January 2013

Lifetime Income - An Important Focus for Retirement Planning

By Anna Rappaport

Many of the ideas in this article come from discussions with Kelli Hueler or research that we have done together. Thank you to Kelli Hueler.

Successful retirement strategies depend on managing financial resources and life situations during retirement. The work of the Committee on Post-Retirement Needs and Risks focuses on strategies during retirement, and the committee has focused on the need to create a post-retirement paycheck in several projects. Actuaries work with several different sets of stakeholders, and are very concerned about this topic. However, it proves to be a difficult topic and there are important barriers to choice of lifetime income when it is an option.

This topic has become more challenging in light of the changing structure of the retirement system. Although defined contribution plans have become more prominent in the retirement landscape, there is no accepted strategy with regard to helping employees focus on a paycheck replacement strategy in retirement, or even any agreement that the employer has a role in supporting a paycheck replacement strategy. Roles that employers can play include the following:

  • Create a culture focused on the importance of paycheck replacement
  • Provide illustrations that focus on paycheck replacement during working years
  • Offer in-plan income options: Lifetime income can be offered through competitive purchasing platform or through choice of a single insurance company
  • Serve as purchasing agent: Offer purchase of lifetime income through use of competitive purchasing platform
  • If DB plan is offered, permit rollover of DC money to the DB plan
  • Permit employees to leave their funds in the plan post-retirement and offer investment options, and/or managed accounts, and installment payouts; investment options which work well pre-retirement may not work well post-retirement, and vice-versa
  • Offer education with regard to options and considerations – both before retirement and at time of retirement
  • Ensure that plan administration providers understand employer’s philosophy and are supporting it in implementation
  • Offer advice either through an advice service, or by hiring advisors to work individually with employees.

These roles are not mutually exclusive. An employer may choose to implement several of these steps to work together. Actuaries supporting employers have an important role to play in helping them to think through these roles and evaluate the costs, benefits and risks linked to each role. Actuaries working with financial services companies have an important role to play in helping them think through what support services and products will be appealing to employers as they think about what to offer their employees. Actuaries working with individuals have an important role in helping them understand alternatives and think through the costs, benefits and risks from their perspective. From an individual perspective, it is important to think about this topic from a “portfolio point-of-view.” Questions to be answered include not just how much money should be used for paycheck replacement, but how various options fit into the total picture, when to make choices and how much to allocate to each choice.

Trade-offs between options from the perspective of the individual
There are major differences and trade-offs between options from the individual’s perspective. The first challenge is gaining an understanding of the range of options. Some of the advisors and salespersons working with individuals represent particular types of products or are compensated primarily by taking specific actions. They may tend to present their preferred approach or product rather than explaining all of the relevant types of choices. The Exhibit below indicates some features of major retirement income funding options:

Features Income Annuity Other Products
with Guarantees
Guaranteed income for life Yes Yes, but at lower level than income annuity No
Mortality leveraging* Yes Some No
Liquidity/access to funds Not in most products Yes, within limits Yes
Remaining account value goes to heirs if early death No Yes, after fees for guarantees Yes
Owner can control funds in the account while income is being paid out No Yes, within limits Yes

*Mortality leveraging means that early deaths among people receiving payouts from the pooled annuity funds subsidize the payouts for those who live longer. This pooling effect benefits policyholders by enabling higher payouts than if taking systematic withdrawals.
Source: Society of Actuaries, Designing a Monthly Paycheck for Retirement, 2012

More on trade-offs
An individual who decides to buy life income will need to make choices about the product design. Some of the choices that are important to an individual include when to buy, how much to buy, whether or not to include inflation protection, whether or not to add joint and survivor benefits, whether to include a period certain, and whether to make the purchase in stages. An employer who provides a program needs to decide what individual choices will be embedded in the program and how to offer them. The employer also needs to choose between using a single carrier or a competitive billing platform.

Steve Vernoni provides much more detail about various methods of producing long-term income. He defines three retirement income generators (or methods of producing income) and then rates them on five criteria: amount of initial income, longevity protection, inflation protection, flexibility and financial legacy, and whether exposure is minimized. He uses a three point rating scale. His discussion focuses on the individual perspective, and he also looks at examples of products from specific financial services organizations in his book.

The Committee on Post-Retirement Needs and Risks has an ongoing project to understand the issues from the perspective of a plan sponsor. That project recognizes that there is a difference between focusing on what amount of income is delivered the participant and focusing on how the plan sponsor is involved. As indicated above, the plan sponsor can choose to assume a variety of different roles, singly or in combination.

Barriers to life income
There are several barriers to annuitization. They may relate to the plan sponsor or the individual. Understanding and dealing with barriers is an important part of building a strategy.

Barrier Applies to Individual Applies to
Plan Sponsor
Negative perceptions and press Yes Yes
Employer concern about fiduciary and legal liability No Major barrier
Financial advice steering individuals away from annuitization, including very strong disclaimers on websites discouraging certain offerings Yes May influence plan sponsor offering and can undo an employer program
Confusion about products and failure to fairly present broad range of products Affects individual Yes
Requirement in some benefit plans that decision to annuitize be an all or nothing decision Is a deterrent to the individual using lifetime income Plan sponsor can offer a program that includes choice of when to annuitize and allows partial annuitization—All or nothing decisions are difficult and often not in best interest of employee
Individuals have too short a planning horizon, and often do not Yes Influences response to various offerings
Lack of control and liquidity in life annuity options Major issue and must be considered as part of trade-off evaluation Is a concern; death benefits can be included in annuity options

From the plan sponsor point of view, fiduciary liability is a major barrier to getting involved directly.

