Optimal Distribution Rules for Defined Contribution Plans: What Can the United States
Learn from Other Countries?
Jonathan Barry Forman*
I.
Introduction
The United States and most other industrialized nations have multi-pillar retirement
systems that include a public component and a private component. Increasingly, the private
component is an employer-provided defined contribution plan or other privately-managed
individual retirement savings account. In order to get adequate retirement income from these
defined contribution plans, employees need to ensure that significant contributions are made to
these plans (the contribution phase), that those contributions are invested well and retained until
retirement (the accumulation phase), and that the accumulated retirement savings are used to
*
Copyright 2012, Jonathan Barry Forman. Alfred P. Murrah Professor of Law, University of
Oklahoma; B.A. 1973, Northwestern University; M.A. (Psychology) 1975, University of Iowa;
J.D. 1978, University of Michigan; M.A. (Economics) 1983, George Washington University.
This paper is based on a presentation for a conference on “Employee Benefits in an Era of
Retrenchment” sponsored by Washington University School of Law and the Center for the
Interdisciplinary Study of Work and Social Capital, St. Louis, Missouri, March 29, 2012, and a
longer version appears as Jonathan Barry Forman, Optimal Distribution Rules for Defined
Contribution Plans: What Can the United States and Australia Learn from Other Countries?,
2012 N.Y.U. REV. OF EMP. BENEFITS & EXECUTIVE COMPENSATION 3-1.
1
provide benefits throughout retirement (the distribution phase).
This article focuses on the rules governing the distribution phase. Part II of the article
discusses the current rules governing benefit distributions from defined contribution plans in the
United States and other countries. Part III explains the various types of financial products that
can be used to provide defined contribution plan participants with lifetime retirement income.
Finally, Part IV of the article considers how distribution rules and regulations can be used to
encourage retirees to take their defined contribution plan distributions in the form of annuities or
other lifetime income products.
II.
A Defined Contribution World
The United States and most other industrialized nations have multi-pillar retirement
systems that can be categorized within the World Bank’s multi-pillar model for retirement
savings, consisting of (1) a government pension, (2) an occupational pension, and (3) personal
savings.1 Increasingly, the second and third tier components take the form of defined
contribution (DC) plans, Individual Retirement Accounts (IRAs), and similar types of individual
1
WORLD BANK, AVERTING THE OLD AGE CRISIS: POLICIES TO PROTECT THE OLD AND PROMOTE
GROWTH xiv (1994); see also ROBERT HOLZMANN & RICHARD HINZ, OLD-AGE INCOME SUPPORT
IN THE 21ST CENTURY: AN INTERNATIONAL PERSPECTIVE ON PENSION SYSTEMS AND REFORM
2
(2005) (suggesting an additional pillar for informal intrafamily or intergenerational sources of
both financial and nonfinancial support to the elderly, including access to health care and
housing).
2
retirement savings accounts. Under a typical defined contribution plan, the employer contributes
a specified percentage of the worker’s compensation to an individual investment account for the
worker. For example, contributions might be set at 10% of annual compensation. Under such a
plan, a worker who earned $30,000 in a given year would have $3,000 contributed to the
worker’s individual investment account ($3,000 = 10% × $30,000). The benefit at retirement
would be based on all such contributions plus investment earnings.
Defined contribution plans are also known as “individual account” plans because each
worker has his or her own account, as opposed to the more traditional defined benefit pension
plans which pool plan assets for the benefit of all employees.2 Another key difference is that at
2
For a defined benefit plan, an employer promises its employees a definite benefit at retirement.
To provide that benefit, the employer typically makes payments into a trust fund, contributed
funds grow with investment returns, and eventually the employer withdraws funds from the trust
fund to pay the promised benefits. JONATHAN BARRY FORMAN, MAKING AMERICA WORK 215
(2006). For example, a plan may provide that a worker’s annual retirement benefit (B) is equal
to 2%, multiplied by the worker’s number of years of service (yos) and the worker’s final average
compensation (fac) (B = 2% × yos × fac). Under this final-average-pay formula, a worker with
thirty years of service would receive a retirement benefit equal to 60% of his or her preretirement earnings (B = 60% × fac = 2% × 30 yos × fac). Final average compensation is
usually computed by averaging the worker’s salary over the last three or five years prior to
retirement.
3
retirement, typical defined contribution plans distribute benefits in the form of lump sum cash
distributions, while traditional defined benefit pension plans are designed to pay monthly pension
benefits from retirement until death.3
A.
Defined Contribution Plans in the United States
The United States has a “voluntary” pension system.4 That is, employers are not required
to provide pensions to employees. However, when employers do provide pensions, those
pensions are typically subject to regulation under the Employee Retirement Income Security Act
of 1974.5
Most pension plans qualify for favorable tax treatment. Basically, an employer’s
contributions to a tax-qualified retirement plan on behalf of an employee are not taxable to the
employee.6 Moreover, the pension fund’s earnings on those contributions are tax-exempt.7
3
In the United States for example, defined benefit plans are generally designed to provide
annuities that are “definitely determinable benefits . . . over a period of years, usually for life
after retirement.” 26 C.F.R. § 1.401-1(b)(1)(i) (2006).
4
FORMAN, supra note 2, at 214; Kathryn L. Moore, An Overview of the U.S. Retirement Income
Security System and the Principles and Values It Reflects, 33 COMP. LAB. L. & POL’Y J. 5, 17
(2011).
5
Employee Retirement Income Security Act of 1974, Pub. L. No. 93-406, 88 Stat. 829.
6
I.R.C. § 402 (2006).
