Should a 401(k) Be Used to Buy a Deferred Income Annuity?

A new EBRI issue brief reviews whether and to what extent purchasing a qualified longevity annuity contract (QLAC) offered through a DC plan can help improve retirement readiness.

In “Deferred Income Annuity Purchases: Optimal Levels for Retirement Income Adequacy,” the Employee Benefit Research Institute explores 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 deferred income annuity (DIA).

As part of the backdrop for the report, EBRI explains that DIAs are designed to reduce the probability of outliving savings by providing monthly benefits in the later stages of retirement, but some may believe cost is an issue. Because of their delayed payments, however, DIAs could be offered for a fraction of the cost for a similar monthly benefit through an annuity that starts payments immediately at retirement, which could mitigate retirees’ reluctance to give up control over a large portion of their DC balance at retirement age.

Overall, EBRI finds that even at the historically low interest rates in 2015, the transfer of longevity risk provides a significant increase in retirement readiness for the longest-lived quartile, compared with only a small reduction for the general population.

At current annuity rates, purchases of a deferred income annuity (DIA) at age 65 deferring 20 years with no death benefits result in an overall improvement in retirement readiness for all ages of death combined for DIA purchases up to 20% of the 401(k) balance, explains author Jack VanDerhei.

However, there is an overall decrease in retirement readiness for DIA purchases equal to 25 and 30% — due in part to the interaction with long-term care costs, he further notes. If a pre-commencement death benefit is added to the DIA, there is an overall improvement in retirement readiness for DIA purchases equal to 5, 10, and 15% of the 401(k) balance, according to the report.

Nuanced Results

But when the results are broken out by age at simulated death, EBRI finds overall decreases in retirement readiness for those dying before benefits begin (ages 65–84) as well as for those dying soon after benefits begin (ages 85–89). For each of the groups living beyond age 89, however, EBRI finds an increase in retirement readiness. Moreover, the report shows that, for this cohort, the larger the percentage of 401(k) balance used to purchase a DIA, the larger the percentage increase in retirement readiness.

Perhaps not surprisingly, when a pre-commencement death benefit is added, the results are significantly improved for those who die before benefits begin, but this is offset by larger decreases in retirement readiness for those dying between ages 85 and 89 and smaller increases in readiness for those living beyond age 89.

The need for longevity protection is arguably less for those in the lowest wage quartile given their greater reliance on Social Security, VanDerhei further explains. “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,” he says in the report.

However, households with higher wages had a much more positive experience, with those in the second age-specific wage quartile experiencing an increase in retirement readiness for all purchases through the 20% value. Households in the third age-specific wage quartile experienced an increase in readiness for all purchases through the 25% value and those in the highest age-specific wage quartile experienced an increase in readiness for all purchases simulated through the 30% level, the report shows.

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