirees.

Figure 1: Welfare Gains at Age 66 with Access to Default Longevity Income Annuity (LIA)

Note: Expected values in $2013 based on 100,000 simulated life cycles. Welfare gain ($) refers to the retiree’s additional utility value from having access to the LIA versus no access at age 66. In this fixed fraction plus threshold default approach, 10% of retirement plan assets are converted into a longevity income annuity at 65 payable at age 85. This occurs only when a worker’s 401(k) account equals or exceeds the $65,000 threshold. Source: Horneff, Maurer, and Mitchell (2017)

LIAs Allow People to Consume More, Raising Their Quality of Life

Nonetheless, Figure 2 indicates that almost all owners of longevity income annuities could consume more with the same retirement savings, particularly at older ages. Horneff et al. (2017), estimate that people with the LIA can consume at roughly the same level annually prior to age 85, compared to people without the LIA. And at age 85, people with LIAs can consume about $1,000 more per year on average. That is shown in Figure 2, where darker areas indicate more probable outcomes. Notice that all do not benefit at exactly the same age, as indicated by the “fanning out” of the diagram. For example, at age 99, LIA-holders at the 25th percentile could consume $98 more a year, while the 75th percentile could spend $9,680 more per year.

Figure 2: Consumption Differences Over the Life Cycle With Versus Without Access to the Longevity Income Annuity (LIA)

Note: Distribution (99%; 1%) of consumption differences for 100,000 life-cycles with and without access to longevity income annuities starting benefits at age 85. Darker areas represent higher probability mass. The solid line represents expected consumption differences. Distribution shown for base case (college-educated female). Source: Horneff, Maurer, and Mitchell (2017)

Impact of Automatic Purchase

The study also examined the impact of using a portion of 401(k) funds to automatically purchase a longevity income annuity around retirement age. The authors showed that even lower-paid workers with lower-than-average life expectancies can be better off if they annuitize some fraction of their accounts—say 10%—over a relatively low threshold of about $65,000. People can consume the remainder, or leave some savings to heirs or charitable organizations.

Conclusion

Vanya Horneff, Raimond Maurer, and Olivia S. Mitchell investigate the U.S. Treasury’s new regulation that makes it easier to purchase longevity annuities as a retirement benefit option in 401(k) plans and IRAs. The authors show that LIAs could increase retirement consumption for most people with at least $65,000 in savings at retirement. LIA’s benefit the better educated more, and men more than women—though unisex pricing enhances their appeal to female retirees.