7
I.R.C. § 501(a) (2006).
4
Workers pay tax only when they receive distributions of their pension benefits, and at that point,
the usual rules for taxing annuities apply.8 Also, employers typically get to deduct their
contributions.9
There are a variety of defined contribution plans, including money purchase pension
plans, target benefit plans, profit-sharing plans, stock bonus plans, and employee stock
8
I.R.C. §§ 72, 402 (2006). An individual receiving benefits under an annuity or pension usually
excludes a fraction of those benefits from income. That fraction (the “exclusion ratio”) is based
on the amount of premiums or other after-tax contributions made by the individual. The
exclusion ratio enables the individual to recover his or her own after-tax contributions tax free
and to pay tax only on the remaining portion of benefits which represents income.
9
I.R.C. § 404 (2006); Jonathan Barry Forman, The Tax Treatment of Public and Private Pension
Plans Around the World, 14 AM. J. OF TAX POL’Y 299 (1997). This exempt-exempt-taxable
approach is followed by many of the world’s pensions. See, e.g., ORG. FOR ECON. COOPERATION
& DEV., PENSIONS AT A GLANCE 2011: RETIREMENT-INCOME SYSTEMS IN OECD AND G20
COUNTRIES 58, 122–23 (2011); KWANG-YEOL YOO & ALAIN DE SERRES, TAX TREATMENT OF
PRIVATE PENSION SAVINGS IN OECD COUNTRIES 76 (Org. for Econ. Cooperation & Dev. ed.,
2005). Also of note, since 2002 in the U.S., certain low and moderate income individuals have
been able to claim a tax credit of up to $1,000 for certain qualified retirement savings
contributions. I.R.C. § 25B (2006); LISA SOUTHWORTH & JOHN GIST, AARP PUB. POLICY INST.,
THE SAVER’S CREDIT: WHAT DOES IT DO FOR SAVING? (2008).
5
ownership plans (ESOPs).10 Of particular note, profit-sharing and stock bonus plans often
include a feature that allows workers to choose between receiving cash currently or deferring
taxation by placing the money in a retirement account according to Internal Revenue Code
section 401(k). Consequently, these plans are often called “401(k) plans,” and they are the most
popular type of retirement plan in the United States.11 The maximum annual amount of such
elective deferrals that can be made by an individual in 2013 is $17,500, although workers over
the age of fifty can contribute another $5,500, for a total of up to $23,000.12
Favorable tax rules are also available for certain IRAs.13 Almost any worker can set up an
IRA with a bank or other financial institution. In 2012, individuals without pension plans can
contribute and deduct up to $5,000 to an IRA, although individuals over age fifty can contribute
and deduct another $1,000, for a total of up to $6,000, and spouses can contribute and deduct
10
See, e.g., Six Ways to Save for Retirement, 3 BUREAU OF LAB. STAT. PROGRAM PERSP., no. 3,
2011, at 1, 2.
11
See, e.g., BLS Examines Popular 401(k) Retirement Plans, 2 BUREAU OF LAB. STAT. PROGRAM
PERSP., no. 6, 2010, at 1.
12
IRS Announces 2013 Pension Plan Limitations: Taxpayers May Contribute up to $17,500 to
their 401(k) plans in 2013, INTERNAL REVENUE SERVICE (Oct. 18, 2012), available at
http://www.irs.gov/pub/irs-news/IR-12-077.pdf.
13
I.R.C. § 219 (2006).
6
similar amounts.14 If a worker is covered by another retirement plan, however, the deduction
may be reduced or eliminated if the worker’s income exceeds $58,000 for a single individual or
$92,000 for a married couple.15 Like private pensions, IRA earnings are tax-exempt, and
distributions are taxable.
Also, since 1998, individuals have been permitted to create Roth IRAs.16 Unlike regular
IRAs, contributions to Roth IRAs are not deductible. Instead, withdrawals are tax-free. Like
regular IRAs, Roth IRA earnings are tax-exempt. And since 2006, employers have been
permitted to establish Roth 401(k) plans that operate in a similar fashion.17
B.
The Dominance of Defined Contribution Plans
In recent years, defined contribution plans have come to dominate the pension landscape.
For example, 50% of full-time private industry workers in the United States participated in
defined contribution plans in 2011, up from 40% in 1989–90; meanwhile, participation in
14
Retirement Topics—IRA Contribution Limits, INTERNAL REVENUE SERVICE (Aug. 3, 2012),
available at http://www.irs.gov/retirement/participant/article/0,,id=211358,00.html.
15
Internal Revenue Service, supra note 12.
16
I.R.C. § 408A (2006).
17
I.R.C. § 402A (2006).
7
defined benefit plans fell from 42% in 1989–90 to just 22% in 2011.18 In the aggregate, defined
contribution plans held 57% of pension assets in the United States in 2011, up from 52% in
2001.19 Similarly, 81% of pension assets in Australia were held by defined contribution plans
(the same percentage as in 2001), 60% in Switzerland (up from 49% in 2001), and 39% in the
United Kingdom (up from just 8% in 2001). All in all, the era of the traditional defined benefit
pension plan is largely behind us,20 but the relatively low savings rates in our new “defined
contribution world” have led many analysts to wonder if future retirees will have adequate
retirement incomes.21
C.
18
The Decline of Annuitization
William J. Wiatrowski, Changing Landscape of Employment-Based Retirement Benefits,
BUREAU OF LAB. STAT. (Sept. 29, 2011), available at
http://www.bls.gov/opub/cwc/cm20110927ar01p1.htm.
