The Friendly Guide to 
Annuities in 401(k) Plans

Why are plans considering adding annuities?

‍

‍Plan sponsors that are considering adding annuities share the perspective that they are offering a retirement plan, not just a savings plan, to employees. Repeated academic research has concluded that income from an annuity makes a retirement portfolio more efficient, enabling people to spend more throughout retirement and not worry about running out of savings.

‍

Beyond that, plan sponsors have been exploring adding lifetime income to their plans for many reasons, including to:

‍

• Improve worker retirement security (quantitative outcomes): Guaranteed income allows retirees to more efficiently spend their assets through retirement. 
• Support “on-time” retirement: Employees who work past their desired retirement age cost companies money and can slow the career development cycle   
• Reduce worker anxiety about retirement while saving: Concerns about retirement planning and the adequacy of saving add stress and reduce productivity while also giving them the confidence to retire on time.
• Recruit and retain talent: Benefits are an important factor in both hiring and retaining workers. Today, pension-like options may help an employer stand out among candidates or allow a plan sponsor to compete against a company that offers a pension.
• Replace a closed pension: Employers that used to offer a pension may want to replace that lifetime income benefit. 
• Enable more ways for workers to spend their savings in retirement.

‍

‍

How do annuities improve retirement outcomes?

‍

‍Research shows that annuities improve retirement outcomes because lifetime income offsets several risks. The first is “longevity risk,” which is the unknown length of retirement because we don’t know how long a retiree will live. The common fear is that a retiree might run out of money, but realistically this usually means either severely curtailing spending at some point, spending less early in retirement, or relying on others to fund expenses.

‍

The second risk that annuities help offset is investment risk, since guaranteed income is a steady payment that isn’t affected by markets. We often think of equities presenting the greater risk and equities vary more in value than bonds. However, shifts in the bond market affect bond rates and therefore bond fund or bond ladder values and returns. Traditionally, the view has been that fixed income is uncorrelated from equity, but that hasn’t always proven to be true. Even a very conservative strategy is exposed to bond risk and is less efficient than annuity payments.

‍

This also reduces “sequence of returns” risk, which highlights the importance of the order of returns rather than the average. We can compare the expected outcomes of two retirees relying on withdrawals from who experience returns that produce the same but in a different order. They both rely on portfolio withdrawals to fund retirement but one happens to encounter a market drop early in retirement (within the first five years) and the other experiences it later; the first retiree may have to curtail spending while the second may end up with a large surplus.

‍

The more an individual’s essential expenses are covered by all guaranteed income sources, the less they need to worry about market fluctuations (both equity and bond) and how retirement portfolio performance will affect their retirement lifestyle.

‍

‍A word on risk-reward

‍

‍Many investments reward risk with additional gains. For example, equities aren’t guaranteed but there is an expected “risk premium” for the possibility that the value of a stock can go both up and down. By the same token, bond rates are linked to the risk of the issuer; an issuer that has a higher chance of not paying the bond has to pay a higher interest rate to attract investors.

‍

However, there is no risk premium for individuals assuming longevity risk. A person may end up receiving total payments that are worth more or less than the original premium paid for the annuity, but they don’t receive higher rates on their investments simply because they’ve decided to take on longevity risk.Annuities are insurance products and operate under different principles, so there is no inherent market compensation for self-insuring against longevity risk.

‍

‍The “annuity puzzle” and retirement plans

‍

‍Even though researchers find that annuities increase the economic efficiency of a retirement income portfolio for many retirees, relatively few people have used them in retirement planning, a phenomenon that they call the “annuity puzzle.”

‍

There are many behavioral and market reasons that explain the reluctance to use the type of annuity studied in research, which exchanges a lump sum of money for future income without being able to access a cash balance.

‍

• First and foremost, the annuities that pay the highest guaranteed income are generally irrevocable and people usually buy them with a lump sum. It can be difficult to decide to exchange a large amount of money for a much smaller stream of income.
• Arguably, most consumers don’t know much about annuities and how they work. They may not understand enough to want to buy an annuity on their own or find an advisor who’s able to help them.
• The retail market isn’t structured to encourage the purchase of annuities for irrevocable lifetime income.

‍

For these and other reasons, making annuities available within employer-sponsored retirement plans gives retirees another avenue to receive income from an annuity. The availability of education (leading up to and at retirement) and employer-vetted solutions can increase awareness and use of lifetime income. Nevertheless, the industry is still early in the development of strategies to help participants understand whether annuity income is right for them.

‍‍

‍

The “license to spend” of guaranteed income‍

‍

Retirees who have guaranteed sources of income spend more than those who have the same equivalent wealth but less assurance about future paychecks. Researchers call this the “license to spend” because they believe the knowledge that regular income will arrive (without reducing the balance of retirement assets) gives retirees the confidence to spend.

‍

They compare spending by those who have lifetime income and estimate that a retiree tends to spend twice as much for every dollar spent to purchase annuity income. This rise in spending can make a big difference early in retirement, especially among those who worry about running out later in life. The most recent version of the research from David Blanchett and Michael Finke is available online and includes a survey in addition to analysis on retirement spending data.

‍

For an employer, worker access to lifetime income means more than improving the efficiency of a retirement income portfolio; it can also encourage their workers to enjoy retirement more than they might otherwise.