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Jeffrey Brown: Saving for Retirement 'Only Half the Puzzle'

The noted retirement researcher explores 401(k)s, "the annuity puzzle," long-term care, and Social Security.

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Our guest on the podcast today is Dr. Jeffrey Brown, the Josef and Margot Lakonishok Professor and the Dean of the University of Illinois Gies College of Business. A key focus of Dean Brown's research is how to create sustainable retirement income, including the role of annuities, Social Security, 401(k)s, pensions and long-term care planning. He's a research affiliate at the National Bureau of Economic Research, a faculty affiliate of the Institute on Government and Policy Affairs, and a fellow at the TIAA Institute. He also serves as a trustee for TIAA. In addition, he served on the Social Security Advisory Board under President George W. Bush and was also a senior economist at the White House Council of Economic Advisers. He has published extensively on the topic of retirement security and public and private insurance markets, and he has received numerous awards for his research as well. He holds a Ph.D. in economics from MIT, and a master's in public policy from Harvard. 

Background
Jeffrey Brown bio 

Jeffrey Brown C.V. 

Jeffrey Brown publications and working papers 

Defined Contribution (DC) Plans
Defined contribution plan definition 

Defined benefit plan definition 

A Brief History of the 401(k), Which Changed How Americans Retire,” by Kathleen Elkins, CNBC.com, Jan. 4, 2017. 

The Disappearing Defined Benefit Pension and Its Potential Impact on the Retirement Incomes of Baby Boomers,” by Barbara A. Butrica, Howard M. Iams, Karen E. Smith, and Eric J. Toder, Social Security Bulletin, Vol. 69, No. 3, 2009. 

What Killed Pensions,” by Mary Beth Franklin, Kiplinger, Oct. 6, 2011. 

Public Pensions Are Still Marching to Their Death,” by Jeffrey Dorfman, Forbes.com, Sept. 11, 2014. 

House Passes SECURE Act to Ease 401(k) Compliance, Promote Savings,” by Stephen Miller, SHRM.org, May 23, 2019. 

How the SECURE Act Would Impact Your 401(k),” by Simon Moore, Forbes.com, June 25, 2019. 

Annuities in 401(k)s Won’t Solve the Retirement Crisis. Here’s Why,” by Mary Romano, Barron’s, June 28, 2019. 

What Does It Mean to Annuitize?” by Justin Pritchard, Thebalance.com, Jan. 21, 2019.  

Crash Course Needed: Four Out of Five Americans Fail When Quizzed on How to Make Their Nest Eggs Last,” by The American College for Financial Planning, Dec. 3, 2014. 

401(k) Nudges and Course Corrections,” by Kimberly Blanton, Squared Away blog, Oct. 24, 2017. 

Thank Richard Thaler for Your Retirement Savings,” by Ben Steverman, Bloomberg, Oct. 10, 2017. 

Plan Quality Varies Significantly by Industry,” by John Manganaro, PlanAdviser, March 20, 2017. 

Corporate Profits and 401(k) Plan Performance Go Hand in Hand: T. Rowe Price,” by Michael S. Fischer, ThinkAdvisor, Sept. 17, 2018. 

“The Conundrum of State-Run Retirement Plans,” by Terry Dunne, InvestmentNews, May 8, 2017. 

Reasons to Be Wary of State-Run Retirement Plans,” by Jeffrey Brown, Forbes.com, Feb. 10, 2014.  

Multiple Employer Plan (MEP) definition 

How Hard Should We Push the Poor to Save for Retirement?” by Andrew G. Biggs, The Journal of Retirement, Spring 2019. 

Thrift Savings Plan 

Annuities

Use Annuities to Protect Yourself from Yourself,” by Jeffrey Brown, Forbes.com, May 22, 2014. 

Income Annuities Provide Retirees Longevity Protection,” by Wade Pfau, Investment News, Sept. 28, 2019. 

Why Don’t People Insure Late-Life Consumption? A Framing Explanation of the Under-Annuitization Puzzle,” by Jeffrey R. Brown, Jeffrey R. Kling, Sendhil Mullainathan, and Marian V. Wrobel, National Bureau of Economic Research, January 2008.

Variable annuity definition

Equity-indexed annuity definition 

Deferred payment annuity definition 

The Main Types of Annuities Made Easy,” by Clair Boyte-White, Investopedia, July 27, 2019. 

Annuities and Inflation Risk,” by Robert Bloink and William H. Byrnes, ThinkAdvisor, Sept. 3, 2011. 

Lifetime Income for Women: A Financial Economist’s Perspective,” by David F. Babbel, Wharton Financial Institutions Center Policy Brief, Aug. 12, 2008. 

Jeff Brown Tackles Tough Annuity Questions,” by Michael Finke, ThinkAdvisor, Sept. 29, 2014. 

Annuities and Individual Welfare,” by Thomas Davidoff, Jeffrey Brown, and Peter Diamond, The Center for Retirement Research at Boston College, May 2003. 

Behavioral Impediments to Valuing Annuities: Complexity and Choice Bracketing,” by Jeffrey R. Brown, Arie Kapteyn, Erzo F.P. Luttmer, Olivia S. Mitchell, and Anya Samek. National Bureau of Economic Research, Oct. 11, 2019. 

Intertemporal choice definition 

Long-Term Care
Does Medicare Cover Long-Term Care?” Medicare.com

"Insuring Long-Term Care in the U.S.," by Jeffrey Brown and Amy Finkelstein, National Bureau of Economic Research, September 2011.

The Interaction of Public and Private Insurance: Medicaid and the Long-Term Care Insurance Market,” by Jeffrey R. Brown and Amy Finkelstein, National Bureau of Economic Research, October 2004.

Can Increasing The Long-Term Care Insurance Elimination Period Make Coverage Appealing Again?” by Michael Kitces, Nerd’s Eye View, Jan. 7, 2015. 