19
TOWERS WATSON, GLOBAL PENSION ASSET STUDY 2012 8, 34-36 (Jan. 2012), available at
http://www.towerswatson.com/assets/pdf/6267/Global-Pensions-Asset-Study-2012.pdf.
20
EDWARD A. ZELINSKY, THE ORIGINS OF THE OWNERSHIP SOCIETY: HOW THE DEFINED
CONTRIBUTION PARADIGM CHANGED AMERICA (2004); Edward A. Zelinsky, The Defined
Contribution Paradigm, 114 YALE L. J. 451 (2004).
21
See, e.g., Jack VanDerhei, The Importance of Defined Benefit Plans for Retirement Income
Adequacy, EMP. BENEFIT RES. INST. NOTES, Aug. 2011, at 7; Steven Greenhouse, After the Storm,
the Little Nest Eggs that Couldn’t, N.Y. TIMES, Mar. 7, 2012, at F1.
8
The United States has a well-developed annuity market.22 Nevertheless, over the years,
there has been a significant decline in annuitization of retirement savings by American workers.
The shift to defined contribution plans is a large part of the story, because defined contribution
plans typically distribute benefits in the form of lump sum distributions rather than as annuities.23
Indeed, relatively few defined contribution plans even offer annuity options, and relatively few
participants elect annuity options.24 All in all, people rarely choose to buy annuities voluntarily,
even though purchasing annuities could rationally help maximize their expected retirement
22
Anthony Webb, The United States Longevity Insurance Market, in SECURING LIFELONG
RETIREMENT INCOME: GLOBAL ANNUITY MARKETS AND POLICY 63 (Olivia S. Mitchell, John
Piggott & Noriyuki Takayama eds., 2011).
23
TOWERS WATSON, INTERNATIONAL PENSION PLAN SURVEY: REPORT 2011 1–5 (2011),
available at http://www.towerswatson.com/assets/pdf/6036/TW-EU-2011-22755-IPP-survey.pdf.
An annuity is a financial instrument (e.g., an insurance contract) that converts a lump sum of
money into a stream of income payable over a period of years, typically for life. The person
holding an annuity is called an annuitant.
24
See BUREAU OF LABOR STATISTICS, U.S. DEP’T OF LABOR, NATIONAL COMPENSATION SURVEY:
HEALTH AND RETIREMENT PLAN PROVISIONS IN PRIVATE INDUSTRY IN THE UNITED STATES, 2010
(2011); BEVERLY J. ORTH, APPROACHES FOR PROMOTING VOLUNTARY ANNUITIZATION (2008)
(presented at the 2008 Retirement 20/20 Conference, Society of Actuaries in Washington, D.C.,
November 17-18, 2008).
9
incomes.25
Of note, the Internal Revenue Service and the U.S. Department of Labor recently
mounted a joint effort to improve lifetime income options for retirement plans.26 The U.S.
Treasury and the Internal Revenue Service also recently released a package of proposed
regulations and rulings intended to make it easier for plans to offer partial annuities and longevity
insurance to retirees.27
D.
Defined Contribution Plans in Other Countries
As in the United States, the level of voluntary annuitization is generally low around the
world.28 In Australia, for example, just seventeen life annuity policies were sold in 2009.29 In
25
See Shlomo Benartzi, Alessandro Previtero & Richard H. Thaler, Annuitization Puzzles, 25 J.
ECON. PERSP. 143 (2011).
26
Joint Hearing on Lifetime Income Options Before the U.S. Dep’t of Labor & U.S. Dep’t of the
Treasury (Sept. 14-15, 2010).
27
U.S. DEP’T OF THE TREASURY, TREASURY FACT SHEET: HELPING AMERICAN FAMILIES ACHIEVE
RETIREMENT SECURITY BY EXPANDING LIFETIME INCOME CHOICES (2012), available at
http://www.treasury.gov/press-center/pressreleases/Documents/020212%20Retirement%20Security%20Factsheet.pdf.
28
Olivia S. Mitchell & John Piggott, Turning Wealth into Lifetime Income: The Challenge
Ahead, in SECURING LIFELONG RETIREMENT INCOME, supra note 22, at 1, 3.
10
Sweden, the development of the annuity markets has been held back by public pensions and by
traditional occupational pensions.30 In Germany, annuity markets are well-developed but
underutilized.31 For tax reasons, annuities are unattractive in Japan,32 and in India, government
policy on life annuities is underdeveloped.33
However, there are a few countries that have significantly higher levels of annuitization.
For example, approximately two-thirds of all participants in Chile’s national defined contribution
29
Hazel Bateman & John Piggott, Too Much Risk to Insure? The Australian (non-) Market for
Annuities, in SECURING LIFELONG RETIREMENT INCOME, supra note 22, at 96 tbl. 6.5; see also
Jack Jie Ding, Annuitization with Phased Consumption Requirements: Who, When and How
Much (Macquarie Univ. Dep’t. of Econ., Working Paper, Dec. 3, 2011), available at
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2014453.
30
Edward Palmer & Bo Larsson, The Swedish Annuity Market: Where it is and Where it’s
Headed, in SECURING LIFELONG RETIREMENT INCOME, supra note 22, at 13, 15, 27.
31
Barbara Kaschützke & Raimond Maurer, The Private Life Annuity Market in Germany:
Products and Money’s Worth Ratios, in SECURING LIFELONG RETIREMENT INCOME, supra note
22, at 131.
32
Junichi Sakamoto, Annuity Markets in Japan, in SECURING LIFELONG RETIREMENT INCOME,
supra note 22, at 159.
