Putting Insurance Into 401(k) Plans

Making the Argument On Sunday night, The Wall Street Journal blogged a short article by Wharton Professor Olivia Mitchell, entitled "How to Put the Pension Back into Retirement Plans." Mitchell advocates that 401(k) plans make deferred-income annuities available to participants. It's not a sexy subject--as of this writing, her article had attracted no comments--but it is, I think, an important one.

The WSJ blog is based on an academic paper that Mitchell co-authored with two faculty (Vanya Horneff and Raimond Maurer) of Goethe University, Frankfurt. Deferred-income annuities, sometimes called longevity-income annuities, are insurance policies that pay out on a future birthday rather than on death as with life insurance. Also, rather than being a lump sum, the payment consists of ongoing cash flows until the purchaser's death.

To cite a simple example, an employee who retires at age 65 with $500,000 in 401(k) assets could put $75,000 into a deferred-income annuity that pays out at age 85. If the employee dies before age 85, the insurance policy disappears--but the time horizon was short enough that the employee should have had no problems making ends meet with the remaining $425,000.

If, on the other hand, the employee survives until age 85, then that $75,000 insurance policy will kick out about $30,000 in annual income. (That figure is based on today's quotes.) As that amount is nominal, rather than adjusted for future inflation, it isn't as impressive as it first appears. Nonetheless, the combination of the deferred-income annuity payments, Social Security, and what might be left of the asset pool should suffice for the rest of the employee's life.

Two Uses Thus, deferred-income annuities serve a dual purpose: They are insurance, and they are investments.

They are insurance in that they protect against the risk that the retiree outlives her assets. (Theoretically, it could be "his," but as a reader wrote me regarding the standard assumption that retirees plan for 30 years of retirement, "I have never known a single male who retired at age 65 to make it until age 95.") Time horizon is the largest uncertainty for retirees, even larger than the unpredictability of the markets, and deferred-income annuities directly address the issue.

They also are investments. As with Social Security checks, deferred-income annuities are effectively like having a long, high-quality bond. The steady, ongoing nature of such payments makes for an extremely safe portfolio, meaning that retirees who own deferred-income annuities might be able to hold more stocks with their investment assets. Many who study the issue of proper asset allocation during retirement urge that investors be more aggressive; a deferred-income annuity could be one tool that enables them to do so.

Mitchell et al. confirm what intuition suggests: Assuming that they are fairly priced (excessive costs, of course, can ruin even the most attractive of investments), deferred-income annuities will benefit most retirees. Per the output from the authors' complex model (better they create it than me), those who put 8%-15% of their assets in such an annuity when they retire will generally enjoy better outcomes. The paper estimates a net gain of 5%-20%.

As with any annuity, the benefit increases with longevity. Those who expire early provide the money for those who reach the payout age--and those who live the longest reap the highest rewards of all. Thus, all things being equal, deferred-income annuities are best suited for the highly educated, as life expectancies increase with education. (Those with college degrees have longer expected life spans than those with high school degrees, who in turn outlive those without high school degrees.)

Practical Considerations The idea would seem to make financial sense. Whether it can and will occur, though, is another matter.

The good news is that two years ago the U.S. Treasury department relaxed tax rules that had penalized deferred-income annuities that were used within tax-sheltered retirement accounts. (The penalties were not intentional; they were an accidental byproduct of the Required Minimum Distribution regulations.) There are no longer legal reasons not to include such insurance products within 401(k) plans.

There are a host of practical problems, though.

Deferred-income annuities are very different from the investment-only funds that currently dominate 401(k) plans. If these are to become prevalent, the marketplace has much learning to do. Those who sell and service 401(k) plans will need to understand insurance products just as they currently understand investment vehicles, as will plan sponsors.

There are also legal concerns. The 401(k) marketplace is heavily litigated, with dozens of lawsuits currently pending. Because of these legal actions, the rules of engagement for large-company plans have been pretty thoroughly mapped out, and they don't include annuities. That's not to say insurance features couldn't become standard fare in the giant 401(k) plans, but that would require setting some precedents in a legal climate that discourages innovation.

The toughest nut of all is the employee. What retail investors understand, appreciate, and value the benefits of fixed-payment annuities? To answer that rhetorical question, very few. Fixed annuity sales are perpetually poor. Purchasing an annuity is an odd business. It requires spending a great deal of money up front, with a slow future payoff. The task is psychologically difficult.

Mitchell et al. suggest, with a tinge of wishful thinking, that 401(k) plan sponsors default a portion of their employees' monies into deferred-income annuities as those employees approach retirement age. After all, sponsors already default their employees into target-date funds. However, funneling the relatively few dollars of a beginner's 401(k) plan into the standard investment of a target-date fund is quite different from re-allocating a large sum of money, in a veteran's 401(k) plan, into the unusual purchase of an annuity.

That road will be difficult to cross. Not impossible--but if that event is to occur, it will take a great deal more public discussion.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com 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.