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With a rapidly aging population and increasing average lifespan, Americans recognize that an effective retirement plan must provide a secure and preferably guaranteed lifetime income.
As a result, the industry has worked to introduce lifetime income solutions into 401(k) plans. While these attempts are well-intentioned and necessary for some, their complexity and high cost highlight the fundamental challenge that has been hard-coded into our retirement system – that defined contribution (DC) plans are unsuitable for providing lifetime income security. Fortunately, there is a simple enough response to these challenges – defined benefit (DB) programs, including cash balance plans, are excellent solutions to this need.
For the purpose of this article, guaranteed lifetime income is a provision or product that provides participants lifetime income in retirement that cannot be outlived.
In the 1980s and 1990s, 401(k) plans entered the U.S. pension market as a tax-deferred and flexible supplemental retirement savings system. Their design and features emphasize transparency, flexibility and individualism. There's no doubt that they are excellent vehicles for helping individuals save for retirement with a tax-deferred strategy.
However, over time, these plans have become the primary source of retirement income for many Americans, even though they cannot pool risks in retirement – particularly the risk of outliving one's money, known as longevity risk. Risk pooling is the secret sauce that allows people with wildly uncertain individual lifespans to finance their retirement without fear of outliving their assets. It enables each individual to budget for their average life expectancy with the confidence that deviations from the average will cancel off across a population, giving everyone security in numbers.
For 401(k) participants to take advantage of longevity risk pooling, they must purchase insurance from an insurance company. These products, called annuities, offer a stream of future payments, guaranteed to last for the rest of the participant's lifetime, in exchange for an upfront premium payment. To make this feasible, the insurer puts the premium into low-risk investments - pooling annuities together to decrease risk. However, this solution suffers from a few fundamental challenges:
Insurers must recoup the money they pay out to participants, plus other expenses such as commissions, marketing costs and administrative and overhead costs, through pooled investments. These significant costs reduce the actuarially fair retirement income they can provide per dollar used to purchase the annuity.
Insurers must assume that participants buying annuities are more likely to be in good health, as a person in poor health is less likely to trade a lump-sum amount for lifetime income because their lifetime may be shorter than average. Referred to as anti-selection by actuaries, this is factored into the actuarial calculations, reducing the income level per dollar cost.
Insurance companies need to make a profit. They make money by converting the lump sum into the income stream, again reducing the level of income provided.
These factors create a drag on the income purchasers receive from an insurance annuity and are usually not explicitly priced. Instead, their impact is hidden in an insurer's assumptions to calculate the annuity cost.
Therefore, it is misleading when annuities or other annuity-based products claim to charge no fees. While not charging an explicit fee, by adjusting the monthly income level they provide in exchange for the upfront payment, insurers have infinite flexibility to include margins for their expenses and profits.
We have recently seen new attempts to solve this riddle, often by embedding immediate or deferred annuities inside 401(k) investment products. Unfortunately, while creative, these products suffer from all the same challenges and are obscured in more complicated models with bells and whistles that do not solve the core pricing challenge of insured annuities.
In contrast, DB programs (such as cash balance plans) are designed to offer efficient and pure risk pooling in retirement. The uncertainty of individual lifespans is handled efficiently by grouping many retirees in a single pension plan backed by a collective pool of assets. All members benefit from a more straightforward and cost-effective conversion of accumulated savings into lifetime income.
DB programs require a guarantor – typically the employer or plan sponsor. The guarantor's role is to ensure the plan meets its obligations to its retirees, allowing it to operate efficiently. Critics consider them risky for the plan sponsor who provides the guarantee. But, in truth, while short-term fluctuations can impact costs, plans that are well-managed by experts can mitigate much of the risk through appropriate investment strategies.
The need for guaranteed lifetime income supported by longevity risk pooling is fundamental to retirement security. The efforts to add expensive and complicated income solutions into 401(k)s demonstrate that these methods are the wrong fit for participants, resulting in higher hidden costs and lower retirement income. DB plans, especially cash balance programs, are the right tool for this job. Employers should embrace them so that their employees won't rely on a less efficient, outdated system that drives insurer profits at the expense of retirement security.
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