33
Mukul G. Asher & Deepa Vasudevan, Market Structure and Challenges for Annuities in India,
in SECURING LIFELONG RETIREMENT INCOME, supra note 22, at 32.
11
system purchase annuities.34 Chile has achieved this high rate of annuitization largely by
restricting the options for retirement distributions. The main options are a phased withdrawal
benefit or a life annuity. Under the phased withdrawal approach, the retiree retains ownership of
the account balance, and the fund administrator makes monthly distributions based on a
government formula that takes into account the retiree’s age, sex, and marital status.
Alternatively, retirees can purchase life annuities from insurance companies. Because of
government regulation and the relatively large and competitive market for annuities in Chile,
commissions to purchase life annuities are quite low—under 2%—and money’s worth values are
relatively high.35
Switzerland also has markedly higher annuitization rates compared to most other
countries—approximately 80%.36 Switzerland has a mandatory occupational pension system for
34
Jose Ruiz & Olivia S. Mitchell, Pension Payouts in Chile: Past, Present, and Future
Prospects, in SECURING LIFELONG RETIREMENT INCOME, supra note 22, at 107, 111, 126.
35
Id. at 111, 122–26. The “money’s worth ratio” is, “the discounted expected present value of
the lifetime payment stream relative to the premium, conditional on survival.” Id. at 124.
36
Monika Bütler & Stefan Staubli, Payouts in Switzerland: Explaining Developments in
Annuitization, in SECURING LIFELONG RETIREMENT INCOME, supra note 22, at 195, 203; B.
Avanzi, What is it that Makes the Swiss Annuitise? A Description of the Swiss Retirement
System, 16 AUSTL. ACTUARIAL J. 135 (2010); Monika Bütler & Martin Ruesch, Annuities in
Switzerland 89 (World Bank, Policy Research Working Paper No. WPS4438, 2007).
12
most employees. Payout choices are also strongly influenced by the fact that in most pension
plans, the default option is an annuity, and peer effects are also important.
The United Kingdom has the largest annuity market in the world, primarily because
individuals who have saved in tax-favored pension plans are required to annuitize at least 75% of
their pension wealth.37
Singapore recently announced that its citizens must annuitize a minimum amount of their
retirement assets in the country’s Central Provident Fund, although the rest can be taken as a
lump sum.38 Pension income from approved annuity providers is exempt from tax. The
government will also enter the insurance market as an annuity provider.
Poland’s new pension system will also pay out benefits in the form of life annuities.39
37
Edmund Cannon & Ian Tonks, Compulsory and Voluntary Annuity Markets in the United
Kingdom, in SECURING LIFELONG RETIREMENT INCOME, supra note 22, at 171. To be sure,
retirees have considerable leeway over how much to annuitize and when.
38
Joelle H.Y. Fong, Olivia S. Mitchell & Benedict S. K. Koh, Longevity Risk Management in
Singapore’s National Pension System 1 (Pension Research Council, Working Paper No.
WP2010-10, 2010).
39
Marek Szczepański, The Design of Supplementary Pension Schemes in Poland and Longevity
Risk: Current Situation and Proposed Changes 4 (Pensions Inst., Discussion Paper No. PI-1202,
2012). As for third-tier, supplementary pension schemes, the annuity market in Poland is fairly
thin. Id. at 8.
13
III.
Lifetime Retirement Income Products
A.
Managing Longevity Risk
Retirees face numerous risks in managing their assets through retirement.40 Longevity
risk—the risk of outliving one’s retirement savings—is probably the greatest risk facing current
and future retirees with defined contribution plans. As life expectancy increases, accumulated
retirement savings in individual accounts will need to finance an ever-greater portion of retirees’
ever-longer retirements. At present, a sixty-five-year-old woman has a 50% chance of living past
age eighty-six, while a sixty-five-year-old man has a 50% chance of living past age eighty-four.41
The joint life expectancy of a sixty-five-year-old couple is even more remarkable. There
is a 50% chance that at least one sixty-five-year-old spouse will live to age ninety-one, and there
40
The top risks for today’s retirees include: longevity, inflation, market volatility, withdrawal
rate, health care expenses, and unexpected events. AMERIPRISE FIN., MAKING YOUR RETIREMENT
INCOME LAST A LIFETIME (Nov. 2010), available at
http://cdn.ameriprisecontent.com/cds/alwp/advisor/david.p.weidman/cdocuments-andsettingsandrewdesktopwebsite-downloadsmaking-your-retirement-income-last-alifetiime634532517160486099.pdf.
41
H.R. DOC. NO. 112-102, at 91 tbl. V.A4 (2012).
14
is a 25% chance that at least one will live to ninety-five.42 That means married couples can easily
have twenty-five or thirty years in retirement. Pertinent here, one study estimated that three out
of five new middle class retirees will outlive their financial assets if they attempt to maintain
their pre-retirement standard of living.43
As more fully described below, retirees can use a variety of approaches to help manage
their longevity risk, including systematic withdrawals, traditional lifetime annuities, longevity
insurance, and variable annuities with guaranteed lifetime withdrawal benefits.44 Depending on
each retiree’s specific circumstances, the best strategy may involve a combination of these
products.
B.
42
Systematic Withdrawals
Fred Reish, Just out of Reish: Living “Room”? The Problem with Living Too Long, PLAN
SPONSOR (Aug. 2011), available at
http://www.plansponsor.com/MagazineArticle.aspx?id=6442481375.
43
ERNST & YOUNG LLP, RETIREMENT VULNERABILITY OF NEW RETIREES: THE LIKELIHOOD OF
OUTLIVING THEIR FINANCIAL ASSETS i (2008).
