Partial and Deferred Annuitization Makes Sense for Many

The latest Issue Brief publication from the Employee Benefits Research Institute (EBRI) shows only a very small percentage of defined contribution (DC) and individual retirement account (IRA) balances are annuitized in a given year.  

What’s perhaps more surprising is that a significant percentage of defined benefit (DB) plan accruals have been taken as lump-sum distributions when the option was available. According to EBRI, the hesitation to annuitize retirement savings can leave individuals exposed to longevity risk and other challenges, such as uncertainty about how much one can spend monthly without risking running low on funds at some point during retirement.

“Some believe that cost is an issue,” the EBRI brief suggests, but researchers point out that not all annuities are expensive relative to other products or investment options. The Issue Brief points to deferred income annuities (DIAs) as an example of an annuity-type product that is designed to reduce the probability of outliving savings by providing monthly benefits only in the later stages of retirement.

“Because of their delayed payments, DIAs could be offered for a small fraction of the cost for a similar monthly benefit through an annuity that starts payments immediately at retirement,” EBRI’s brief says. “Many [experts] believe that the lower cost would at least partially mitigate retirees’ reluctance to give up control over a large portion of their DC and/or IRA balances at retirement age.”

The Issue Brief goes on to explore “how the probability of a ‘successful’ retirement, measured by the EBRI Retirement Readiness Rating (RRR), varies with the percentage of the 401(k) balance that is used to purchase a DIA.”

“We find that, at current annuity rates, purchases of a DIA at age 65 deferring 20 years with no death benefits result in an overall improvement in RRR (for all ages of death combined) for DIA purchases equal to 5%, 10%, 15%, and 20% of the 401(k) balance,” the brief says. “However, there is an overall decrease in RRR for DIA purchases equal to 25% and 30%—due in part to the interaction with long-term care costs. If a pre-commencement death benefit is added to the DIA, there is an overall improvement in RRR for DIA purchases equal to 5%, 10%, and 15% of the 401(k) balance.”

According to EBRI, when the results are broken out by age at simulated death, overall decreases in RRR are measured for those dying before benefits begin (ages 65 to 84) as well as for those dying soon after benefits begin (ages 85 to 89). 

“For each of the groups living beyond age 89 we find an increase in RRR, and, as expected, the larger the percentage of 401(k) balance used to purchase a DIA, the larger the percentage increase in RRR,” the Issue Brief explains. “The results are significantly improved by adding a pre-commencement death benefit for those who die before benefits begin, but this is offset by larger decreases in RRR for those dying between ages 85 and 89 and smaller increases in RRR for those living beyond age 89.”

Stepping back from these detailed findings, the Issue Brief highlights how the need for longevity protection is “arguably less” for those in the lowest wage quartile given their greater reliance on Social Security.

“We broke out the overall RRR changes by age-specific wage quartiles and found that in all but the smallest DIA purchase (5% of the 401(k) balance), households in the lowest age-specific wage quartiles experienced a decrease in RRR from the purchase of a DIA without a pre-commencement death benefit,” the brief concludes. “However, households with higher wages had a much more positive experience, with those in the second age-specific wage quartile experiencing an increase in RRR for all purchases through the 20% value.”

Households in the third age-specific wage quartile experienced an increase in RRR for all purchases through the 25% value, the Issue Brief says, and those in the highest age-specific wage quartile experienced an increase in RRR for all purchases simulated (through the 30% level).