Linking Social Security to the use of retirement funds and income strategy in retirement
For employees with limited financial assets and no defined benefit plan, Social Security is their main source of income in retirement. Their only paths to increase income in retirement are to defer claiming Social Security and to work longer. Yet most people claim early and many of them do not evaluate the options for claiming. Employers can assist employees in focusing on the issue and provide—or point them to—resources for looking at options.

Social Security is a source of retirement income available to nearly all working Americans. It is a very important part of retirement income for the majority of the population. The amount of monthly income if claimed at age 70 is about 75 percent percent greater than if Social Security is claimed at age 62. There are additional issues for couples as they consider their strategy for claiming these benefits.

This is an important area for actuaries to think about. Anyone who can influence decision making around retirement should encourage people to evaluate the options before automatically making an early Social Security claim decision. Actuaries working with plan sponsors and individuals can help their clients by raising the issue, and pointing them toward tools and information to make informed decisions. One of the Society of Actuaries Issue Briefs is on Social Security claiming.

Advising employers, plan sponsors and those who develop products and approaches
Important insights as employers consider their strategies include:

  • There are several different types of strategies and there are important trade-offs between the different payout methods. Many employees are hampered from making the most appropriate choices because they do not understand the options. The Society of Actuaries Issue Briefs and the book from Steve Vernon lay out the trade-offs and Vernon provides some evaluation of them. From an employer perspective, this is important in deciding what options to offer, what education to offer, how to structure advice offerings, and whether to offer tools or advice on where appropriate tools can be accessed. Providing access to good information is an important first step.

  • The choice of payout methods and investment strategies should be considered from a bigger picture portfolio perspective. Many individuals will want to diversify during retirement, and may choose multiple methods of payout. However, different advisors and plan administration services differ with regard to the extent to which they offer post-retirement support, and if they do, whether they offer a fair presentation of a range of options, vs. “steering” people in a specific direction.

  • Competition matters as does access to payout options without needing to go to the retail market. For example, for immediate life annuity purchasing, the Hueler Income Solutions® platform includes competitive bidding for all quotations. An analysis of several thousand quotations indicated that the average difference between high and low quotes in the United States was 8 percent, and that in some cases spreads could be as high as 20 percent (although spreads over 15 percent were unusual.)ii An analysis of quotes in the United Kingdom showed considerably greater spreads.

  • Active guidance matters. Advice can steer people toward investigation of annuities or away from them. The employees and retirees who wish to explore an annuity option are much more likely to complete an annuity purchase if they are able to have a conversation with a trusted person whom they perceive as unbiased. Many buyers will have multiple conversations.

  • All or nothing decisions are not desirable. The best programs allow employees flexible timing to make choices and allow them to devote part of their funds to specific payout options. Timing flexibility is feasible with defined contribution plans, but it is not feasible with the choice of payout options in defined benefit plans. A desire for such flexibility may be a reason for employees to take a lump sum, roll their account balance into a retail IRA and then focus on managing retirement funds using the IRA. But this can be an expensive strategy.

  • A plan sponsor offering a program needs to decide what types of participant choices should be embedded in the program.

  • Many plan sponsors have worked hard to lower expenses in their 401(k) plans and offer very efficient investment options. In contrast, retail IRAs have much higher expense charges than plan investment options. Employees should be discouraged from taking lump sums and rolling them over into retail IRAs unless they have carefully investigated the costs involved. They should be encouraged to pay attention to expenses.

  • As employers consider life income options, it is important for them to remember that guaranteed life income is an important part of retirement security. Paycheck replacement without guarantees is helpful, but it leaves an important gap. Annuitization is not a good choice for everyone, but it needs to be included in the options presented and offered. Ideally, participants will understand a range of options for the pay down phase, and they can make choices considering trade-offs and a total portfolio approach.

There is growing recognition that the post-retirement period is very important, and it is expected that more employers will offer at least some support for post-retirement planning. Both the Department of Labor and the Treasury have been working on related issues and can be expected to issue further guidance in the coming months. It is becoming increasingly important for employers to actively review their strategies and do what works to balance employer resources with an approach that meets employee needs. Actuaries advising them need to encourage a focus on these issues.

Important resources offer information for employees and insights for employers as they consider what they should do. Three recommended resources are:

Hueler, Kelli and Anna Rappaport. 2012-11. The Role of Guidance in the Annuity Decision Making Process, Pension Research Council Working Paper.

Vernon, Steve. 2012. Money for Life: Turn Your IRA and 40(k) Into a Lifetime Retirement Paycheck. Rest of Life Communications.

Issue Briefs: Designing a Paycheck in Retirement and Deciding When to Claim Social Security, Society of Actuaries, 2012.

Anna Rappaport, FSA, serves as chairperson of the Committee on Post-Retirement Needs and Risks.