Long-Term Care Financing Project

Hybrid Long-Term Care Policies,” by Wade Pfau, Forbes.com, Jan. 21, 2016. 

“Is the LTC Cost Guarantee of Today's Hybrid Life/LTC or Annuity/LTC Insurance Policies Just a Mirage?” by Michael Kitces, Nerd’s Eye View, Oct. 16, 2013. 

Life-LTC Hybrid Sales Level Off: LIMRA,” by Allison Bell, ThinkAdvisor, July 22, 2019. 

Social Security
Social Security Trustees’ Summary Report, 2019.

How Would You Fix Social Security?” The Center for Retirement Research at Boston College. 

How the Latest Report on Social Security’s Solvency Changes Your Retirement Plan,” by Bob Carlson, Forbes.com, May 24, 2019. 

Transcript

Christine Benz: Hi, and welcome to The Long View. I'm Christine Benz, director of personal finance for Morningstar, Inc.

Jeff Ptak: And I'm Jeff Ptak, global director of manager research for Morningstar Research Services.

Benz: Our guest on the podcast today is Dr. Jeffrey Brown, the Josef and Margot Lakonishok Professor and the Dean of the University of Illinois Gies College of Business. A key focus of Dean Brown's research is how to create sustainable retirement income, including the role of annuities, Social Security, 401(k)s, pensions, and long-term-care planning. He's a research affiliate at the National Bureau of Economic Research, a faculty affiliate of the Institute on Government and Policy Affairs, and a fellow at the TIAA Institute. He also serves as a trustee for TIAA. In addition, he served on the Social Security Advisory Board under President George W. Bush and was also a senior economist at the White House Council of Economic Advisers. He has published extensively on the topic of retirement security and public and private insurance markets. And has received numerous awards for his research as well. He holds a Ph.D. in Economics from MIT, and a Master's in Public Policy from Harvard. We're pleased to have him as a guest today.

Dean Brown, welcome to The Long View.

Dr. Jeffrey Brown: Thank you for having me.

Benz: We're thrilled to have you here. Let's get into a very general question. We have more and more people retiring without the benefit of pensions, and many of them appear to be facing a shortfall in their savings. Where did we go wrong in this transition away from a defined-benefit system?

Brown: Well, it's a great set of questions. And I think first, it's important to put into perspective that the defined-benefit system in its heyday was never perfect either. There is sort of a longing for those days, but honestly, if you look at the fraction of the population that was covered by DB pension plans back in the ‘70s it’s very similar to the fraction covered by 401(k) and DC plans today. I think where we went wrong is that we never really intentionally designed the DC system to be a primary retirement plan, and therefore it's lacking some features, like annuitization and so forth, that make the pensions a little bit more secure source of retirement income.

Benz: So, you mentioned annuitization and I know that there has been some interest in adding annuitization to the DC space specifically in relation to the SECURE Act. We'll talk more about annuities later on. But let's talk about that decumulation process within the defined-contribution system. Do you have any thoughts on how that could work better for investors?

Brown: Yeah, so I always tell people that it's really important when you think about retirement planning to recognize that saving for retirement is really only half of the puzzle. The other half of the puzzle is figuring out how to decumulate or dis-save or how quickly to spend your money down in retirement. And that's actually a pretty complicated problem in the absence of annuity products, because most of us don't know how long we're going to live. And so, we're forced to trade off two risks. One risk is that if we consume too aggressively, too quickly, we might find ourselves at 90 or 95, and not have enough money left to maintain our living standard. But if you deal with that by just taking a very conservative spend-down approach, then the risk you run is that you're going to die having sort of subjected yourself for your lifetime to a much lower level of consumption then you could have otherwise afforded. And in the absence of things we economists refer to as life annuities, which also include things like Social Security, your defined- benefit plans—that's a tricky problem to solve. And I think, especially in this environment that we're in today, I would say that annuitized income is even more important to think about. Because with interest rates low and and so forth, you know, people are having more difficulty accumulating enough wealth, converting it into a sustainable income stream and some of the alternatives to annuitization, like 4% spending roles and the like, don't really work very well in this low-interest-rate environment.

Benz: So, are you supportive of the idea of making it easier to add annuitization to defined-contribution or 401(k) plans?

Brown: 100%. I think at minimum, we need to make it a widely available option. Honestly, I think the reason that it hasn't been traces back to the origins of the 401(k) system in the U.S., and how some of the regulation came about. If you recall back and, the act that established the 401(k) was really intended as a supplemental savings plan, not as a primary retirement plan. And then what happened is that the government essentially decided at some point that when they were going to go and regulate the providers, they decided that there was no requirement to annuitize the money. So, if you just wanted to get your employees to retirement, then kind of leave them on their own, that was essentially OK. But if you as an employer decided to offer an annuity in your plan, then you were going to be held to a very high fiduciary standard, which was the safest annuity available standard. Which essentially meant that if you were going to provide an annuity option and anything went wrong with that annuity, you were going to be held liable. And that scared most plan sponsors away for many, many, many years.

Now, the Department of Labor eventually relaxed those standards. But it meant that for the first two decades or so of the 401(k) existence, there was a strong kind of legal incentives to stay away from them. And so, the whole system really built up around accumulation without a lot of emphasis or discussion or options around decumulation side. That's really how we got to where we are today. And I think most retirement experts would agree that if we were going to design a system from scratch, we would never design it that way. We'd want to think about both halves of the problem; not just how do we get people to save enough? But how do we get them to spend down in a sustainable way.

Ptak: So, if we do address that other half—the annuitization, call it facet—do you have thoughts on what best practices would look like? Let's say we switch that feature on and it's enshrined by legislation, what have you. Do you have sort of a solid idea of how that would work best for participants if offered?

