Accommodating Life Annuities in a Defined Contribution World
Most retirees get a lump sum, not a lifetime annuity, with their 401(k) account. What are some ways employers can give employees more flexibility in how they take out money upon retirement?
The concern is that some retirees will withdraw too much in the early years and need to slash withdrawals later to avoid running out of money. Others might overreact by withdrawing so little that it forces them into a lower standard of living.
When retirees can choose between lump sums and life annuities, typically over 80 percent elect lump sums.
A retiree receiving a lump sum is faced with two unknowns: how long the money will need to last and the investment returns on the remaining assets. These uncertainties may be of little consequence to higher earners who have significant other assets or to lower earners who rely primarily on Social Security benefits to provide retirement income. However, the uncertainties are meaningful for the largest group in the middle who have significant account balances that are needed to supplement Social Security.
Historically, most DC plan sponsors have not offered life annuities because it was the company’s DB plan that addressed lifetime income needs. That excuse is no longer valid where employer-sponsored retirement benefits are provided in a DC plan.
Another roadblock to providing life annuities in a DC plan is that they must be provided through an insurance company rather than directly from plan assets. That means setting up arrangements with insurers and subjecting retirees to retail annuity pricing that reflects insurer conservatism and profit margins.
Based on the experience of DB plans that offer annuities and lump sums, most retirees in DC plans likely would continue to elect lump sums even if annuities were readily available.
Some observers have attributed the tendency to elect lump sums as a lack of employee understanding of the advantages of lifetime income. To address that concern, there have been regulatory and legislative proposals that would encourage or require DC plan sponsors to provide participants estimates of how much annuity could be provided from their account balances.
That is only part of the story. The fact is that a lump sum offers tremendous flexibility to accommodate changing needs in retirement. Life annuities also have a perception problem — if death occurs prematurely, the retiree might view that as causing a loss in value.
Defined contribution plans are touted for their flexibility. Yet, when it comes to payment forms, the only fairly common alternative to a lump sum is paying the account over a fixed period such as five or 10 years. While DB plans offer more payment forms, they usually do not allow participants to take a portion of their benefits in one form and the remainder in another, or to begin a portion of the benefit at retirement and the remainder at some later date. The result of all this inflexibility is that many retiring employees view the lump sum as the only viable choice – the bird in the hand syndrome.
Historically, these restrictions were justified because of the administrative hassle of allowing multiple forms or start dates and because it was thought that few retirees would be interested in such arrangements. Today, there is good reason to believe that both of those factors are no longer present given modern administrative systems and the greater diversity of retiree situations.
A few years ago, the U.S. government recognized the emerging need to encourage lifetime income in IRS regulations that allow DC plans to offer qualified longevity annuity contracts, or QLACs. A retiree could elect a partial lump sum at retirement with the remainder of the account applied to purchase an insured annuity beginning as late as age 85. Because such a “deeply deferred” annuity would be relatively cheap, most of the account would be paid in a lump sum, and such lump sum would only have to last until the annuity starting date.
This is a promising development, although so far not many DC plan sponsors have offered these arrangements. That could change as this line of business becomes more competitive among insurers.
Alternatively, if the sponsor maintains a DB plan, that plan could allow a transfer of some or all the participant’s DC account balance to the DB plan to provide an additional life annuity directly from the DB plan’s assets at more favorable pricing than from insurers. The life annuities could be offered with minimum payment features to address the perception that value would be lost in the event of early death.
For many employees, retirement is no longer a straightforward process of moving from working full-time to retiring overnight. Plan sponsors that recognize the need to provide accessible and affordable life annuities and flexibility in payment forms to accommodate diverse and changing retiree needs will have a leg up.
Larry Sher is a partner at October Three Consulting. Comment below or email firstname.lastname@example.org.