Longevity Policy: Facing Up to Longevity Issues Affecting Social Security, Pensions, and Older Workers

6 - Defined Contribution Plans: Encouraging Annuitization

105 6 Defined Contribution Plans Encouraging Annuitization Retirees risk outliving their assets. While Social Security provides a guaranteed lifetime benefit, it does not provide enough income for most retirees to maintain their preretirement standard of living. Accordingly , individuals who reach retirement with a 401(k) plan and without a traditional defined benefit plan generally need to convert at least part of their account balance to a flow of income to pay for their retirement consumption. Relatively few, however, actually do that. Only 10 percent of individuals with defined contribution plans annuitized their account balances when terminating employment at ages 60 to 64 and ages 65 to 69 (Gale and Dworsky 2006). Defined contribution plans can pay old-age benefits in any, or a combination, of five basic ways: 1) a lump sum, 2) a life annuity, 3) a phased withdrawal (based on annual recalculation of life expectancy), 4) installment (term-certain) payments, or 5) ad hoc withdrawals. An annuity is a financial instrument that converts an account balance into a stream of periodic payments. With life annuities, workers receive periodic payments that continue until death. Life annuities, referred to here simply as annuities, insure workers against running out of money if they live longer than expected. The U.S. pension system has shifted dramatically over the past 20 years from defined benefit plans to defined contribution plans, primarily 401(k) plans. While defined benefit plans traditionally provided benefits as annuities, most 401(k) plans do not provide that option. Historical data indicates that traditionally defined contribution plans have generally not provided annuities. For example, in 1985, only 29 percent of full-time participants in retirement savings and thrift plans had annuities as a payout option (Mitchell 1992). Defined contribution plans accrue benefits in the form of an account balance and typically pay benefits as a lump sum. Money purchase plans are required to provide the option of a joint and survivors annuity, but few participants choose 106 Turner that option (Advisory Council on Employee Welfare and Pension Bene fit Plans 2005b). While 401(k) plans are permitted to make a joint and survivor benefit the normal form of benefit payment, relatively few do. In 2000, 33 percent of defined contribution plans offered annuities (Blostin 2003). This chapter considers changes in policy and changes in features of annuities to expand the extent to which 401(k) plans offer annuities and participants choose them. It makes a distinction between two types of 401(k) plans. For 401(k) plans that are sole or primary plans, it recommends further requirements so that they will function as pension plans rather than as savings plans. For 401(k) plans that are secondary plans, it does not recommend any changes. To summarize the chapter in broad generalities, four approaches can be used to increase the annuitization of 401(k) plans: 1) changes in public policy (laws and regulations), 2) changes in annuity products, 3) changes in marketing of annuities, and 4) changes in the advice people receive when planning for retirement. POLICIES ENCOURAGING WORKERS TO ANNUITIZE Because of the insurance against outliving one’s assets that annuities provide, many public policy analysts support public policy to encourage annuitization. This section considers policy options for encouraging workers to annuitize their 401(k) account balances. Mandatory versus Voluntary Annuitization Mandatory annuitization is the only policy that assures that everyone obtains an annuity from their 401(k) account balance. Because trivial benefit payments would result, mandatory annuitization generally excludes small account balances. Mandatory annuitization need not require that full annuitization of the account balance occur at retirement. Some degree of mandatory annuitization, such as partial annuitization or annuitization at an older age, would help assure that workers would not outlive their retirement savings. Mandatory annuity purchases would reduce annuity prices by expanding the market to cover individ- Defined Contribution Plans: Encouraging Annuitization 107 uals regardless of health and life expectancy. Also, mandatory annuities would be less expensive to administer than voluntary annuities, as they would offer greater economies of scale and reduced enrollment costs. The requirement of mandatory annuitization could be limited to de- fined contribution plans that are the primary plan provided to workers. Thus, if an employer also provided a defined benefit plan, annuitization would not be mandated for the secondary...