How Should We Insure Longevity Risk in Pensions and Social Security?

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As baby boomers approach retirement, individuals and policymakers are increasingly concerned about retirement income security. Thanks to dramatic advances in life expectancy over the last century, today’s typical 65–year old man and woman can expect, on average, to live to ages 81 and 85 respectively. Perhaps even more impressive, over 17 percent of 65–year old men and over 31 percent of 65–year old women are expected to live to age 90 or beyond. Most people would agree with President Clinton that increasing life expectancy is "something wonderful." However, uncertainty about length of life carries the risk that individuals may outlive their resources and be forced to substantially reduce their living standards at advanced ages.

Fortunately, financial products exist that allow individuals to protect themselves from this risk. In particular, a life annuity is an insurance product that pays out a periodic (e.g., monthly) sum of income that lasts for life, in exchange for an up–front premium charge. The primary appeal of the life annuity is that it offers retirees the opportunity to insure against the risk of outliving their assets by exchanging these assets for a lifelong stream of guaranteed income.

In the United States, the two primary sources of life annuities for most retirees are the Social Security system and employer–provided, defined benefit (DB) pension plans. The first and most important of these, the Social Security system, is facing significant future imbalances that have led to numerous proposals for reform, including supplementing or partially replacing the existing system with an individual accounts program. The second of these sources, employer–provided pensions, is undergoing a dramatic shift towards defined contribution (DC) plans, in which over 70 percent of participants are not even offered a life annuity as a payout option. As the U.S. retirement landscape shifts to one that places more emphasis on self–directed accounts, it is important to consider the impact of these changes on retirees’ ability to adequately protect against the risk of outliving their resources.