Could a Small Annuity in Your 401(k) Protect Your Retirement?

Researchers think they have found a relatively inexpensive way for retirees with 401(k) accounts to insure against outliving their savings.

Putting just a small portion of 401(k) savings into a certain kind of deferred annuity will help retirees live securely, according to recent research from the Brookings Institute.

The paper, “Automatic enrollment in 401(k) annuities: Boosting retiree lifetime income,” recommends that 401(k) plans include a default option that invests 10 percent of each account’s assets above $65,000 in a deferred income annuity that begins making payments when the account holder turns 85. A default option means this would automatically be done unless the account holder opts out.

Such a deferred annuity would provide relatively high payments at a low cost, compared with an annuity that begins paying out earlier.

Guarding Against Retirement Risks

This strategy, the paper argues, will provide insurance against the risk that retirees will exhaust their savings and wind up with no money at an advanced age. This could also help retirees who suffer from age-related cognitive declines, the paper says, greatly enhancing their ability to spend their money.

Economists say that such an arrangement would free retirees up to plan for the rest of their savings to last until they begin receiving payments from the annuity, instead of having to guess how long they’ll live.

This is a focus of researchers as retirees are increasingly more likely to have lump-sum retirement savings accounts then they are to have pensions.

According to the Investment Company Institute, Americans have $8.4 trillion in defined contribution plans, such as 401(k)s, compared with $3.2 billion in private-sector pension plans, also known as defined benefit plans.

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$65,000 Threshold for Annuity Purchase

“This reality is set against the backdrop of a rapidly aging population, underfunded public pension and Social Security programs, and the disappearance of defined benefit plans,” says the Brookings study. “Consequently, policymakers are increasingly concerned that millions of financially inexperienced — and very likely, inattentive — older consumers may do a poor job handling investment and longevity risk in their self-directed retirement accounts.”

Study co-author Olivia S. Mitchell, noted that 401(k) plans, unlike pensions, don’t pay retiree income for life. “They give you a lump sum and say, ‘Manage it. Try not to run out,’” she told Annuity.org. “What we’ve argued is that it would make sense to include a default deferred annuity as part of the 401(k) plan but only if you have at least $65,000 accumulated in your 401(k).

“If you have less than that, it’s probably not going to buy you much of an annuity anyway. Makes no sense. But if you do have $65,000 or more, and the median is something like $140,000 or $150,000, then all we propose is that you take 10 percent of your nest egg , only 10 percent, at age 65 and buy yourself a deferred annuity that starts paying you” in 15 to 20 years.

“We’ve been proposing this as a way to let people keep part of their assets but protect themselves against longevity risks with a small portion. And I think it makes a lot of sense,” Mitchell added.

The paper addresses what is known as longevity risk, which it notes, “results from the fact that people are uncertain about how long they will live. Such uncertainty can make it difficult to plan how to draw down one’s retirement assets and not run out of money, particularly in old age, when few people can return to work and when healthcare costs may be large.”

The paper argues that $65,000 is a “reasonable threshold inasmuch as workers in their 60s who earned $40–$60,000 per year averaged $96,400 in their 401(k) accounts; those earning $60–$80,000 per year averaged $151,800; and those earning $80–$100,000 held an average of $223,640 in these retirement accounts, as of 2014.”

Using Social Security to Your Advantage

More research from the Center for Retirement Studies at Boston College explored various options for annuitizing 401(k) funds. The paper compares the value of annuitizing 20 percent of defined contribution wealth to purchase an immediate annuity that is not adjusted for inflation. The authors recommend what they call a “Social Security bridge” to allow people to increase their Social Security earnings.

The proposal would use 401(k) funds to pay retirees between the ages of 60 and 69 monthly amounts equal to what they would receive if they began claiming Social Security at their full retirement age. The retirees, under this proposal, would delay claiming Social Security, however, until they reach the age of 70, enabling them to maximize their monthly Social Security payments.

Strategy Increases Social Security Payments

This results in an increase of about 8 percent in monthly payments for every year a retiree delays claiming Social Security benefits up to age 70. Social Security has a table showing the complex calculations that apply to people born in different years with different designated full retirement ages.

For example, people born in 1955 will reach their full retirement age of 66 years and two months in 2021.

If they begin claiming Social Security at the earliest allowed age of 62, their monthly payments would equal just over 74 percent of the amount they would receive every month if they waited to claim benefits until reaching full retirement age.

If they wait until they turn 70 to claim Social Security benefits, they will receive monthly payments of more 130 percent of the amount they would receive at their full retirement age of 66 years and two months.

Study co-author Wenliang Hou told Annuity.org that delaying Social Security as described in the research paper is currently “the best deal you could get in the market.”