The Government’s Plan for Your Retirement Savings

photo: Don Hankins

The federal government is looking into ways of convincing you to turn some of your 401(k) over to an insurance company. Don’t pick up your pitchfork just yet, though. Let me explain.

The trouble with 401(k)s

Compared to old-school pension plans, 401(k)s have some advantages: they don’t bankrupt companies; they allow workers to make their own investment choices; and they’re relatively portable from one job to the next.

But in other ways, 401(k)s are busted. Workers don’t save enough in their 401(k)s for retirement, and when they do retire, they take all their savings as a lump sum and spend through it long before they die.

Uncle Sam is looking at the second problem. In risk management jargon, we’re talking about “longevity risk”: the risk that you will live longer than your money. And one way to manage longevity risk is with (wait for it) an annuity.

The word “annuity” tends to be met by one of two responses: (1) SNORE. (2) Aren’t those the financial instruments designed to take my money and put it into the pocket of an insurance salesman?

So the Department of Labor has done a little rebranding and is now using the term “lifetime income products.”

Whatever you call it, annuities are really, really unpopular. “In a lot of cases, when given the option, people often take a lump sum versus an annuity-type option,” said Michael Davis, Deputy Assistant Secretary of the Employee Benefits Security Administration (EBSA).

He’s not kidding. About 2% of retirees turn all or part of their 401(k) balance into an annuity, according to a 2009 survey by the Retirement Security Project.

So Davis’s department sent out a survey inviting companies, researchers, and anybody else to respond to 39 questions about annuities–er, sorry, lifetime income products. They got 700 responses. Yes, that’s right, there are at least 700 people in the country who can talk about annuities without falling asleep.

I’m one of them, baby, so let’s do this.

What IS an annuity, anyway?

Here’s how an annuity works, in its simplest form.

Step 1: I take a large sum of money and hand it over to an insurance company.

Step 2: There is no step 2. Kidding! Step 2: The insurance company puts my contribution through a formula and turns it into a monthly payout. You can try this yourself, right now, using an annuity calculator.

The payout lasts until you die, and then if there’s anything left over, the insurance company keeps the rest. But if you live to be 102 and your balance is long-depleted, the company has to keep those payments rolling as long as you do. You can also buy a joint annuity, which covers you and your spouse as long as either of you is alive.

The fact that your leftover money goes to the insurance company rather than your heirs is one reason people don’t like annuities. But there are several other reasons.

One is that insurance companies have an even worse reputation than banks. And there’s no FDIC for annuities. In my state, Washington, annuities are insured up to $500,000, but in most states the insured amount is much lower.

Which brings us to the second objection: even a $500,000 annuity doesn’t look like much. I just ran the numbers for a joint annuity, and that $500,000 turns into $2656/month. I mean, holy crap. You want me to turn half a million bucks into an amount that wouldn’t buy a decent used car? Of course, if you draw down your half-mil at the recommend 4 percent per year in retirement, that’s $1667/month. No wonder people outlive their savings.

Finally, remember how “financial innovation” almost destroyed the world? Annuities have seen more than their share of financial innovation. The simple immediate annuities I described are not evil at all…but they have evil twins, evil cousins, and evil great-aunts. These are the products that have a deserved reputation for lining insurance company pockets at your expense, and they’ve given all annuities a bad name.

The box that rocks

Here’s one solution the government has in mind: put a box on your 401(k) statement showing how much your balance would turn into if you bought an annuity with it at retirement age. It might look something like this:

In fact, a bipartisan Senate bill would mandate this kind of box, which is based on those annual Social Security statements you already receive.

I ran the idea by Robyn Credico, a consultant with Towers Watson, which helps companies manage their retirement plans. I asked her if she knew of any company already using the annuity box. “No, I don’t,” she said. “I also don’t know how you would do it, because it’s very dependent on your assumptions, and so if I make assumptions that make the annuity look very good, and when the person goes to buy an annuity, it looks very different, it’s a big issue.” (Among the assumptions she’s referring to would be one’s age and life expectancy, the prevailing interest rates at the time you annuitize and so forth.)

One way around this is to let 401(k) participants lock in an annuity rate now by buying a deferred annuity: you pay now, but don’t collect until you’re 65.

But this raises all sorts of other issues. What if the insurance company goes bankrupt in the, say, 60 years between now (when you buy the deferred annuity) and when you die? What happens if you switch jobs and your new employer doesn’t offer an annuity with the same company? Once you get into an annuity, you generally can’t check out.

Furthermore, companies worry that if they sell you a deferred annuity, they’ll get sued. “A lot of employers don’t know if they have safe harbor to offer those options,” said the Labor Department’s Davis. In other words, the government allows certain default options for 401(k) investments; annuities are not one of them. And when annuities aren’t the default, we’re back to the original problem: people don’t use them.

“A lot of people are interested in talking about them,” said Credico, “but certainly for the options that are in the plan, we have seen very few large companies actually do that.”

Some of the risks of deferred annuities could be regulated away, but for now, they generally make retirement planning more complicated, not less.

What’s next

The Senate Special Committee on Aging is holding a hearing on June 16, where the Department of Labor will present the results of their survey. Chair Herb Kohl (D-WI) is one of the sponsors of the bill that would put a box on your 401(k) statement. (I wonder how the 75-year-old Kohl feels about being referred to as “Aging Chairman” on his own press materials.)

As for you: regardless of what the government does, don’t be a chump. Turning some of your retirement savings into an annuity at retirement is a good move for nearly every retiree. Those who don’t are doomed to rely solely on the annuity we all share: Social Security.

What if you don’t have enough money in your 401(k) to even think about retiring, let alone “lifetime income”? Reformers are looking at that problem, too, and in a future column I’ll talk about what major retirement reform might look like. Bring your pitchfork, just in case.

Matthew Amster-Burton, author of the book Hungry Monkey, writes on food and finance from his home in Seattle.