VOL. 21, NO. 4
WINTER 2008
BENEFITS LAW
JOURNAL
From the Editor
Thou Shalt Take an Annuity— Or Are
Retirees Consenting Adults?
W
hat is it about annuities that causes experts to unanimously
agree that just about every retiree should have one, but makes
most people reluctant to sign up? Should the government mandate
such supposedly beneficial payment schemes, or should it treat retirees as responsible adults who can choose for themselves?
The Pension Protection Act of 2006 (PPA) created both incentives
and protections to allow employers to default their workers into saving through a 401(k) plan. The PPA’s success has now led academics, regulators, and politicians to focus on the flip side of retirement
planning—distributions. The evidence is overwhelming that age does
not necessarily bring financial wisdom; rather, many imminent retirees
remain clueless about critical payout issues such as life expectancy,
investment strategy, Social Security, inflation, and compound interest.
Yet a basic grasp of such concepts is necessary to reach the Zen-like
state of spending precisely the right amount of money in each year of
retirement to make it last until you die. Spend too fast, and you end
up relying on Social Security alone; spend too slowly, and you end up
depriving yourself of comforts or even essentials that you could have
afforded after all. Financial experts and economists have concluded
(I believe correctly) that other than the lucky minority of workers
who can count on a sizeable monthly pension, reasonably healthy
retirees should use at least half their 401(k) nest eggs to purchase an
annuity.
Yet as a practical matter, few 401(k) or other defined contribution
(DC) plans even offer annuities as a distribution option. Even when
DC plan participants are allowed to elect an annuity, installments, or
From the Editor
a lump sum, they nearly always grab the cash upfront. Even more
telling, participants in cash balance and other pension plans act similarly when given the option, electing a lump-sum distribution over a
lifetime pension check.
This has led some to predict a doomsday scenario where millions
of Baby Boomers prematurely blow through their 401(k) accounts
and, unable to survive on Social Security alone, overwhelm the US
social welfare system. (For younger readers who are fed up with the
spendthrift Baby Boomer generation and wonder “when will it end,”
check the Web site www.boomerdeathcounter.com for an up-to-theminute estimate of boomer morbidity.)
Many among the pension intelligentsia believe the solution is to
coerce retirees to take an annuity. Among the proposals circulating
through Washington: mandating that DC plans offer an annuity as
a distribution option or, like a pension plan, as the normal form of
payment; defaulting participants into an annuity at retirement; requiring that at least half of DC accounts be used to purchase an annuity;
requiring that new retirees “test drive” annuity-type payments for two
years before they can change to a different form of payment; or giving a tax break for annuity payments and/or penalizing single-sum
retiree distributions.
Slow down, Big Brother. Let’s think this one through.
Clearly, employers prefer not to offer an annuity distribution option
because it is a large pain. It saddles them with fiduciary responsibility
for selecting a provider and the hassles of complying with the Internal
Revenue Code Section 401(a)(11) spousal joint and survivor rules.
The US Department of Labor offered employers some fiduciary relief
in 2007, when it slightly relaxed the rules for selecting an annuity for
a defined contribution plan distribution. Employers still lack, however, a Section 404(c)-like safe harbor to let the participant choose
for him- or herself. Plus, employers know that not offering an annuity
option does not stop a motivated retiree from buying an annuity with
his or her 401(k) account. With a few mouse clicks, it is easy to find
and purchase an annuity from numerous insurance companies via an
individual retirement account (IRA) rollover. For employers, offering
retirees an annuity really has no upside—particularly since there is no
clamor from workers for that payout option.
The real issue is why do annuities remain uniformly unpopular
with retirees despite their obvious benefits. Retirees face four major
financial risks—living too long (mortality), investment (down markets
and/or poor choices), inflation, and unexpected uninsured expenses
(illness, injury, fire, etc.). An annuity neatly takes care of mortality and investment concerns. For a price, some annuities include a
cost-of-living adjustment, making it three for four. Unless a retiree is
independently wealthy or intends to leave a large inheritance, a good
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From the Editor
hedging strategy against financial risk would be to purchase an annuity with roughly half his or her nest egg, keeping the rest liquid to
cover unexpected expenses and/or inflation.
