Why the Government Should Learn Which Annuities Are Useful

When retirement wonks (like us) look at the state of the American experiment in defined-contribution retirement plans, one problem they almost always see is that not enough people annuitize enough of their assets when they retire. These retirement wonks then conclude, sensibly enough, that the government should do more to encourage annuitization.

Armed with these insights, they tend to recommend that Congress and the Department of Labor, which regulates private-sector employer-sponsored retirement plans, make more annuities available. (Here are some examples of government reports and even a journal article I wrote a few years ago making this case.)

My colleague Jasmin Sethi has written a new paper with a different message: the government should design policy to encourage good annuities, which are uniquely positioned to help retirement savers and retirees ensure they do not run out of money in retirement.

The Term “Annuity” Means Virtually Nothing

This logic is all fine in theory. The problem is that the American annuity market seems to be broken, starting with the name annuity. The term annuities refers to a staggering array of product types. Some of these are transparent, simple, and easy to compare. Most annuity products are extremely complex, however, and the ones salespeople try to steer clients to tend to be in the complex category because such contracts are more profitable for insurance professionals.

The simplest forms of annuities, known as single-premium immediate annuities (and their closely related cousins, deferred income annuities) are purchases of a stream of payments until death for a fixed sum of money. These payment streams can start today or, in the deferred case, years in the future.

More-complex annuities layer in various forms of investment risk, downside risk protection, and various kinds of guaranteed minimum withdrawal benefits.

Retirement investors, for their part, have largely recognized this fact. Annuities do not have nearly the market share in retirement accounts as traditional mutual funds. Few retirement savers think about product allocation between annuities and other kinds of investments at least in part because of the complexity of annuities and lack of trust in the insurance industry.

Guaranteed-Income Products Are Uniquely Useful

That's all a shame. As Sethi discusses in the paper, products she calls "guaranteed-income products" solve a key challenge for retirees that really can't be solved with any other product except for theoretical ones like tontines, which are not available in the United States. Workers who have saved during their entire careers might run out of money in retirement because they don't know how long they might live. Put another way, they don't have enough insurance to protect against the risk (pleasant though it may be) that they live an unusually long time.

At best, because they are cognizant of that risk, underannuitized Americans are spending less than they should to really enjoy their retirement. By self-insuring for longevity risk, they spend less than they could with some allocation to a guaranteed income product that pools their risk of living a long time with that of other retirees—making sure no one will outlive their savings.

The Government Can Make It Easier for Retirement Investors to Access the Good Annuities

So, what is to be done? Hopefully, at some point, more consumer demand for high-quality, guaranteed-income products will mean more retirement plans start offering them. But the government can take some steps—some of which it’s even contemplating right now—to make good annuities easier to access, while perhaps reducing the proliferation of opaque, expensive, and sometimes less-than-useful flavors of annuities.

Of course, annuities are typically regulated by state governments, but there are two big exceptions: 1) the SEC regulates variable annuities, which are close enough to securities that they are treated as such, and 2) the Department of Labor regulates annuities when they appear in certain retirement accounts, such as 401(k) plans.

In Morningstar's paper, Sethi makes four basic recommendations for federal action:

1) Provide a special safe harbor for simple, single-premium immediate and deferred annuities so that employers can use them as defaults.

2) Fix some arcane tax laws to make deferred-income annuities more attractive and easier to access.

3) Ensure there’s a strong fiduciary standard when advisors recommend rolling a 401(k) into an annuity product so that conflicts of interest don’t drive recommendations.

4) Enhance disclosures of variable annuities, so they’re easier for people to compare.

The bottom line for us is this: there are good and not-so-good annuities. It’s time for the federal government to learn the difference and set policy accordingly.