44
See, e.g., SOC’Y OF ACTUARIES, MANAGING RETIREMENT DECISIONS SERIES: DESIGNING A
MONTHLY PAYCHECK FOR RETIREMENT (2012); Steve Vernon, The Retirement Income Menu: An
Idea Whose Time Has Come, 2 INST. RETIREMENT COUNCIL UPDATE, no. 9, 2011, at 1, 5;
Anthony Webb, Making Your Nest Egg Last a Lifetime, B.C. CTR. FOR RETIREMENT RES., Sept.
2009, at 1-4.
15
One of the simplest and most common strategies to manage retirement savings is to invest
all of the funds in a diversified portfolio, and then use a conservative withdrawal rate and a
systematic withdrawal plan designed to have a high probability that the retirement savings will
last for twenty or thirty years. To be sure, many people start out by simply trying to live off of
their interest and dividends, with an eye towards leaving their principal to heirs.
More typically, however, individuals invest their retirement savings and try to draw down
their principal and investment income carefully through managed withdrawals. In that regard,
financial planners often suggest following the 4% rule.45 The basic idea is to invest retirement
savings in a 50% stock, 50% bond portfolio, and initially to set spending at 4% of retirement
savings. Each year thereafter, spending is increased to keep up with inflation. For example,
assuming that our hypothetical investor has a $1,000,000 nest egg, in the first year the retiree
would withdraw 4% ($40,000), and each year thereafter that dollar amount would increase to
keep up with inflation.46 Assuming a 3% inflation rate, annual withdrawals would increase to
$41,200 in the second year, $42,436 in the third year, and so on. While there is some possibility
of running out of money, most financial planners believe this strategy will work for thirty years
45
William P. Bengen, Determining Withdrawal Rates Using Historical Data, 7 J. FIN. PLAN. 171
(1994).
46
See Eleanor Laise, A Strategy for a Lifetime of Income, KIPLINGER, Aug. 17, 2011 (applying
the 4% rule), available at http://www.kiplinger.com/features/archives/
krr-a-strategy-for-a-lifetime-of-income.html.
16
of retirement.
C.
Lifetime Annuities
Traditional lifetime annuities offer another approach for managing longevity risk.
Depending on the retiree’s age, immediate annuities can provide cash flows of 7% of funds
invested or more, and immediate annuities provide a powerful hedge against longevity risk. For
example, for a sixty-five-year-old man who purchased a $100,000 immediate, level-payment
annuity without inflation protection in 2011, the annual payout would be around $6,732 or 6.73%
of the annuity’s purchase price.47 Alternatively, he could buy an inflation-adjusted annuity. For
example, if he instead purchased an annuity with a 3% escalator, he would receive $4,944 in the
first year and ever-increasing amounts in later years.
However, annuities do have several disadvantages. In particular, annuitants lose control
of the underlying funds, and unless a guarantee feature is selected, nothing will remain for the
annuitants’ heirs in the event of early death. Also, because of adverse selection (meaning that
those who voluntarily purchase annuities tend to live longer than those who do not), annuities are
not priced very well. In that regard, many analysts believe that most retirees will get the most
value for their investment if they defer the decision to annuitize until the age of seventy-five or
47
Immediate Annuities Update, ANNUITY SHOPPER, Jan. 2012, at 28 tbl. 5. Women tend to live
longer than men, therefore the annual payout for a sixty-five-year-old woman who elected an
immediate, level-payment annuity in 2011 would be just $6,264 or 6.26% of the annuity’s
purchase price. Id.
17
eighty.48 Finally, it is important to note that Social Security and Supplemental Security Income
already provide inflation-adjusted monthly benefits that may crowd out private annuities.49
D.
Longevity Insurance
Alternatively, retirees can protect against longevity risk by purchasing longevity
insurance.50 The typical approach is to buy a deferred annuity at age sixty-five that starts making
annual payments only if the annuitant lives past age eighty or eighty-five. For example, in
February of 2012, a sixty-five-year-old man could invest $100,000 in a MetLife deferred annuity,
and beginning at age eighty-five, he would receive a level lifetime income of $25,451.04 a year.51
Alternatively, that $100,000 could buy a deferred annuity that would pay $17,069.40 a year
starting at age eighty, $11,649.84 a year starting at age seventy-five, or $8,133.60 a year starting
48
See Moshe Arye Milevsky, Optimal Annuitization Policies: Analysis of the Options, 5 N. AM.
ACTUARIAL J., no. 1, 2001, at 57, 66.
49
See, e.g., Monika Bütler, Kim Peijnenburg & Stefan Staubli, How Much Do Means-Tested
Benefits Reduce the Demand for Annuities? (Network for Studies on Pensions, Aging and
Retirement, Discussion Paper No. DP 06/2011-52, 2011).
50
See Jason S. Scott, The Longevity Annuity: An Annuity for Everyone?, FIN. ANALYSTS J., Jan.-
Feb. 2008, at 40; Anthony Webb, Guan Gong & Wei Sun, An Annuity that People Might Actually
Buy, B.C. CTR. FOR RETIREMENT RESEARCH, July 2007, at 1.
51
E-mail from Hersh Stern, WebAnnuities Insurance Agency, Inc., to Jonathan Barry Forman
(Feb. 07, 2012, 9:46 AM) (on file with author).
18
at age seventy. Companies do not offer inflation-adjusted deferred annuities, but some
companies do offer fixed step-ups.52 To be sure, there is some risk of running out of money
before the year that the deferred annuity starts, but that is certainly less of a risk than trying to
manage one’s retirement savings from the start of retirement over the indefinite future.