Brown: Yeah, and this is a more complicated issue to deal with than say, default-savings options and so forth. Because of the nature of an annuity is where the income power really comes from is kind of this irreversible feature that once you annuitize you're kind of locked in. And so we want to be careful not to force people to annuitize for whom it's not a good deal. I don't mean a good deal, but for whom it's clearly a suboptimal decision. So, if you reach retirement at age 65, and you have already been diagnosed with a horrible disease and you know you're not going to live very long, it's probably not a great idea to force that person to annuitize.

Short of that, though, I think there are things we can do. And one, and this is a bit controversial, but I do think we ought to essentially require that 401(k) plans and other defined-contribution plans offer an option for an annuity. It could be an in-plan annuity option, it could be…here's a platform you can go to, so that at least we force them to make people aware of the decision. Force people to at least think about it without necessarily requiring them to do it. I have also long been an advocate, and have some research to support it, around the importance of as people are accumulating wealth in these plans of reporting their—in addition to their account balance— reporting how much income it's going to provide them in retirement.

The reason I think this is important is most of us are not saving for retirement just so that we have some lump sum on an arbitrary retirement date. We're saving for retirement, because we want to provide for consumption in our old age. And the evidence is pretty clear that most people are not very sophisticated or numerate when it comes to translating income flows into lump-sum equivalents. And so, people tend to overestimate how much $100,000 is going to provide them every month for the rest of their life. And I think reporting that information as part of your quarterly or your annual statements would also be a good step in the right direction. There's other things as well, that I'm happy to talk about, but I would at least start there.

Benz: So, moving back to the accumulation side for a minute, and I think we'll probably spend the bulk of the conversation on the decumulation side, but I want to talk a little bit about accumulation. Do you view that part of the retirement problem as in sort of a better position than the decumulation issue and specifically, do you feel like nudges to help people make better choices to help them contribute in the first place—do you feel like those things have gotten things moving in the right direction on the accumulation side of the ledger?

Brown: I really do. I'm an optimist overall about the potential of our DC-based system to be an effective retirement system. I do think it needs some additional tweaks mainly on the decumulation side, but on the accumulation side—if you go back into the ‘90s, and you look at the typical plans, there were a lot of problems, but the world today is very different than it was 20 years ago. Automatic enrollment has been proven extremely effective and widely adopted; automatic escalation of contributions; the use of qualified default-investment options that provide diversification and automatic rebalancing. I think essentially the DC system works actually quite well, for those who have it. And if I were to pinpoint two problems with the DC system that we have in place today, one I've already mentioned is the decumulation side. But the other is that there are too many part-time workers and employees of small companies that just simply don't have access to these well-designed 401(k) plans. But you know, if you work for a large company, a Fortune 1000 company, and you've got a 401(k) plan, most of them today are pretty well designed to set you on your way.

Ptak: But we also observed that employees at smaller firms that perhaps do have access to a defined-contribution plan, a 401(k) plan, there can be a pretty stark contrast in the quality of that plan versus the plan you describe at a larger firm, which perhaps is equipped with better investment, lower-cost investment options, and perhaps other features. Would you agree?

Brown: I do agree and it's absolutely the case that we have unfortunate a bit of a have and have-not model. Because, you know, the majority of people who are employed at large firms and participate have a pretty good plan. But there are a lot of citizens that do not have access to that kind of a plan. And that's what's given rise to various policy experiments, whether it's the, you know, the OregonSaves or…Illinois has its program; a number of states have tried to go into offering a state-run plan for individuals that don't have access through an employer. And you know, it's still early and I think the jury is still out on the pros and cons of those approaches. But clearly, there is a large segment of our population that's not being as well served.

Now, what's interesting, though, there is a debate in the academic literature as to how big of a problem this is. When you take into account the fact that lower-income workers, you know, part- time workers and often at smaller firms, they do have a much larger fraction of their income replaced by Social Security and so forth. But on net, I think most of us agree there is a problem. It's not a majority of households that are at risk, but it's a sizable minority. And that's another set of issues that we're going to have to figure out how to deal with more effectively.

Benz: So, you reference the multiple-employer plans. And I think we can agree that more coverage is probably good. But I guess something that nags at me is just whether isn't that tremendously inefficient for each of these states to be fielding their own plans? It reminds me a little bit of the 529 infrastructure where you've got every state fielding its own college savings plan. What's your thought on that?

Brown: I couldn't agree with you more, Christine. When this idea first came out, I confess I was actually somewhat critical of the idea and not because I disagreed with the problem. I agree there's a problem. But I was really concerned that if we did this piecemeal state by state and the states were each adopting different sets of rules, it was going to be a disaster. You know, if you had electrical-distribution company and you had employees in Illinois and Indiana and the states had different rules, and I just didn't see that going well. Second, I really did think it would just be more efficient and better to have this conversation at a federal level. And finally, I had concerns early on, but I'm happy to admit, I think I've been proven wrong, that coming from the state of Illinois, I don't have the greatest confidence in a lot of the state's abilities to manage retirement funds particularly well. But to their credit, most of the plans that have launched on the state DC plans have set them up so that the governance and you know, third-party asset management, and so forth, seems like it's off to a good start. But yeah, I think we'd be better off with a nationwide solution rather than a state-by-state approach.

Benz: So, what would that look like? Would it be similar to sort of a Thrift Savings Plan for rank and file workers or what would sort of be your vision for that?

Brown: Yeah, that's exactly the analogy that I would use is something like a Thrift Savings Plan. You know, that's a low-cost, diversified set of options; there's an independent board that every few years goes and rebids the management contracts out to ensure that the fees remain low. It's a small number of investment options. But while it's a small number, they are pretty comprehensive in terms of their coverage of various asset classes. So, I think that's a great model to think about. The challenge, and this is always the trick, right? The challenge here is, how do we do that to help the people that don't already have access to plans without crowding out a lot of employer-provided plans that might actually be better or more generous, right? So, you know, as an economist, we're always concerned about trade-offs. And the good thing about having, you know, a TSP for all, so to speak, would be, now everybody's got access to a plan.

