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The most consequential retirement policy reforms in more than a decade was signed into law last week, including a key reform designed to make more annuities as an option in 401(k) plans. But will access to annuities be beneficial to consumers?
Economists tend to favor annuities because they are one of the only ways to handle the greatest uncertainty in retirement: how long each retiree will live. But consumers have been far less enthusiastic. Indeed, economists have coined the term the “annuity puzzle” to describe the gap between expected and actual demand for the products.
The new law, known as the SECURE Act, is designed to make it easier for employers to offer annuities as an option in 401(k)-type plans. Under current law, many employers worry that offering an annuity puts them on the hook for assessing the financial health of the life insurance companies providing the annuity—and that they could be sued if the insurer goes under down the line. The new law provides a safeguard for employers who undertake a diligent search and offer an annuity from an approved company with a solid track record.
Annuitization advocates are hopeful that this will mean more workers have access to annuity, perhaps leading to more take-up of the products. As it stands, few workers can buy an annuity in their workplace plan; one recent survey found that only 6% of plans offered annuities as an option.
But before celebrating this new law, it’s worth pausing to consider if more access to annuities will improve retirement for millions of older workers.
Economists’ support for annuities is often tied to the observation that uncertain lifespans makes retirement planning a seemingly impossible task. Spending too much means running the risk of exhausting your savings; spending too little many mean foregoing the rewards of a lifetime of work. Annuities, and the regular payment they provide, can help smooth that gap.
But Americans consumers haven’t had much affection for annuities, with sales of annuities lagging behind the explosive growth in retirement assets. Over the past decade, balances in retirement saving accounts have more than doubled from $8.7 trillion to $18.3 trillion, but very little of that stockpile has been used to purchase annuity contracts.
Part of the problem may be that consumers don’t quite know how to think about annuities. When economists study annuities, they typically are modeling the benefits of “income annuities”—namely annuities where consumers buy a guaranteed stream of income in exchange for lump-sum payment. In the real world, however, many savers buy “variable annuities”—product that in practice look a lot like mutual funds and are often not annuities at all.
In broad strokes, income annuities are more akin to an insurance product—like the insurance homeowners buy against a flood or fire—while variable annuities are more closely related to an investment account. And the fees on variable annuities, including sales commissions and management fees, can be outstandingly high—especially when compared to a low-cost index fund.
READ: This financial planner believes you probably don’t need an annuity for your retirement
Academic evidence supports the notion that annuities are more popular when framed as an insurance product, rather than an investment vehicle. For example, one study found that the share of consumers preferring an annuity more than tripled when the product was framed as a way to boost lifetime consumption, rather than as a way to raise investment income.
Some may rightly point to the annuity-like security offered by Social Security and ask if more annuitization is needed. Social Security is indeed the cornerstone of American retirement, providing an average annual benefit of around $18,000 to 97% of retirement-age households. But the simple fact is that Social Security benefits are insufficient to support the livelihood of many retirees. And with the near-extinction of company pensions, workers are increasingly staring down retirement with a 401(k) balance and a Social Security IOU from the government. Putting some of one’s savings in an annuity can supplement Social Security and provide a bit more certainty.
With the changes made in the SECURE Act, the hope is that we’ll see more employers offering their workers income annuities with reasonable fees. For some, this may mean having the option to buy an annuity with part of the savings accumulated in a 401(k); for others, it could mean devoting part of each paycheck to buying incrementally more annuity income throughout their career.
In either case, more widespread access to annuity plans in a workplace account may mean more workers have a guaranteed payment for life and, by extension, more security in retirement.
Ben Harris is a visiting associate professor at the Kellogg School of Management at Northwestern University in Evanston, Ill., and the executive director of the Kellogg Public-Private Initiative. Follow him on Twitter at @econ_harris.