Pertinent here, the current U.S. minimum distribution rules, which generally requires
participants to begin taking distributions soon after they reach age seventy-and-a-half, can make
it difficult to purchase deferred annuities that commence after that age with funds that are held
inside defined contribution plans.53 In that regard, however, the Internal Revenue Service
recently released proposed regulations that would ease the minimum distribution requirements to
permit up to $100,000, or, if less, 25% of the participant’s account balance, to be used to
purchase a “Qualifying Longevity Annuity Contract.”54
Of particular note, workers could be encouraged to buy deferred annuities in installments,
starting at a young age. For example, a worker could use a portion of the worker’s retirement
52
Joseph A. Tomlinson, Income Choices, FINANCIAL PLANNING, May 1, 2011, available at
http://www.financial-planning.com/fp_issues/2011_5/income-choices-2672801-1.html.
53
See I.R.C. § 401(a)(9) (2006); Natalie Choate, New! Longevity Insurance for IRAs,
MORNINGSTAR ADVISOR (Mar. 9, 2012), available at
http://www.morningstar.com/advisor/t/52769065/new-longevity-insurance-for-iras.htm.
54
Longevity Annuity Contracts, 77 Fed. Reg. 5443 (proposed Feb. 3, 2012) (to be codified at 26
C.F.R. pt. 1); U.S. DEP’T OF TREASURY, supra note 27.
19
contributions each year to purchase a deferred life annuity that started at age sixty-five or a later
age.55 Deferred annuities like these could provide retirement benefits that mimic the lifetime
pensions provided by traditional defined benefit plans.
E.
Guaranteed Lifetime Withdrawal Benefits
Finally, retirees can use variable annuities with Guaranteed Lifetime Withdrawal Benefits
(GLWB) funds to manage their longevity risk.56 A GLWB annuity is based on a variable
annuity, but it allows investors to lock in a minimum guarantee for life. Mechanically, the
investor or retiree deposits, or rolls over, a sum of money into a variable annuity with
subaccounts that are invested in stocks, bonds, and other generic investments. Depending on
market performance, that investment portfolio grows—or shrinks. In any event, at retirement,
the annuitant starts taking guaranteed withdrawals from the account. Payouts come from the
invested funds, but if those funds are ever depleted due to long life or poor investment returns,
the guaranteed minimum kicks in.
The guaranteed withdrawal rate is determined at the time of the sale, and it might be set at
55
Moshe A. Milevsky, Real Longevity Insurance with a Deductible: Introduction to Advanced-
Life Delayed Annuities (ALDA), 9 N. AM. ACTUARIAL J., no. 9, 2005, at 109.
56
Moshe A. Milevsky & Ling-wu Shao, Annuities and their Derivatives: The Recent Canadian
Experience, in SECURING LIFELONG RETIREMENT INCOME, supra note 22, at 50, 56.
20
between 4% and 6% depending upon the age when withdrawals are to begin.57 The guaranteed
amount is determined by multiplying the guaranteed rate by the guaranteed base, which is
determined when withdrawals begin. Depending on the contract, if the investment portfolio
performs well, the guaranteed base might reset to a higher level and generate even greater
withdrawals.
On the downside, GLWB annuities can be very complicated, they can have annual costs
that exceed 3% of asset value, they can have heavy surrender charges, and they typically do not
have an inflation adjustment.58 All in all, GLWB annuities are similar to systematic withdrawal
in that the investor maintains control over the assets, but the investor trades a lower rate of return
(meaning gross return less fees) for the guarantee of not outliving assets.59
IV.
Optimal Distribution Rules
Clearly, there are a number of approaches and products that can help retirees manage their
longevity risk. While lump sum distributions tend to dissipate quickly, annuities and similar
57
See generally Benny Goodman & Seth Tanenbaum, TIAA-CREF Inst., The 5% Guaranteed
Minimum Withdrawal Benefit: Paying Something for Nothing?, RESEARCH DIALOGUE, Apr.
2008.
58
SOC’Y OF ACTUARIES, supra note 44, at 6; see also Tomlinson, supra note 52.
59
“Stand-alone living benefits” are similar to GLWBs, except that instead of using a variable
annuity chassis, stand-alone living benefits use mutual funds or managed accounts as the base.
Tomlinson, supra note 52.
21
products can last a lifetime. Government policy should be designed to mandate, or at least
encourage, retirees to purchase such lifetime income products.60
A.
Mandate or Encourage Annuitization
One approach for promoting lifetime retirement income would be for the government to
require retirees to purchase annuities or similar lifetime income guarantees. As mentioned, that
is what Singapore, Sweden, and Poland are doing, and the United Kingdom and Chile have been
promoting annuitization for years. President George W. Bush’s Commission to Strengthen
Social Security also recommended that at least a portion of the balances in its proposed
individual accounts should be annuitized.61 More specifically, the Commission recommended
60
See, e.g., FORMAN, supra note 2, at 238–39; U.S. GOV’T ACCOUNTABILITY OFFICE, GAO-11-
400, RETIREMENT INCOME: ENSURING INCOME THROUGHOUT RETIREMENT REQUIRES DIFFICULT
CHOICES (2011); PAMELA PERUN, THE ASPEN INST., RETIREMENT SAVINGS: CONFRONTING THE
CHALLENGE OF LONGEVITY (2010); Roberto Rocha & Dimitri Vittas, Designing the Payout
Phase of Pension Systems: Policy Issues, Constraints and Options (World Bank, Policy Research
Working Paper No. 5289, 2010).
