Longevity-insured retirement distributions from pension plans: Market and regulatory issues

Jeffrey R. Brown, Mark J. Warshawsky

Research output: Chapter in Book/Report/Conference proceedingChapter

Abstract

The method of funding retirement in the United States is in the midst of a major transition, one that is placing greater responsibility on individuals for managing their own retirement assets. The past two decades have witnessed a large shift away from defined benefit to defined contribution pension plans, a trend that appears likely to continue for the foreseeable future. According to some estimates, the average retiree's balance in 401(k) plans alone will rise tenfold over the next thirty years and will rival Social Security as the major source of retirement wealth.1 While defined benefit and defined contribution plans differ along many margins, one of the most important is the method of distributing retirement income. Traditional defined benefit plans typically paid benefits in the form of a life annuity and thus provided retirees with a form of insurance against outliving their resources. According to standard economic life-cycle theory, this longevity insurance is quite valuable to consumers, because it provides a higher sustainable level of consumption than is available in the absence of this insurance. Defined contribution plans, on the other hand, are much less likely to offer life annuities to retirees. Instead, defined contribution plans offer some form of lump-sum payment and/or "phased withdrawal" options upon retirement. While these alternative distribution methods offer retirees a high degree of flexibility and liquidity, they fail to provide a formal mechanism by which individuals can insure against the risk of outliving their resources, the central issue of this paper. Individual responsibility for retirement asset decumulation has also emerged as a policy issue in the debate about supplementing or partially replacing the current Social Security system with an individual accounts program. The existing system is currently the primary source of annuitized income for the majority of U.S. households and is the only meaningful provider of inflation-indexed annuities. As such, any plans to alter the existing Social Security benefit structure could affect the desirability of alternative distribution methods from private pension plans. insurance is quite valuable to consumers, because it provides a higher sustainable level of consumption than is available in the absence of this insurance. Defined contribution plans, on the other hand, are much less likely to offer life annuities to retirees. Instead, defined contribution plans offer some form of lump-sum payment and/or "phased withdrawal" options upon retirement. While these alternative distribution methods offer retirees a high degree of flexibility and liquidity, they fail to provide a formal mechanism by which individuals can insure against the risk of outliving their resources, the central issue of this paper. Individual responsibility for retirement asset decumulation has also emerged as a policy issue in the debate about supplementing or partially replacing the current Social Security system with an individual accounts program. The existing system is currently the primary source of annuitized income for the majority of U.S. households and is the only meaningful provider of inflation-indexed annuities. As such, any plans to alter the existing Social Security benefit structure could affect the desirability of alternative distribution methods from private pension plans. insurance is quite valuable to consumers, because it provides a higher sustainable level of consumption than is available in the absence of this insurance. Defined contribution plans, on the other hand, are much less likely to offer life annuities to retirees. Instead, defined contribution plans offer some form of lump-sum payment and/or "phased withdrawal" options upon retirement. While these alternative distribution methods offer retirees a high degree of flexibility and liquidity, they fail to provide a formal mechanism by which individuals can insure against the risk of outliving their resources, the central issue of this paper. Individual responsibility for retirement asset decumulation has also emerged as a policy issue in the debate about supplementing or partially replacing the current Social Security system with an individual accounts program. The existing system is currently the primary source of annuitized income for the majority of U.S. households and is the only meaningful provider of inflation-indexed annuities. As such, any plans to alter the existing Social Security benefit structure could affect the desirability of alternative distribution methods from private pension plans. insurance is quite valuable to consumers, because it provides a higher sustainable level of consumption than is available in the absence of this insurance. Defined contribution plans, on the other hand, are much less likely to offer life annuities to retirees. Instead, defined contribution plans offer some form of lump-sum payment and/or "phased withdrawal" options upon retirement. While these alternative distribution methods offer retirees a high degree of flexibility and liquidity, they fail to provide a formal mechanism by which individuals can insure against the risk of outliving their resources, the central issue of this paper. Individual responsibility for retirement asset decumulation has also emerged as a policy issue in the debate about supplementing or partially replacing the current Social Security system with an individual accounts program. The existing system is currently the primary source of annuitized income for the majority of U.S. households and is the only meaningful provider of inflation-indexed annuities. As such, any plans to alter the existing Social Security benefit structure could affect the desirability of alternative distribution methods from private pension plans. This paper examines the extent to which individuals can and do insure themselves against longevity risk in defined contribution plans. This issue is of policy concern for several reasons. The distribution method chosen can directly affect the extent to which retirees are able to finance consumption in old age-particularly those individuals who live significantly longer than they anticipated at retirement. Also, increasing average longevity and the trend toward earlier retirement presumably make the problem of ensuring adequate resources throughout individuals' old age more widespread among the population. The adequacy of old-age income directly affects the extent of poverty rates among the elderly, a problem that is especially acute for elderly widows.2 In addition, if individuals fail to provide adequately for old-age consumption needs, the financial pressure on means-tested social assistance programs such as SSI (Supplemental Security Income) and Medicaid could increase. Finally, the distribution method chosen can significantly affect the size of intergenerational transfers taking place in the economy and thus the wealth distribution of the next generation. This paper focuses on five issues. First, we review the welfare gains from annuitization that result from a standard life-cycle model. We then discuss several reasons why households may choose not to annuitize despite these theoretical welfare gains, including the presence of Social Security, pricing of annuities in the market, bequest motives, inflation risk, health uncertainty, ignorance, and regulatory impediments. Third, we demonstrate that one result of the shift from defined benefit to defined contribution plans is a reduction in opportunities to annuitize retirement wealth; the majority of defined contribution plans do not offer an annuity payout option. Fourth, we indicate that even though the fraction of retiree wealth that is annuitized will likely decline, the individual annuity market will likely experience substantial growth in the coming decades as households who desire longevity insurance are forced into the individual market with their retirement assets. One likely implication of this shift toward individual markets is a reduction in the annuity income available per dollar of retirement wealth, because annuity payouts in the individual market may be lower than those in the group market. Finally, we discuss the pros and cons of a number of regulatory options available, including annuity mandates, tax incentives, and government provision, for increasing annuitization of defined contribution account balances.

Original languageEnglish (US)
Title of host publicationPrivate pensions and public policies
EditorsWilliam G. Gale, John B. Shoven, Mark J. Warshawsky
PublisherBrookings Institution Press
Pages332-369
Number of pages38
ISBN (Print)0815702388, 9780815702382
StatePublished - Dec 1 2004
Externally publishedYes

ASJC Scopus subject areas

  • Social Sciences(all)

Fingerprint Dive into the research topics of 'Longevity-insured retirement distributions from pension plans: Market and regulatory issues'. Together they form a unique fingerprint.

Cite this