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How Much Might Longevity Income Annuities Matter?

New research considers the potential impact of longevity income annuities, and finds some real benefits in retirement security.

Back in 2014, the Treasury Department issued a rule that essentially allows employees to convert part of their IRA or 401(k) balances into a longevity annuity. Under that rule, an IRA or 401(k) can allow participants to use $125,000 or up to 25% of their IRA or 401(k) — whichever is less — to buy a longevity annuity.

The research paper, “Putting the Pension Back in 401(k) Plans: Optimal versus Default Longevity Income Annuities,” considered the impact of including these LIAs — deferred annuities which initiate payouts not later than age 85 and continue for life — in the menu of plan payout choices.

The researchers compared that optimal LIA allocation to two default options that plan sponsors could implement. In the first, no LIA is available, while in the second, at age 65 the individual can convert some of her 401(k) account assets to the LIA that begins paying benefits as of age 85. Subsequent sensitivity analysis comparing results for people with different lifetime income profiles concluded that an approach where a fixed fraction over a dollar threshold is invested in LIAs would be preferred by most to the status quo, while enhancing welfare for the majority of workers.

They conclude that both women and men benefit in expectation from the LIAs, and even less-educated and lower-paid persons stand to gain from this innovation. Moreover, they note that plan sponsors wishing to integrate a deferred lifetime annuity as a default in their plans can do so to a meaningful extent, by converting as little as 10% or 15% of retiree plan assets, particularly if the default is implemented for workers having plan assets over a reasonable threshold.

From age 85 onward, both groups with LIAs enjoy additional income compared to the non-LIA group. For example, from age 85, the college-educated women receive an annual LIA payment for life of $7,790, while female high-school graduates are paid $2,610 per year. The HS dropout receives the least given her small purchase, paying out only $680 per annum. For men, the optimal LIA purchase at 66 generates an annual benefit of $11,100 for the college-educated, $5,210 for HS grads, and a still relatively high annual benefit of $2,510 for HS dropouts. In other words, the researchers say, “the LIA pays a reasonably appealing benefit for those earning middle/high incomes during their work lives.”

The researchers found that introducing a longevity income annuity to the plan menu is attractive for most DC plan participants who optimally commit 8-15% of their plan balances at age 65 to a LIA that starts paying out at age 85. Moreover, that optimal annuitization boosts welfare by 5-20% of average retirement plan accruals at age 66 (assuming average mortality rates), compared to not having access to the LIA.

As for why: With the LIA, all groups of women and men withdraw more and retain less in their retirement plans post-retirement compared to those without access to lifelong benefits.

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