61
COMM’N TO STRENGTHEN SOC. SEC., EXEC. OFFICE OF THE PRESIDENT, STRENGTHENING SOCIAL
SECURITY AND CREATING PERSONAL WEALTH FOR ALL AMERICANS 41–42 (2001); John F. Cogan
& Olivia S. Mitchell, Perspectives from the President’s Commission on Social Security Reform,
in LESSONS FROM PENSION REFORM IN THE AMERICAS 216, 229–30 (Stephen J. Kay & Tapen
Sinha eds., 2008).
22
that each retiree be required to annuitize enough to keep the retiree’s annual income above the
poverty level throughout retirement.62
Alternatively, the government might want only to encourage annuitization. For example,
the government could require defined contribution plans to make annuity options available to
plan participants.63 The government might even require plans to default participants into
annuities or trial annuities, unless plan participants affirmatively elect otherwise.64
62
COMM’N TO STRENGTHEN SOC. SEC., supra note 61, at 41. On the plus side, if everyone had to
buy an annuity with all or part of their defined contribution plan savings, annuity prices would
fall, both because the larger annuity market would be more efficient and because adverse
selection would decline as virtually every retiree would buy an annuity, not just those who
expected to live a long time. Estelle James, Truman Packard & Robert Holzmann, Reflections on
Pension Reform in the Americas: From ‘Averting the Old-Age Crisis’ to ‘Keeping the Promise of
Old-Age Security’ and Beyond, in LESSONS FROM PENSION REFORM IN THE AMERICAS, supra note
61, at 164, 169–70.
63
See, e.g., U.S. GOV’T ACCOUNTABILITY OFFICE, supra note 60, at 38–39.
64
U.S. GOV’T ACCOUNTABILITY OFFICE, supra note 60, at 39–40; GORDON A. (SANDY)
MACKENZIE, THE DECLINE OF THE TRADITIONAL PENSION 200–03 (2010). See generally Jeffrey
R. Brown, Understanding the Role of Annuities in Retirement Planning, in OVERCOMING THE
SAVINGS SLUMP 178, 199–200 (Annamaria Lusardi ed., 2008); William G. Gale, J. Mark Iwry,
David C. John & Lina Walker, Increasing Annuitization in 401(k) Plans with Automatic Trial
23
It could even make sense to encourage or require individuals to allocate a portion of their
contributions to annuities or annuity-like products.65 Such “in-service” annuities would enable
workers to obtain streams of lifetime income each year that they work, just as workers with
traditional defined benefit plan pensions currently do.66
For that matter, the government could actually get into the market of selling annuities and
other lifetime income products or, alternatively, guaranteeing products sold by private
companies.67 The U.S. Department of the Treasury already sells inflation-adjusted bonds that
Income (The Retirement Sec. Project, Paper No. 2008-2, 2008); J. Mark Iwry & John A. Turner,
Automatic Annuitization: New Behavioral Strategies for Expanding Lifetime Income in 401(k)s
(The Retirement Sec. Project, Paper No. 2009-2, 2009); JEFFREY R. BROWN, AM. COUNCIL OF
LIFE INSURERS, AUTOMATIC LIFETIME INCOME AS A PATH TO RETIREMENT INCOME SECURITY
(2009).
65
See, e.g., BROWN, supra note 64, at 4; Paul Yakoboski, TIAA-CREF INST., Retirees,
Annuitization and Defined Contribution Plans, TRENDS AND ISSUES, Apr. 2010, at 3, 5.
66
Moreover, by annuitizing savings in multiple installments over many years rather than just at
retirement, in-service annuities would reduce investment risk and income risk to individuals.
MACKENZIE, supra note 64, at 195–96.
67
See, e.g., ORTH, supra note 24, at 3; Henry T.C. Hu & Terrance Odean, Paying for Old Age,
N.Y. TIMES, Feb. 25, 2011, at A19; Lawrence A. Frolik, Protecting Our Aging Retirees:
24
can be useful in developing inflation-adjusted financial products.68
Some analysts have also suggested using the tax system to encourage people to take their
distributions as annuities. For example, the government could exempt annuity payouts from
income taxation or favor them with a reduced tax rate.69
B.
More Financial Education about Lifetime Income Products
The government also has a role in promoting financial education about annuities and
other lifetime income products. For example, in addition to showing the total balance in a
defined contribution account, benefit statements could be required to include an estimate of the
“annuity equivalent” lifetime income stream of payments.70 More specifically, individual benefit
Converting 401(k) Accounts into Federally Guaranteed Lifetime Annuities, 47 SAN DIEGO L.
REV. 277 (2010).
68
See, e.g., Treasury Inflation-Protected Securities (TIPS), TREASURYDIRECT (Apr. 22, 2011),
available at http://www.treasurydirect.gov/indiv/products/prod_tips_glance.htm.
69
See, e.g., Retirement Security Needs Lifetime Pay Act of 2009, H.R. 2748, 111th Cong.
(2009); Szczepański, supra note 39, at 8.
70
See, e.g., Lifetime Income Disclosure Act, S. 267, 112th Cong. (2011); H.R. 677, 112th Cong.
(2011); U.S. GOV’T ACCOUNTABILITY OFFICE, supra note 60, at 48–49; ADVISORY COUNCIL ON
EMP. WELFARE & PENSION BENEFIT PLANS, REPORT ON THE SPEND DOWN OF DEFINED
CONTRIBUTION ASSETS AT RETIREMENT (2008) (“Recommendation 4: Encourage and allow
25
statements could be required to show the monthly annuity payment that would be made if the
employee’s total account balance were used to buy a single life annuity that commenced when
the employee reaches age sixty-five. For married employees, these individualized statements
would also show the monthly annuity payments under a qualified joint and survivor annuity.