What we don't know, and I don't know how big the effect would be is, are there some midsized or larger employers who would say, hey great, I'm happy to now get out of the retirement business. And those employees could actually turn out to be worse off in the sense that they had a generous match from their employer or whatever. And now they've just walked away and left it up to the federal program. But, you know, this is where we're going to need to do some experimentation. The one benefit of doing this state by state is that we'll have some variation and how it's done across the country. And I'm sure there'll be some smart empirical economists that go out and study the issue and inform us on it.

Benz: So, switching back over to decumulation, I want to talk more about annuities because a lot of your research has been in that area. So, let's just start the discussion by talking about what you view is the key benefits of annuities in retirement.

Brown: Yeah, so quite simply it goes back to the problem I articulated earlier, which is that in the absence of annuities, it's actually a very difficult problem to figure out how to optimally spend down your wealth over retirement, because you don't know how long you're going to live. And so you've got this huge uncertainty about the end date, and you want to make your money last for life. But you don't know if that's going to be 10 years, 20 years, 30 years, or 40 years. And any strategy that does not involve an annuity is doing one of two things. It's either giving you a lower standard of living than you could afford with the annuity, or it is giving you as good or better standard of living for a while but putting you at risk that if you live longer than life tables suggest you will on average, you're going to not have enough money to sustain it. And there really is, I mean, we can show it mathematically, there's nothing that beats an annuity when it comes to dealing with what we call longevity risk. I mean, as you know, the annuity works you hand over a pot of money either as a lump sum or along the way, and just like Social Security, it pays you back. And that payment will continue as long as you live. So, that's the main benefit. It's an insurance product. And what you're insuring is that you're going to be able to maintain a minimum level of spending or consumption no matter how long you live.

Now, the fact that there's this risk-pulling element of it that some people live less long and others live longer, and that's how you know the product works…does mean that the amount of income that you can get each period is also higher. Because essentially, people who live longer are having their income supplemented by the people who didn't live as long. And that's really where a lot of the value comes from. Now, that's not free. The cost is that, money that you annuitize is no longer available to leave behind as a bequest to your children or to a charity. But you know, there are ways to deal with that. And I'm certainly not suggesting that people annuitize all of their wealth, but a significant enough fraction to kind of cover the basics.

Ptak: Are there types of annuities that you find are most beneficial? Or is it difficult to sort of resolve to a particular type of annuity?

Brown: Yeah, so first of all, I think it's really important for people to understand that when economists like me talk about annuities, we're really talking about a true insurance product where the payout is contingent on how long you live. There are a lot of products out there in the market that have the term “annuity” associated with them, and legally they are annuities, but they have no life-contingent income benefit to them at all or it's only an option. And so I'm not talking about equity-indexed annuities. I'm not talking about variable-annuity contracts that people use as accumulation devices and so forth. I'm really talking about this, annuities that serve an income purpose. And to a large extent, I think the simpler the better. There's a pretty active market out there for what we call single premium, immediate annuities, which are the most plain-vanilla, stripped-down product that it's easy to price compare, where you say, hey, look, I'm 65-year-old male, and I have a 64-year-old spouse, and we want to buy a joint and survivor annuity, and here's $500,000. The insurance company says, great, here's how much we will pay you for the rest of your life, or if it's a joint and survivor annuity, for as long as either of you live. It's a very simple product. And I think it plays an important role. The main feature that I don't like about those products is that very few of them have inflation protection built in. And so, it does give you some risk around purchasing power, but at least you're assured of the nominal value lasting as long as you do.

Benz: So, one bifurcation is immediate versus a deferred annuity. It seems like at least among some of the retirement researchers I've spoken with recently, there's a lot of enthusiasm for the deferred types of products. Let's talk about the differences first. And whether you have a preference or whether you think it’s kind of dependent on an individual's own situation.

Brown: Sure, and I will say the terminology in the industry and in academia is not helpful here, because we all use slightly different terms to refer to slightly different products and different companies call them different things. So, let's just kind of break it down even a little further than you just did. First of all, there's the question of how are you going to pay for the annuity? And what I'm definitely a big fan of is, and especially if we did it in the context of a 401(k), is buying small units of future-annuity income as you go. So, imagine that you're putting money into a QDIA or a default option and part of that money, instead of just going into bonds, is going into buying future units of income that won't start paying out until you reach retirement age. I think that's a brilliant idea, and I love it. We don't see a lot of those products out there. I think we will see some products like that coming out down the road. That allows you to kind of do the rough equivalent of dollar-cost averaging, of a future-annuity income, do a little bit of a hedge against some interest-rate risk etc. I think that's a wonderful idea.

Outside of a 401(k), you still have the option to buy deferred annuities. But a lot of products that are called deferred annuities are really just interest-bearing savings account where there's no life contingency until you reach the point of retirement and convert it into an income stream. And those I don't really have a strong bias for or against, it's just OK, if it's just interest-bearing accumulation device along the way then I just want to compare the rate of return to other after-tax rate of returns that I can get. And then you want to really pay attention to what the conversion rate is around the lifetime income.

Now, the other thing you may be referring to and sorry, I'm going on a little long here, are when people refer to deferred payout annuities or sometimes people call it longevity insurance, although I don't like that term, because I think all annuities are longevity insurance. But let's say you know, you reach retirement age, and maybe you don't want to put a whole bunch of your nest egg away. And you really are just worried about what happens if I live to be 85 or above. So, you can take a small amount of your wealth at age 65, buy an annuity that will not start paying you any income unless and until you reach age 85. That's a great product. It really is. It has a lot of features that are desirable. It looks and feels a little bit more like an insurance product that doesn't require that you tie up so much wealth; but what it does is it truncates your planning horizon, because now you know that if your income is taken care of from age 85 and beyond, then from 65 to 85, I can take the rest of my wealth and now I have a well-defined problem.

