Retirement Security Improved by Allocating a Portion of DC Plan Assets Into Annuities

To counter retirees’ hesitation to elect guaranteed lifetime income as a decumulation vehicle, plan sponsors could automatically allocate a portion of retirees’ assets to annuities, according to findings from the National Bureau of Economic Research’s recently published paper, “Defaulting 401(k) Assets into Payout Annuities for ‘Pretty Good’ Lifetime Incomes.”

The research, analyzed by Vanya Horneff and Raimond Maurer, professors at Goethe University Frankfurt, and Olivia Mitchell, a professor at the Wharton School of the University of Pennsylvania, found that defaulting 20% of a retiree’s assets greater than a certain threshold into an immediate annuity should enhance retirement security for most participants. An annuity deferred to age 80 is particularly beneficial for college graduates.

“Our research shows that … integrating deferred income annuities as a default in [retirees’] DC plan payout structure can overcome the behavioral factors driving non-annuitization and make retirees materially better off,” Mitchell says in an email response to questions.

The researchers used a “life-cycle model” to determine the optimal share of 401(k) assets that individuals should convert to an annuity at a worker’s retirement age, defined as age 66.

“Our [life-cycle] framework uses a dynamic economic model that analyzes how individuals make optimal decisions about consumption, saving, investment, and spending over their lifetimes, [accounting for] uncertainty in lifespan, income, health and market returns,” Mitchell says.

The research found that plan sponsors could default workers into a target-date fund with a built-in annuity allocation. At retirement, the annuitization option could be presented, requiring participants to opt out again if they did not want to set up guaranteed payouts.

According to Mitchell, the largest demographic group buying annuities is between ages 55 and 75, especially those between the ages of 60 and 70. A great majority fall into the middle-class range, with a median household income of $79,000.

Potential Effects on Decumulation

The authors’ work suggested that the partial annuitization of 401(k) assets would be valuable to better-educated workers, due to their longer lifespan and greater earnings during their working years. As a result of those advantages, the better-educated group would be able to save more in retirement accounts, receive higher Social Security benefits when retired and “supplement their lifetime incomes by purchasing additional annuities from their DC assets,” the authors wrote.

The least-educated retirees would benefit less due to their Social Security benefits replacing a larger share of their pre-retirement income and their higher early mortality rates, which often deter members of the group from investing in annuities that are both priced based on unisex mortality tables and do not account for education.

While research has demonstrated that retirement system defaults can powerfully shape workers’ investing and saving behaviors, less is known about how defaults might affect investors’ decumulation decisions. However, the paper found that several known factors may contribute.

A U.S. Government Accountability Office survey from 2016 found that approximately 70% of employees surveyed “indicated that if their employer automatically invested a small percentage of their future contributions in a competitively priced guaranteed income product, they would stay invested in the product.”

Additionally, research shows that having a higher level of financial literacy and a having a product presented as a default make individuals more likely to find annuities attractive.

“In any case, additional education about longevity risk would be helpful in raising participants’ awareness of the need for longevity income protection,” Mitchell says.

Obstacles Remain

The proposed default into annuities is not without regulatory hurdles. U.S. law and regulatory practice currently do not permit plan sponsors to include illiquid annuities as a default investment in defined contribution accounts. For example, the qualified default investment alternative safe harbor rules require default investments to remain liquid and be available for withdrawal or transfer at least once every three months.

The bipartisan “Lifetime Income for Employees Act,” first proposed by Representatives Donald Norcross, D-New Jersey, and Tim Walberg, R-Michigan, in 2020, would carve out an exception to this requirement. The bill has not advanced out of the House Committee on Education and the Workforce any of the three times it has been introduced.

Some lawmakers may want to see whether lifetime income provisions can be integrated into a larger retirement policy bill, rather than through a stand-alone bill.

 “With mid‑term priorities on the political front burner, budget wrangling and other legislative priorities taking precedence, stand-alone bipartisan reform packages like the LIFE Act often get deprioritized before advancing to floor votes,” Mitchell adds.

Another option could involve employers directing employers’ contributions or matches to deferred income annuities, as the paper noted: “current law does allow plan sponsors to require that employer contributions be held in a deferred annuity.”

It would also be feasible to default a portion of an employer’s contributions into a deferred income annuity. However, challenges of liquidity and transferability could arise when participants change jobs during their career.

“In any event, our research illustrates that defaulting a portion of retirees’ DC plan assets into a deferred income annuity is an attractive way for plan sponsors to provide their retirees with ‘pretty good’ lifetime incomes,” the report stated.