Recently popular reporter John Oliver tackled retirement plans as the topic du jour on his weekly program. And this week Steven Rattner wrote a piece in the NYT about the same subject. Retirement planning is so hot these days. Both get some things right and some things wrong.
The Obama administration fiduciary regulations have garnered a lot of attention and controversy this year, but let's set those aside for now.
Rattner states that employers started abandoning defined benefit plans that promised regular monthly income in retirement in recent decades due to mounting costs and increased regulatory burdens. That's only part of the story- as soon as workers started changing jobs 3, 4 or more times in a career, the defined benefit plan design falls short of replacing final years wages as intended.
Still, he makes one point that is not raised often enough - how sensible is our 401(k) system that has a foundation of every individual making reasonable investment choices over an entire lifetime, both before and after retirement, including managing the cash withdrawals process throughout retirement? In the late 1980s and 1990s pension actuaries came up with "hybrid" pension plan designs that were intended to combine the better features of defined benefit and 401(k) style plans. Unfortunately, some of the transitions from the old DB plan to the hybrid plan were managed badly, leading to lawsuits and an understandable avoidance of these plans by employers trying to keep it simple.
Rattner's solution for the individual is to save early and often and as much as possibly and invest in low-cost index funds, which is all straightforward. He says nothing about annuities.
Oliver's report centers on the experience of his small company as they sought advice and a provider for their start-up 401(k) plan. For him and his millennial audience, there is no awareness of defined benefit plans, other than as a dinosaur. Unfortunately, Oliver blasts annuities as an option due to his company's experience with the high cost driven in part by high commissions. The type of annuity he criticizes is a variable annuity, which is designed for flexibility, but can be notoriously complex and costly due to administrative expenses, principle guarantees and high commissions.
The Case for a Fixed Income Annuity
Fixed income annuities that a retiree buys at or after retirement provide a great solution to the problem of maintaining adequate income for a lifetime following retirement. The logic is simple. Annuities are the reverse of life insurance.
During your working lifetime, you need life insurance which protects your beneficiaries by paying a large amount if you die, but the amount you paid in premiums was much lower than the payout. The people who live get nothing, but their premiums pay for the proceeds of those who die. This is an efficient financial mechanism to provide protection to families.
After your working life ends with retirement, you need regular annual income for your remaining lifetime and possibly the remaining lifetime of your spouse after that. In most cases, there is no need for further income or cash in your accounts. So, if you are managing your retirement savings as you plan for a possible 25 or more years in retirement, it is almost impossible to hit the target of your money running down to zero at precisely the moment you die. You either live long and run out of money or you die sooner and leave too much on the table. A fixed annuity takes care of this problem. You are guaranteed income continues even if you live to age 95, 100, or older. In return, you pay for this protection by losing out if you die early because you paid for protection you did not need. Here is the psychological problem with fixed annuities vs. life insurance. With life insurance, everybody wins - either you die earlier, but receive a large payout to your heirs OR you live longer and do not receive a death benefit. The problem people have with annuities is that they give up a large chunk of money all at once upfront and feel like they lose if they do not live long. That's why many fixed annuities have a death benefit, but that costs money and to the extent the death benefit is more generous and not needed for retirement income, the intended purpose of retirement income protection is chipped away.
There are variations of fixed income annuities that are perhaps becoming more common in the marketplace or at least being discussed. DOL under President Obama has begun pushing the QLAC (qualified longevity annuity contract), a form of deferred annuity, which has some positive features such as low cost for the amount of protection provided, but would be klunky in practice and seems unlikely to take off anytime soon.
Of course, the fixed income annuity(with cost of living adjustments) that works efficiently because there are no high commission sales people would be Social Security, so any move toward shoring up that system makes sense. As noted above, private sector DB plans fell by the wayside because workers began switching from job to job. Not a problem for Social Security because job hoppers tend to remain with the the covered Social Security system through their working lives.
For the latest comprehensive report on the retirement system in the U.S., see especially Section III. on facilitating lifetime income options: Securing Our Financial Future:Report of the Commission on Retirement Security and Personal Savings.
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