Benz: Right.

Brown: I've got to stretch this out over 20 years and that's a much, much, much easier problem to deal with.

Ptak: What type of retiree is going to benefit from an annuity the most and on the flip side of the ledger, what are the characteristics of retirees who you think would benefit relatively less?

Brown: It's great question. And if we did individual underwriting of annuities, then I would say everyone could benefit, right? Just depending on your own personal health characteristics, we'd price it appropriately. The market doesn't really work that way. And so there's kind of the obvious set of observations that if you are an extraordinarily healthy individual and your parents live to a ripe old ages, and you expect to live to a ripe old age, and you're fit and healthy, an annuity is going to look great to you. If you're entering into retirement with significant, serious health concerns, and you have very good reason to think you're not going to live as long, then an annuity priced on general population characteristics is not going to be as good of a deal.

Now, taking that logic a little further—what's interesting is if you go into the retail-annuity market, they're allowed to price differently for men and women and since women live longer the price or the payouts reflect that; but in the qualified-plan space, they're not allowed to discriminate on the basis of gender. And so, what happens is that women are actually getting a better deal from an in-plan annuity than men are, because they use gender-neutral mortality assumptions. So, it's especially a good deal for women, less so for men. And I actually think one of the things I always encourage people to think about is if they are married, or in a domestic relationship, they have a life partner to think about the flow of income, and what happens when the primary insured dies. How much of that income do you want to continue? Because most products allow you an opportunity to designate a percentage of that income to continue for the second life. And that's really important to take into account. So those are a few of the factors I would consider. The only other thing I was going to mention is obviously the extent to which people care about bequest motives, leaving money behind, might not influence so much whether to annuitize, but perhaps how much you do.

Benz: How about the presence of a pension?

Brown: Well, sure, and that's a good clarification. Because when I talk about the level of annuitization, here's how I talk about it to laypeople. Think about what your basic income needs are going to be in retirement, the money that you really feel like you need to have coming in every month that you just need to live on: pay the mortgage or rent if you have one, put food on the table, keep the roof over your head, do the basic things of life. Take that amount, subtract whatever you get from Social Security, and subtract whatever you get from a defined-benefit pension, if you're fortunate enough to have one, and if you've got a gap there, that gap is monthly income that you feel like you really need, you should buy an annuity that's large enough to cover that gap. Now whether you annuitize above and beyond that gets into a whole set of trade-offs—you can get a little bit higher income, but you're giving up some liquidity; you might want to keep some precautionary savings in the background in case you know of a health shock or something like that. So, the short answer to your question is, yeah, if you have a defined-benefit pension, and it's generous enough that along with Social Security, you've kind of got your basic needs covered, then maybe you don't want to annuitize any further, but that situation is becoming less and less common.

Benz: You referenced the role of health in all of this and some of your research has looked at adverse selection in the annuity marketplace, whether healthier people tend to purchase annuities more. What does your research show on that front?

Brown: Well it shows it does happen, and that does cause annuities to be priced a little higher than they would be in the absence of adverse selection. But we've also found that the effect that it has on price is not so great that it should dissuade most people from doing it. So, if you're just like the typical person walking into retirement, average health, you don't have any particular reason to think that you're going to live a shorter life than most people—I would say that at current market prices, there is still a very important role for annuities to play in your portfolio. By the way, one other thing I should mention, as long as we're taking a broad definition of annuitization—actually one of the best annuities out there is Social Security: its inflation index, it has automatic survivor benefits, and so forth.

And one way to sort of, "buy annuities" is to delay claiming of Social Security. When you delay claiming of Social Security and take it closer to age 70, than closer to age 62, you get a significant increase in your monthly income. And what's nice about it is it's priced using average-population mortality, so you don't have adverse selection working against you. Its inflation-indexed, and to be honest with you, because Social Security actuaries are still using some interest rates from when the legislation was put in place years ago, it's actually a pretty good deal relative to taking the money early. So one of the strategies that I think any sophisticated person who has the liquidity might want to consider is if they retire in their early ‘60s, delay claiming Social Security and spend down some of your liquid financial assets to support consumption up until the point at which you retire. It's the same logic as buying one of those longevity insurance products that kick in later in life.

Benz: So, a lot of your research has centered around the fact that despite the benefits of annuities for many retirement plans, retirees tend to be resistant to purchasing them. So, let's talk about what your research shows specifically starting with whether this appears to be rooted in rational thought, and a lot of your research kind of centers on addressing that question.

Brown: Yeah, you know, it's interesting not to make this about me. But I've been researching annuities for, let's say two decades. In the first decade, I was trained as a neoclassical economist, and I did everything and in a context of thinking about fully rational optimizing people. So, a lot of my early work was around wow, this is really a puzzle. And it's been a puzzle for many decades. And let's explore some different reasons within a rational framework of why people might not do it. Around 2008 or so I wrote a theoretical paper with Peter Diamond and Thomas Davidoff that we kind of came to the conclusion that, you know what, I think we've exhausted all of the rational answers. We haven't solved it; there's something else going on. And so about that same time, I teamed up with some behavioralists and started doing more behavioral economics, behavioral finance work in the area. And I think both the work we've done and the work that others have done, I think over the last decade, has really created a rich literature on this topic.

So, we have found a lot of evidence that people are not optimizing and there's been a number of interesting experiments that have allowed us to make these conclusions that people are not optimizing without having to rely on kind of the subjective assessment of should they annuitize or not. And we've done this through a variety of experiments where we manipulate the information that they're provided—see what affects their decision, what doesn't affect their decision and so forth. And so, I'm a pretty firm believer today that the typical consumer out there is not making annuity decisions on the basis of our formal, rational optimizing models that economists use for so many years.

