As noted last week, one of the biggest challenges facing participants in 401(k) plans will be figuring out how to draw down their $100,000 balances in retirement. Retirees have to decide how much to take out each year. If they take out too much, they risk running out of money; if they take out too little, they risk not covering basic needs.
These risks could be eliminated through the purchase of annuities. The simplest annuity is the single-life, single-premium immediate annuity, which involves a one-time payment from the individual, and payments to the individual begin immediately. That is, the participant gives the $100,000 to an insurance company, and the insurance company guarantees an income for life. Because of “mortality credits,” that income would be higher than what the typical participant could earn on his own.
But people have little interest in traditional annuities. Economists have created an entire sub-specialty that identifies reasons why people don’t want to buy this product. One prominent explanation is that they are expensive for the average person because they are priced for people who will have long lives (the typical purchaser) and they require lots of marketing costs. But even more fundamental is that people do not want to hand their wealth over to anyone. They like holding a pile of assets, and moreover they may need that pile if they get sick.
In 2005, a Canadian actuarial expert (Moshe Milevsky) suggested an advanced life deferred annuity (ALDA). The original notion was that people would pay premiums over their worklife that would produce a stream of income at, say, 85. Most of the conversation these days assumes a single lump-sum premium payment once the person retires.
So, how would it work? Use the typical annuity as a starting point. According to immediate annuity.com, if an individual purchased a $100,000 annuity at 65, he would immediately begin receiving a stream of annual income of $7,000 for life. But the purchase would leave the individual with no cash on hand for an emergency. With an ALDA, the individual could purchase the $7,000 income stream at 65, with payments beginning at 85. Since the payments would not start until 20 years in the future, the cost is significantly less – roughly $10,000. Thus, the individual would retain $90,000.
Think of all the good things an ALDA does. First, it provides “longevity insurance” so that the individual will not run out of money. Second, it leaves the purchaser with $90,000 to spend between ages 65 and 85. And third, it makes the spending of the $90,000 much simpler, because the individual knows that the ALDA will kick in at 85.
One problem is that existing ALDAs do not adjust for inflation. That failure means that the $7,000 received at age 85 will have lost a lot of its purchasing power. The lack of inflation protection, however, could be easily rectified if consumers had any interest in the product.
It remains to be seen whether the ALDA can overcome people’s aversion to annuities. So far, it has not. But the ALDA seems have caught the attention of the Obama Administration, which is clearing away some of the regulatory underbrush that might slow the product’s progress. That seems like a good first step.