How Best to Annuitize Defined Contribution Assets?

Abstract

Unlike defined benefit pensions that provide participants with steady benefits for as long as they live, 401(k) plans and Individual Retirement Accounts (IRAs) provide little guidance on how to turn accumulated assets into income.  As a result, retirees have to decide how much to withdraw each year and face the risk of either spending too quickly and outliving their resources or spending too conservatively and consuming too little.  Surveys of individuals’ plans and several recent studies suggest that people will not draw down their accumulations for fear that they will exhaust their money and be unable to cover end-of-life health care costs.  They also must consider how to invest their savings after retirement.  These are difficult decisions.

Better strategies are possible that will ensure a higher level of lifetime income, reduce the likelihood that people will outlive their resources, and alleviate some of the anxiety associated with post-retirement investing.  Workers could use a portion of their 401(k) and IRA assets to purchase an immediate annuity that pays a fixed amount throughout their lives, typically starting at age 65.  Or they could purchase an advanced life deferred annuity (ALDA) that requires a smaller share of accumulated assets and begins payments at a later age like 85.  Alternatively, they could use their assets to delay claiming Social Security – essentially purchasing an inflation-indexed annuity.  Right now, none of these three options is commonly used.  Very few workers choose to purchase immediate or deferred annuities (the first two options).  And few retirees appear to be deferring claiming in order to receive the maximum annuity income from Social Security – most people simply retire earlier and claim immediately.

Increasing annuitization in a meaningful way would require embedding annuities in 401(k) plans, with annuitization as the default.  Recent proposed federal legislation, such as the SECURE Act (Setting Every Community Up for Retirement Enhancement), encourages plan sponsors to offer annuities in their plans by establishing a fiduciary safe harbor when specific statutory conditions are followed in selecting an insurance company.  This legislation does not address, however, the question of defaults or the possibility of using 401(k) assets to purchase additional Social Security benefits.   Moving forward on these fronts would require some consensus about the appropriate share of 401(k) assets to be annuitized and the best method for annuitizing them.

To address these issues, this paper compares the level of lifetime utility generated by alternative annuitization approaches – immediate annuities, deferred annuities, and additional Social Security through delayed claiming.  The analysis also tests different assumptions for the share of initial wealth that participants use to purchase these products.