Benz: Before we leave the rational reasons that someone might not annuitize, I'd like to discuss the role of advisors in this, specifically if you have an advisor who's compensated based on assets under management, he or she may be disinclined to recommend an annuity and that in turn may influence the end investor's decision. So, what about that? Have you looked at that about potential conflicts of interest really, that AUM-based advisors have with respect to annuities?

Brown: Well, it's a great question. And there's a ton of anecdotal evidence on this, that is consistent with your hypothesis that advisors are not recommending them. And in some cases, it might be because of incentives from compensation. It's been very, very difficult to get data on that; a lot of companies hold their broker or agent compensation policies fairly close. And so I've not seen a good study on it, but I've heard that story a lot. But the other angle on this which is a little less nefarious, but which leads to the same outcome, is that financial advisors are people too. And the behavioral biases that we are documenting—I think it's a disservice to call them irrational in the sense that, yeah, true technically, according to an economist’s definition of irrationality, these behavioral biases are not rational. But they're very human. Like we all do it. Even PhD economists are subject to these behavioral biases, and so are financial planners, and so some of the the way that we frame the conversation, the complexity of the decision—all of these things that we're starting to build this body of research showing that matter, there's no reason to think that financial advisors are somehow immune from this. And I think going forward, I would expect to see some really interesting research on exactly that, which is, to what extent do financial advisors experience a lot of these same behavioral biases and how they think about not just annuities, but a whole range of financial decisions?

Ptak: More generally, how do some of the behavioral biases that you've researched and allude to…how do they manifest themselves in an advice context? I think that we're probably most familiar with some of the behavioral biases that afflict us on the accumulation side: we're overconfident, we anchor recency bias. There's a whole litany of sins that we commit, right, as investors, as savers. So how about when it comes to annuities? Like what sort of a textbook example of one of these ticks, or sort of biases, that perhaps we succumb to and not making the optimal choice?

Brown: Yeah, so great question. And there's a lot of good examples. I'll start with my favorite because it was my own first sort of foray into applying behavioral concepts to annuity choice, was how you frame the conversation, how you frame the decision. And so framing is this concept that we've imported from psychology that really is about you're providing the same information to make a decision. But the context in which you're putting that information, essentially, we think what's going on is it's lighting up different parts of the brain. It's putting the decision in a slightly different context for you. It's the way you market it or frame it or get them thinking about it can influence the decision in a very different way. So, the insight we had in the context of annuities was that if you talk to most economists, and you say why is an annuity valuable? They'll say, well, it's because people get their well-being or their utility from consumption. And an annuity is a great way to guarantee to buy insurance that you're always going to be able to have this minimal level of consumption that has a lot of value. But when we go and talk to people on the street, and you ask them about annuity, a lot of times they would say, well, that sounds risky to me, it feels like I've got $100,000 and if I hand it over to you, I might get nothing back if I die tomorrow; or if I lived to be 90, I might get hundreds of thousands of dollars back. So, it feels like I'm gambling on the length of my life.

So, we thought, well, rather than dismiss that as irrational behavior, let's actually examine it. So, we did a study where we presented people with a wide range of financial products, I think, six or seven different ones, but rather than naming them as this is a savings account or this is a bond or this is a perpetuity or whatever, we just described what the product did. And we described it in very numerical terms. But the difference is in half the cases, we used language to evoke what we call an investment frame. So, we would say you invest your $100,000 in this product, it returns to you this much amount of money each month etc., etc. And the other half of the population provided all the exact same description of the products and so forth, but we changed a few words. And instead of saying “invest,” we'd say, “will you buy this?” Instead of saying “it returns,” we would say “it would give you this amount of income that you could spend,”—but all the numbers were the same, the product descriptions were the same etc.

And what we found is when you present the exact same product trade-offs in an investment frame—like nobody wants to buy an annuity; I think the best we found is like maybe 20% of the population would choose an annuity over a simple savings account. But you present the exact same choices using terminology that gets them thinking about the sustainability of spending and the numbers flipped completely. And like 70% to 80% of the people wanted the annuity instead of the savings account. So, the fact that you can get people to flip their decision just based on how you portray the information…

First of all, it's evidence that they're not making fully optimizing decisions. And two, it provides some actual direct insight as to how you might want to frame a conversation if you're an advisor working with a client. So, if you say to them, hey, let's talk about your investment portfolio and how we're going to maximize returns and maximize retirement wealth. And you define success on the basis of how much money you've gotten your account, then it's a lot to overcome to then say, and by the way, we're going to reduce your account from $1 million to $500,000, but we're going to give you this, you know, monthly income. If instead you say let's talk about what you want retirement to be about. You need a certain amount of money each month to spend; what are the things you want to do when you're retired? OK, how are you going to be sure that you're going to have that income coming in, whether you live to be 80 or 90 or 100 years old? Then you say, you know we've got a product that can actually help you achieve that and ensure that you're going to have that income for as long as you live. That's a very different conversation. And I think given the number of companies that are now starting to talk about annuities that way and train their sales forces to do that, and so forth, I think they're finding that it resonates as well.

Benz: Do you think one issue with consumers may simply be that the annuity basket is so diverse, and it does include some really, in my view, not great products that are very high cost? So, consumers have been educated to be sort of on their guard when they hear the term “annuity?”

Brown: I do think that's a part of it…there's a couple things going on here. I mean, first of all, the decision itself, even set aside the products, the decision is a complex decision. We know from psychology and from, you know, behavioral economics that the two kinds of decisions that people have the most difficulty with are what we call intertemporal decisions. Decision that involve trade-offs over long periods of time. And the other kind of decision is when there's a lot of uncertainty. And this is a context that is loaded with both. You're trying to plan a very long retirement horizon—people have a difficult time envisioning what their preferences are going to be 30 years from now, and there's a lot of uncertainty about markets, about how long you're going to live, about your marital status, about your needs, about your health. So, it's a complex setting, all right?