C.
Asset Tests
The government should also better coordinate treatment of pensions and the asset tests
used in means-tested public programs like Medicaid, food stamps, and Supplemental Security
Income. The stringent asset tests under those programs often require low-income workers to
withdraw the balances in their defined contribution plans and “spend down” those assets before
they can qualify for benefits.71 Consequently, these asset tests can encourage individuals to
dissipate their retirement savings and may even discourage individuals from saving for retirement
in the first place. While distributions from retirement accounts should probably count as
“income” in determining eligibility for means-tested benefits, modest amounts held in defined
contribution plans and annuities should probably be excluded from the asset tests.
D.
Other Things Government Can Do
In addition to promoting annuities and other lifetime retirement income options, the
government should also encourage people to save more while they are working. Ideally, the
additional participant disclosure, specifically the conversion of account balances into annual
retirement income.”), available at www.dol.gov/ebsa/publications/2008ACreport3.html.
71
See, e.g., Bütler et al., supra note 49.
26
United States should adopt a mandatory universal pension system like Australia, Singapore, and
Chile.72 At the very least, we should adopt policies that make 401(k) plans or payroll-deduction
IRAs available to all workers.73
The government could also help defined contribution plan participants do a better job
managing their retirement savings.74 Pertinent here, the Pension Protection Act of 2006
encourages employers to replace their low-yield, stable-value bond funds with “qualified default
investment alternatives” like balanced funds, life-cycle funds, and variable annuity contracts.75
The U.S. Department of Labor also recently finalized regulations that will make it easier for plan
72
TERESA GHILARDUCCI, WHEN I’M SIXTY FOUR: THE PLOT AGAINST PENSIONS AND THE PLAN TO
SAVE THEM 263–93 (2008); Jonathan Barry Forman, Should We Replace the Current Pension
System with a Universal Pension System?, 16 J. OF PENSION BENEFITS, no. 2, 2009, at 51; U.S.
GOV’T ACCOUNTABILITY OFFICE, GAO-09-642, PRIVATE PENSIONS: ALTERNATIVE APPROACHES
COULD ADDRESS RETIREMENT RISKS FACED BY WORKERS BUT POSE TRADE-OFFS 52 (2009).
73
FORMAN, supra note 2, at 233–35. See, e.g., Automatic IRA Act of 2012, H.R. 4049, 112th
Cong. (2012); J. Mark Iwry & David C. John, Pursuing Universal Retirement Security Through
Automatic IRAs (The Retirement Sec. Project, Paper No. 2007-2, 2007).
74
Stephen Blakely, Is There a Future for Retirement?, EMP. BENEFIT RES. INST. NOTES, Sept.
2011, at 16.
75
29 C.F.R. § 2550.404c-5 (2011).
27
sponsors to give investment advice to plan participants,76 and another set of regulations that will
improve disclosures about fees, expenses, and investments.77
The government could also do more to encourage people to work longer.78 For example,
the government could raise the age for the Internal Revenue Code section 72(t) penalty on
premature withdrawals from age fifty-nine-and-a-half to age sixty-two, the current early
retirement age for Social Security. Similarly, the government could raise the normal retirement
age for pensions to match Social Security’s full retirement age—currently age sixty-six, but
headed to age sixty-seven.79
76
See Investment Advice—Participants and Beneficiaries, 76 Fed. Reg. 66136 (Oct. 25, 2011)
(to be codified at 29 C.F.R. pt. 2550).
77
Press Release, Emp. Benefits Sec. Admin., U.S. Dep’t of Labor, U.S. Department of Labor
Extends and Aligns Applicability Dates for Retirement Plan Fee Disclosure Rules (July 13,
2011), available at http://www.dol.gov/ebsa/newsroom/2011/11-1063-NAT.html.
78
See, e.g., Jonathan Barry Forman & Yung-Ping (Bing) Chen, Optimal Retirement Age, 2008
N.Y.U. REV. OF EMP. BENEFITS & EXECUTIVE COMPENSATION 14-1; Jack VanDerhei & Craig
Copeland, The Impact of Deferring Retirement Age on Retirement Income Adequacy, 358 EMP.
BENEFIT RES. INST. ISSUE BRIEF, Jun. 2011.
79
Also, as the Social Security system offers actuarially fair increases in benefits to those who
delay taking their benefits, the government should encourage people to delay taking their benefits
at least until they reach their full retirement age. See, e.g., Kenn Beam Tacchino, David A.
28
The government could also do more to make workers preserve their retirement savings
until retirement. In particular, it would make sense to prohibit premature distributions and loans
from defined contribution plans and IRAs.80
V.
Conclusion
Workers today are building up most of their retirement savings in defined contribution
plans and other individual retirement savings accounts. Many of those workers will need to use
their savings to provide retirement income over retirements that can last twenty years or more.
Retirees can best manage that longevity risk by taking their distributions in the form of annuities
and other lifetime retirement income products, and government policies should be designed to
encourage the use of those financial products.
Littell & Bruce D. Schobel, A Decision Framework for Optimizing the Social Security Claiming
Age, 28 BENEFITS QUARTERLY, no. 2, 2012, at 40.
80
See, e.g., FORMAN, supra note 2, at 233; LORI LUCAS, PLUG THE DRAIN: 401(K) LEAKAGE AND
THE IMPACT ON RETIREMENT 9
(2011).
29