Generating and Protecting Lifetime Income:
The Role of Deferred Income Annuities in Defined Contribution Plans
By Tamiko Toland
As the definition of retirement evolves, the systems and plans that support it also must change. Future policy decisions will determine whether we end up looking back at a sustainable transformation of the retirement system or a rolling series of crises. Traditional defined benefit (DB) pensions used to provide workers with a steady stream of income after retirement. However, such pensions are now an endangered species, leaving younger generations of workers holding the bag to manage risks, such as longevity risk, which requires making important decisions to avoid outliving their savings.
Even if the average person were aware of such risks, what tools or education do they have to address it?
Annuities — in particular, deferred income annuities (DIAs) — can help. While their value is well understood within the industry, they still have not made their way into the mainstream of today’s defined contribution (DC) 401(k) plans, where they could serve an important role by replacing a portion of the guaranteed income that pensions used to provide.
How Does a Deferred Income Annuity (DIA) Work?
Based on a payment today, a DIA promises a stream of income that starts at some point in the future. An advanced life deferred annuity is a type of DIA that begins payments later in retirement (deferred to at least age 70, but often later) rather than at the beginning of retirement. As part of a retirement plan, the worker would gradually start putting money in a DIA at a certain age, such as age 50, and gradually increase the amount as they move closer to the time of retirement. This strategy can be incorporated into a target date fund or another structure, such as a managed account. A qualified longevity annuity contract (QLAC) is a specific type of advanced life deferred annuity for use in a qualified retirement DC plan or IRA that is exempt from the required minimum distributions (RMDs) until the annuity payment begins.
The key element here, of course, is the guaranteed lifetime income stream generated by the deferred annuity, which is what makes it a suitable stand-in for the pension. The guarantee is what may be highly valued with an annuity because no other retail product offers the value proposition of lifetime income, which makes it a type of insurance, not a pure investment. The distinction is important because creating the guarantee itself has benefits beyond the economic value of the lifetime payments.
For planning purposes, it is important to understand when the income from a DIA will start. When it begins at retirement, such as age 65 or 67, it should replace income throughout retirement; however, a QLAC with income starting later, such as age 80, assures that a retiree has money in late old age but does not protect against shortfalls in the interim.
Why Should a DIA be Considered for Managing and Generating Retirement Income?
One of the challenges to greater adoption of annuities, including DIAs, is that savers tend to want to maintain control of or access to their funds. The common instinct is to believe that this liquidity is always superior. However, it comes at a cost — and that cost is not strictly financial.
Too often, a lump sum payout of retirement savings at the time of retirement is alluring, but the funds are much less likely to be converted into a guaranteed income stream. We know that in this scenario, too many workers run out of assets very quickly after retirement. Many people intuitively overestimate the lasting power of this money and fail to appreciate the devastating effect that an ill-timed market downturn can have on a portfolio.
Savers stand at a disadvantage in making these decisions. Therefore, a DC plan design that gradually moves assets into a DIA within a 401(k) portfolio gives the worker an often-desired benefit that enhances retirement security. Social Security is often lauded as the best annuity you can get, but it is impossible to opt in for more than the calculated amount — and most people do want more income than the basic benefit will pay. A DIA offers that opportunity to use retirement savings to generate additional guaranteed income. In the 2020 CANNEX/Greenwald Guaranteed Lifetime Income Study, 72% of consumers thought that having some additional guaranteed income in addition to Social Security would be highly valuable.
Savers who invest in DIAs, even if it was not their idea, can benefit from the comfort of knowing that protection is in place. In the 2020 study, as in previous years, we found that people who have guaranteed lifetime income in place are less concerned about losing savings because of a market downturn. More than half (57%) agree that such products protect against market declines. This peace of mind is part of the intangible benefit of providing that guarantee.
Why Does It Make Sense to Include DIAs in DC Plans?
Last year, CANNEX researchers published research that sought to answer questions about whether it makes sense for savers to buy DIAs before retirement. The peer-reviewed paper about this work, “Optimal Allocation to Deferred Income Annuities,” appeared in Insurance: Mathematics and Economics, but we also interpreted what these findings tell us about practical design considerations for retirement plans in “Funding Your Personal Pension: When Do Contributions Into Deferred Income Annuities Before Retirement Make Sense?”
We examined several key variables that affect the desirability of purchasing a DIA before retirement. DIAs may make sense for some individuals but not others, based on a variety of factors, including the amount of retirement savings and desired guaranteed income. Using an annuity such as a DIA within a retirement plan reduces the chance that the retiree will end up running out of money, but some people need more help than others. The research also showed that buying a DIA is similar to investing in fixed income when it pays a death benefit before income starts.
This work focused on the effect of the design of the DIA and the plan’s investment flexibility, but there are other ways to use a DIA within a plan that go beyond this research. For example, the use of a QLAC at retirement can increase the welfare of nearly all workers, according to a recent paper, “Putting the Pension Back in 401(K) Retirement Plans: Optimal Versus Default Deferred Longevity Income Annuities.”
The loss of traditional pensions has left many more workers without the guaranteed stream of income in retirement that our survey shows they clearly desire. To date, there has not been enough progress to identify, educate, and encourage the adoption of solutions to fill this void. The industry and policymakers can and should do more in communicating with both plan sponsors and savers about available options and their benefits.
While solutions exist, such as the DIA, there is still plenty of room for innovation in how to integrate such a solution into a DC plan. Unfortunately, plan sponsors remain hesitant to include such options because of the fear of litigation. Even with the reforms in the recent SECURE Act, both industry experts and policymakers will need to continue to evaluate what more can be done to support and encourage the use of income guarantees within plans.
Tamiko Toland is Head of Annuity Research for Toronto-based CANNEX, which provides data about and analysis of annuities. Her focus is the individual and institutional U.S. annuity market. She is a thought leader with more than 15 years of experience in tracking trends and key issues in retirement income, synthesizing commentary, and analysis for broad audiences and specific clients.
September 2020, 20-11
CANNEX and Greenwald & Associates, “2020 CANNEX/Greenwald Guaranteed Lifetime Income Study,” June 2020.
Georgetown Center for Retirement Initiatives, “Generating and Protecting Retirement Income in Defined Contribution Plans,” June 2019.
Habib, F. et al., “Optimal Allocation to Deferred Income Annuities,” Insurance: Mathematics and Economics 90 (2020) 94–104, July 29, 2019.
Horneff, V. et al., “Putting the Pension Back in 401(K) Retirement Plans: Optimal Versus Default Deferred Longevity Income Annuities,” Journal of Banking and Finance 114 (2020) 105785, February 24, 2020