So the way you have to deal with a complex setting is you've got to simplify the decision and help frame it in a way that makes the decision easier. Unfortunately, what we've done in this country for many decades is we've confused people. We have products out there that will say hey, we're an equity-indexed annuity, and when you look at it, you realize this has nothing to do with providing secure retirement income. It's basically an investment option with some tax benefits, and some options built into it to protect against market downsides. All right, well, then you layer on top of that, there are variable annuities in the decumulation phase—sometimes you can convert them into a variable annuity in the payout phase, sometimes you can't.

And then you throw in some scandals over the years where people mis-sold the products, or there were not very well-designed products that had high fees. And yeah, people are wary. I mean, there's people out there that make their living going around saying, here's why you shouldn't buy annuities, and I think they're doing a disservice because they're painting the whole market with a broad brush. There is a lot of products out there I would never recommend. But when we're talking about converting wealth into lifelong income, that's a really, really, really important conversation. And to be honest, I just wish we had a different term for it. Because I do think the annuity language and the baggage that goes along with that shuts a lot of people down before they've even really considered the option.

Benz: Shifting over to another really difficult decision in the face of uncertainty, I'd like to talk about long-term care because you have researched the long-term care space. And I know that this is an area where a lot of older adults really struggle in part because of what's gone on in that marketplace where people who thought they were doing the right thing and purchased long-term-care insurance have been faced, in some cases, with these staggering premium increases. So, let's talk about the long-term-care decision how you think consumers and advisors who help them should approach that.

Brown: Yeah, this is a really difficult decision. And let's start with you know, what happens to somebody that does not have insurance, all right. Medicare benefits for long-term care are very limited. For the most part you should think of Medicare as not really covering long-term care. There are exceptions to that: if you leave a hospital and you need to go to a facility for a short period of time to rehabilitate before going back to your home and so forth. Some of that is covered by Medicare, but even those benefits are limited. And by long-term care, we mean everything from nursing homes, skilled-nursing facilities, assisted-living facilities, home care, either by a nurse or by workers who come in and help you with other, what we call, activities of daily living. So, Medicare doesn't really cover it.

So how do most people pay for it? Well, most people are not insured. And so you've got two choices. You spend down your wealth, and that can be financially devastating for a large part of the population. And/or once you've spent down your money or if you didn't have any begin with, you end up going on Medicaid. And Medicaid is the means-tested program and the only way you can qualify for Medicaid is if your assets fall to a low enough level. You know, you might say, well, maybe that's not so bad. Like if I'm ending my life in a nursing home, maybe I'm perfectly happy to fall back on Medicaid, spend down my assets, you know, at least I'll be fed and sheltered and the like. But the problem is there are people who go into nursing homes…it's not a one-way street: people do sometimes exit home care or exit nursing homes, and when they've recovered and go back into the community, and you don't want to enter back into the community essentially being impoverished, which is what Medicaid would require.

So, Medicaid is not a very good insurance program. It's a good kind of fail-safe so that we don't have elderly individuals unable to get care. But it's not a great financial tool or insurance program. The problem is the way that Medicaid is structured, it kind of imposes, what my coauthors and I call, an implicit tax on buying a private-insurance coverage, because part of the private long-term-care insurance that you buy, ends up providing benefits that are replacing what you would have gotten from Medicaid had you spent the money down. So, you know, we've done a lot of work on this. And I think we've definitely concluded that people are in, let's say, the upper third of the wealth distribution—they are middle class, they've squirrelled away several hundred thousand dollars and so forth. I think in a lot of those cases, it still makes enormous sense for them to buy a long-term-care insurance policy from the private market.

I think for people who are lower down the wealth distribution and who have so little financial assets that, six months or a year in a nursing home is going to wipe them out anyway. It may be perfectly rational for those folks to just kind of "roll the dice" and plan on Medicaid covering their care if that's what they need. But, you know, I have long-term-care insurance myself. I'm only 51 years old. I bought it relatively young because I wanted to buy it while I was still insurable, while we were still healthy. I have seen premiums go up, but I've chosen to hold on to the policy, in order to de-risk our retirement.

Benz: So, looking at the long-term-care insurance marketplace, I think some have argued that it's kind of a broken marketplace. And Michael Kitces, in particular, has argued that he thinks that the long-term-care insurance industry ought to rethink its product offering so that they're offering products that don't begin paying benefits until maybe you've had a need for a couple years or something like that. Do you think that that would be a good way to go for the industry to help keep it healthy?

Brown: Or to get it healthy. Because I would say it's not a particularly healthy industry already. You know, I am certainly…there are a lot more creative people than me out there. And I'm very open to the fact that someone may stumble upon the magic solution here, but a lot of things have been tried. And what I worry about is that in the absence of some government policy changes, it's it's going to be difficult to get the private market to be able to create a product that's going to be a good financial value for the whole population. And here's what I mean if we could—this might actually cost the government more money, but it might also stimulate the private market and leave people in a much better place. Is suppose that you could sell a, let's call it, a wraparound policy.

So, there was some government program, call it Medicaid, or what have you, that you could buy an insurance that would just supplement what Medicaid was paying. So, you can get into a nicer nursing home, whatever the case might be. That I think a lot of people would find valuable. The problem is, under current Medicaid rules and tax rules and so forth, if you buy the policy, then that policy pays your entire stay in care and until the policy runs out, and you spend all your money, you don't get to use any government benefits, like Medicaid, to pay for it. So, until we have some policy conversations around that, it's going to be hard for the market to really, really have kind of a stand-alone product that gets wide adoption.