Unfortunately, employees approaching retirement tend to view the
world differently. First, they are apt to worry more about dying too
soon than living too long. That makes them uncomfortable weighing
the prospect of getting a future windfall by beating the actuarial tables
against the possibility that the insurer might end up pocketing their
hard-earned savings if they die prematurely and the annuity ends.
Although term certain and survivor benefit features offer protection
against early death, these features require the retiree to accept significantly lower monthly payments, an equally unpleasant result.
Second, annuities are not cheap. The minority of retirees who
choose to annuitize their 401(k) savings usually believe that they stand
a better than average chance of living beyond their life expectancy.
Insurance companies know this and price their products accordingly,
making annuities expensive, especially for those likely to be on the
“wrong end” of the mortality curve. Add in insurance company administrative costs and profits, and annuities become pricey investments.
Third, most people want to maintain control over their money.
Unlike virtually any other investment choice, an annuity is irreversible—
you can’t cancel because the insurance company’s finances
deteriorate, inflation heats up, or a sudden illness strains your finances.
People have to be very, very confident about turning over 50 percent
or more of their life’s savings. (Although some insurers have engineered products that guarantee a minimum payout while allowing
retirees to cash out and even offer some income appreciation potential, these new products are untested and rather pricey.)
Fourth, annuities are highly complex. The product itself is simple—
a monthly payout for life—and there are several reputable insurance
companies offering a choice of commission and load-free products
with help from the 401(k) plan vendor, a financial planner, or just a
Web-savvy relative. The hard part is evaluating whether a particular
annuity is a reasonable deal. As an experiment, I easily obtained
quotes on annuities from the Web site of a name brand company
famous for low fees and financial soundness. Prices were provided
for immediate single, joint, and survivor annuities, with and without
a cost-of-living adjustment (COLA), for a hypothetical retiree and the
retiree’s spouse, both age 65. I then reviewed the quotes with a very
able pension actuary. Yet even after extensive analysis, we could not
agree which policy, if any, was a good deal. While I leaned towards
a single-life annuity with a COLA, my colleague concluded that the
couple would be best off holding onto their cash. Thus, even with
professional advice, but absent a crystal ball, buying an annuity is a
hard decision to make.
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From the Editor
There also are valid non-financial factors that for some participants
trump the economically wise and prudent decision to purchase an
annuity with part of their 401(k) account. Both a financially unsophisticated retiree going on intuition and a knowledgeable, well-advised
retiree who’s done the math may rationally decide to front-load their
retirement spending. These folks may prefer the certain pleasure of
the additional spending during their earlier (and healthier) retirement
years and willingly accept the risk of penury in their final days, when
their quality of life is likely to be severely compromised anyway.
I consider an annuity to be a generally sensible approach to
managing investment and mortality risks for retirees with significant
accumulations in their 401(k) accounts. But neither I nor anyone
in Washington has a right to make that decision for other people.
Any mandate on employers and/or employees would likely increase
costs, discourage savings, and thwart the wishes of many retirees.
Instead, our newly elected President and Congress should create
effective incentives for employers to offer, and participants to elect,
annuity payouts. They might increase fiduciary protection for offering participants the “wrong” annuity, provide a tax break on annuity
distributions, or find another avenue that would make annuities less
expensive and more user-friendly. It would then be left to retirees to
decide what is in their own best interests.
David E. Morse
Editor-in-Chief
K & L Gates LLP
New York, NY
Reprinted from Benefits Law Journal Winter 2008, Volume 21,
Number 4, pages 1-4, with permission from Aspen Publishers, Inc.,
Wolters Kluwer Law & Business, New York, NY, 1-800-638-8437,
www.aspenpublishers.com
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