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Rekenthaler Report

Converting 401(k) Assets Into Social Security Income?

Richard Thaler's latest suggestion.

Mind Games
Many investment decisions are determined by accident--by perceptions that are independent of the economic reality.

Perhaps the most prominent example is with target-date funds. Investors favor them in their 401(k) accounts. With Vanguard-sponsored plans, 52% of participants place their entire contribution into a single target-date fund, and another 25% invest at least partially into target dates. Outside of 401(k)s, though, those same shareholders rarely buy target-date funds.  

There is no logical investment explanation for this behavior. While target-date funds are ill-equipped for many retail uses--such as parking short-term monies, or for minimizing taxes--they suit IRAs every bit as well as they do 401(k) plans. Both accounts prepare for retirement, within similar tax-deferred arrangements. If target-date funds are fine for one, then they should be fine for the other.

The Annuity Puzzle
Today’s column, however, addresses a different topic: immediate annuities.

There’s no question that investors prize guaranteed income, when it comes from defined-benefit plans. To cite a local case, this spring the Chicago Symphony Orchestra went on strike for seven weeks, primarily because management proposed to replace its pension’s guaranteed benefits with a defined-contribution scheme, wherein orchestra members would assume the investment risk. That was very much not their wish; the strike ended being the longest in the CSO’s history.

Yet sales of immediate annuities, which deliver guaranteed-income payments that resemble pension payouts, languish. They were but $10 billion in 2018--a tiny fraction of overall annuities sales, which are themselves considerably smaller than those achieved by the mutual fund and exchange-traded fund industries. The moral appears to be that monthly income checks when sent by a pension fund are good, while those achieved by the investor’s own actions are bad.

The explanation, once again, invokes perception. Because investors view defined-contribution plans as risky, they value the safety of defined-benefit schemes, which tell them ahead of time what they will receive. Defined-benefit participants gain assurance. In contrast, when investors purchase an immediate annuity, they feel as if they have sustained a loss. They have exchanged something they currently own--investment assets--for a future promise. No matter how nicely they ask, they will never be able to get those assets back, should they so desire.

Nominal or Real?
The annuity conundrum extends to how the payments are structured. When surveyed for their preferences, states York University’s Moshe Milevsky, 97% of prospective immediate-annuity buyers sought nominal payments, rather than those that are inflation-adjusted. Says Milevsky, “I think only economists buy real annuities.” Yet Social Security payouts have never been nominal. Recipients are paid in inflation-adjusted dollars, without a hint of complaint.

Once again, the issue involves gains and losses. When buying immediate annuities, investors face a decision. They may select a lower payment today, in exchange for future growth through COLA adjustments, or may earn a higher initial check, albeit with no future increases, by receiving nominal payments. The former feels like a loss, the latter like a gain. Meanwhile, as Social Security never offers the choice, recipients discern no losses when receiving inflation-adjusted checks. That is simply how the bureau’s payments are made.

It is difficult to argue that such divergences in perception are helpful. Guaranteed income satisfies workers, so then it should satisfy those same people when they invest outside of their employer. And either cost-of-living adjustments are beneficial, or they are not. The investor’s answer varies depending upon how the decision is presented, but the underlying economics do not.

A Modest Proposal
Such realities inform a recent recommendation from behavioral researcher Richard Thaler.

His suggestion addresses mid-tier retirees--those who own some financial assets, so that they do not rely on Social Security alone, but who are not so wealthy as to merit attention from experienced financial advisors. This hypothetical investor requires an efficient way to transform his lump sum into income. However, because he views inflation-adjusted immediate annuities negatively, he is unlikely to arrive at the best investment decision.

So why not nudge our retiree in the right direction? Thaler suggests doing so by opening the Social Security Administration’s doors. In addition to contributing involuntarily to the SSA’s coffers during their employment lifetime, workers should be able to voluntarily--the program would always be voluntary--give the SSA some of their 401(k) assets when they retire. The SSA would then convert those monies into inflation-adjusted lifetime income payments. His Social Security checks would increase.

As I read the proposal, its potential merits include: 

1)     The Possibility of Changing Perception

History has demonstrated, abundantly, that few retirees will find guaranteed lifetime income on their own. Swapping today’s hard-won assets for tomorrow’s hopes is painful. The SSA could substantially alter that view merely by entering the game. Its involvement would sanction the tactic. It would signal to 401(k) participants that the federal government has determined that such an exchange would lead to a gain, rather than a loss.

Such an action would have a power to change perception that the private marketplace cannot match.

2)     Hiring the Experts

If nothing else, the Social Security Administration excels at converting assets into income. It already does so with far more money ($900 billion per year), for far more retirees, than does any other U.S. entity--and in inflation-adjusted terms, too. The organization was built for this task.

3)     Improving the Product

No private insurance company can fully assure its annuity providers that it will be around to fulfill its promises. The Social Security Administration can make that promise. (If nothing else, the Treasury can simply print more money to fulfill the obligations.) It also can deliver the closest thing to fair actuarial value with its payouts, given the advantages of its enormous scale.

Reality Intrudes
The proposal’s drawbacks, I believe, are largely political. Many would like to see less federal involvement in retirement planning, not more. In addition, the Social Security program’s long-term viability is frequently questioned. As a Nobel Laureate who already has influenced retirement programs (through, among other things, the development of 401(k) auto-escalation savings programs), Thaler will attract Washington’s attention. Whether the Beltway will listen, I would not venture to guess.


John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.