There've been some creative ideas out there, you know, some of the states in work that was really funded a lot by the Robert Wood Johnson Foundation—a number of states did these partnership programs where they said if you buy a minimally acceptable insurance product we'll raise the wealth limit of how much you can keep before you go on Medicaid. That solves part of the problem, but not all of it. There have been proposals to sort of bundle long-term care with annuity products. But again, these things, they can look really good on paper, but they're just getting even more complex to describe to consumers, and we know from some of our recent research that decision and product complexity is a difficult hurdle to overcome. So, I'm a big fan of private insurance markets. You know, I kind of view government programs as they ought to be our last choice, not our first choice. But you know, this is such a complicated market and such a complicated place and we're not going to eliminate Medicaid; nobody wants to do that. You know, I think we're going to have to have some conversations here about the government's role in all of this and how we can redefine the government's role so that we can then define how the private market can wrap around and supplement that.

Ptak: What do you think about long-term-care annuity or long-term-care life hybrids?

Brown: Depends a lot on how they're structured. I kind of like conceptually the idea that, you know, I buy an annuity product. And then if I meet my ADL limitations to qualify for long-term care, I get some multiple of that—maybe I get, you know, if I was getting $3,000 a month for annuity, and now I'm in long-term care, then suddenly that payment goes to, $8,000 or $10,000. I like that idea conceptually. It still has the same problems with regard to Medicaid as a traditional policy has, but it does have some other nice features. I mean, you might think going back to the conversation about adverse selection, you might think that the adverse selection goes in opposite directions in those two markets and so when you bundle them that will be less of a problem. So, I'd love to see those kind of product innovations. But I'm a little bit sanguine about just how widely adopted it will be. I mean, I don't think we're talking about, you know, half the population ever buying these kinds of products without some significant policy changes.

Benz: So, we have a big topic that we wanted to tackle with just a few minutes left. I'd like to talk about Social Security. And I know that you have done a lot of work and contributed to research in the Social Security space. So, let's just start with a really broad question about the state of Social Security today and how worried people should be about Social Security's financial health.

Brown: Sure, well, it should not come as a secret to anyone that we have a projected deficits in Social Security—they're already upon us from a pure cash flow perspective in terms of tax revenue, relative benefits being paid out. Right now, we're drawing upon the Social Security Trust Fund, and we could have a whole conversation about that. But sometime in the next, you know, in about 12 to 15 years, sometime in the early 2030s, the exact projection varies a little bit from year to year, depending on your assumptions, the Social Security Trust Fund will run dry. And at that point in time, the taxes coming into support Social Security will only be able to support, let's just call it, three quarters—75% give or take a little bit—of the benefits that have been promised to retirees. And so, unless we act before then, Congress will then face a choice of do we cut benefits? Do we raise payroll taxes? Do we take general revenue from the income tax (supporting) system—what do we do? But the chasm is fairly large, I mean, we're talking hundreds of billions of dollars a year in shortfall very shortly thereafter, and that shortfall grows over time.

So, from a personal financial-planning standpoint, I think there's two narratives, both of which are probably wrong. One is no one's ever going to touch it, or we're going to increase benefits. You know, we don't even have a plan in place to pay for the existing program. So, I don't think that these plans to expand Social Security are remotely fiscally realistic. But at the other end, you have people who are like, “Oh, I'm not even, I'm just assuming I'm not going to get any of it.” I think that's also wrong. Because if all we did is simply say, “All right, fine, we're just going to pay out what we can afford to pay based on payroll taxes,” and did nothing else—that's kind of a lower bound on how bad I think things could get. And it would be pretty bad that people would still get on the order of $0.70 to $0.75 on the dollar. Now that would cause enormous hardship on people that rely on Social Security as their primary income source, but it's not zero.

So for middle- or higher-income households that financial planners might be working with, you know, I would basically say, all right, if you're going to account for Social Security and the financial plan, let's assume that at minimum, you're pretty much guaranteed something like 70% of what you've been promised. The wild card here is that many of the proposals for how to cover the shortfall do include means-testing of benefits. And so higher-income, higher-wealth individuals may see their benefit reduced by more than the average person. But even there, you know, it's not going to be taxed away to zero. You know, when Franklin Roosevelt invoked this program, he was very smart politically about how he did it. And, he's been interviewed saying that I made this a universal program that everyone paid into and everyone got something out of so that everyone feels a part of it so that no future politician can undo my program. He used more colorful language than that. But I do think that's the situation we're in so it's not going to go away. But we do have a significant funding shortfall and it's going to hit, you know, about the time I'm hitting retirement age.

Benz: Do you have a favored fix? Or do you think it will be kind of a patchwork of different fixes.

Brown:
Well, I certainly have policies that I like more than others. I'll just start in general by saying at this point, given how close we are to the shortfall, and given the nature of the economic and fiscal situation we're in, it's going to need to be a balanced approach. I don't think we can take it all out of benefit reductions. But I also think we cannot just say we're going to, you know, leave the program exactly as it is and just raise taxes and think that that's going to solve it. I think it's going to take a balanced approach. I would like to see us very gradually reduce benefits for higher lifetime-income workers. So, kind of a progressive reduction in the growth rate of benefits. So future benefits would still be higher than today—just not as high as they would be under current law—and then supplement that with some additional revenue. And there are a lot of different ways one could do that. If we wanted to stick with the existing payroll tax, fine. We could talk about adjusting rates or raising the cap. Or you know, some people have suggested that we ought to consider a new revenue source like a VAT, value added tax, and I'm open to considering that as part of an overall solution.

Benz: Well, Dean Brown, thank you so much for your time today. It's been a terrific conversation.

Brown: I'm really happy to be on it and thanks for the invitation.

Ptak: Thanks again. Take care.

Benz: Take care. Bye Bye.

Thanks for joining us on The Long View. If you liked what you heard, please subscribe to and rate The Long View from Morningstar on iTunes, Google Play, Spotify, or wherever you get your podcasts. You can follow us on Twitter at Christine_Benz.

Ptak: And at @Syouth1, which is, S-Y-O-U-T-H and the number 1.

Benz: Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.

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