A small miracle occurred in Washington last month. Amidst all the political infighting and chaos, the House of Representatives passed the Setting Every Community Up for Retirement Enhancement (or SECURE) Act, with overwhelming bipartisan support. The bill, which expands access to work-place pension accounts and makes it easier to offer annuities, has also been praised by the financial industry and retirement experts. By all accounts, it is good legislation because it aims to right a major policy misstep.
Righting a past wrong
More than 40 years ago, a small provision in the 1978 Revenue Act created the 401(k) which kicked off the rise in defined contribution pension plans, where employees invest and save for themselves and bear all the associated risks (previously, employees were more likely to receive defined benefits plans, which paid out predictable sums after retirement). Other countries followed, and nearly all made the same policy error: There was no guidance for what people should do with their money after they retire.
While the saving part is fairly straight forward, knowing how much to spend and how much to invest in retirement has been called by Nobel Prize winning economist, Bill Sharpe ”the nastiest, hardest problem in finance.” Most retirees don’t know how long they’ll live or what their health expenses will be, yet they still must make their money last. It is a problem placed on savers all over the world, with little help or direction.
States have required companies to adopt policies to help people during their saving years, including defaulting people into plans with a sensible investment strategy, but less progress was made on what people should do after they retire. Some in the financial industry have suggested guidelines, such as spending 4% of your assets each year, but that indexes spending to the ups and downs of the stock market and not to the needs of retirees, who risk out-living their assets.
The solution preferred by many economists are annuities. This is when you hand your savings to an insurance company and they pay you a predetermined income every year for the rest of your life. This ensures you don’t run out of money, and you can spend more than if you financed retirement yourself and budgeted conservatively, not knowing how long you’ll live. The system works because retirees who die relatively young subsidize those who live a long time. Depending on how the annuity is structured, you also don’t need to worry about investment risk, since you get a regular payments from the insurance company.
Currently, it is not easy to buy an annuity. You must go through an agent, information on pricing tends to be opaque, and many of the products are complex so it’s often unclear what you are paying for. Involving agents introduces another level of fees and creates an incentive for them to push more complex and expensive products.
The SECURE Act, among other things, makes it a little easier to buy an annuity because it allows employers who sponsor 401(k) plan to offer them without taking on any legal liability. Currently, if a 401(k) sponsor offers an annuity and a consumer regrets it, they can be sued. Even if the suit is without merit, it can be expensive and costly, and the risk means many retirement plans won’t offer annuities, which leaves individuals on their own. The new legislation should remove that risk (although the plan’s sponsors are still fiduciaries, so they are legally obliged to work in their customers best interests). To spur workers into thinking about annuities, the SECURE Act also requires 401(k) statements to project how much income their savings is expected to buy. Income-based performance measures help people know how much they can spend in retirement, keeps them focused on their goals, and primes them to think about annuitizing their savings while they are young.
But while economists and policy makers are, for once, in full agreement, it’s not clear that the SECURE Act, if it becomes law, will actually change retirement, because people tend to hate annuities.
But will people buy them?
Most people don’t annuitize their retirement savings, even if reduces risk and means more income. There are several reasons why:
- It is hard to buy an annuity. It takes lots of research and retirees must rely on a broker who may not represent their best interests.
- Annuities have a bad reputation. Personal finance columnist tend to hate annuities and advise people to stay away from them because some have many unnecessary and expensive features. But not all annuities are the same and one that turns your current savings into regular, predictable income can be a useful and valuable purchase.
- Annuities are expensive and most people don’t have enough in savings. to make it worth their while. Based on data from the Survey of Consumer Finances in 2016, Americans between age 64 and 69 who had any defined contribution pension assets had a median account balance of just $123,000. That translates into less than $6,000 in annuity payments a year, which may not be enough to justify the fees involved. While the SECURE Act should lower fees, since 401(k) participants will get institutional pricing and cut out the agent fees, that’s not the only reason annuities are so expensive now. Annuity prices are based on the yield curve and as long as interest rates remain stubbornly lows annuities will be expensive.
- People want to hold on to their money. Retirement only ends one way, and there are decent odds that for either you or your spouse it will be expensive and awful. It is not surprising people are reluctant to let go of their lifesavings when they face the possibility of high medical and nursing costs late in life. Evidence suggests people don’t spend their savings in retirement until they or their spouse gets sick, then they spend almost all of it on health expenses. Though this research was based on generations who had less money in defined contribution assets and future generations may have more to spend because they had more years with money invested in 401(k)s and IRAs.
- Most Americans already have an annuity, from Social Security, so they may think it is enough regular income for them. ‘
- People don’t trust insurance companies, and handing over a lifetime of saving to a financial firm can feel like a huge risk, even if that firm has a high credit rating and is tightly regulated.
The SECURE Act, which needs to reconciled with a similar Senate version before it can be signed into law, should help overcome some these hurdles by making annuities cheaper and easier to buy. But that still might not increase adoption, at least right away. From 1995 until 2015, the UK required everyone to annuitize a majority of their pension savings, and it was so unpopular they government dropped the requirement. A voluntary option will probably not do enough to drive US retirees toward annuities, and currently an annuity will not qualify as a default option for plan participants, meaning no one will automatically be on track to annuitize their wealth. Historically, changing behavior in pension plans required defaulting workers into certain investments.
Phil Waldeck, Prudential’s head of retirement, remains optimistic. He says this is just the beginning. “It took more than 10 years for the 401(k) to take off, for target date funds to catch on, and for auto-enrollment” to become adopted. He points out retirees want the security of defined benefit plans and Social Security, so they should like annuities too. He expects annuities will eventually be more popular, but concedes it may not happen any time soon. The SECURE act may be the first step.