Annuities Seen as the Better Choice
An analysis of systematic withdrawals vs. annuities
Art by Michela ButtignolAn academic analysis by Mark Warshawsky, a visiting scholar
at the Mercatus Center at George Mason University, in Arlington, Virginia,
examines two commonly proposed solutions for controlling outflows from defined
contribution (DC) plans—the purchase of immediate lifetime income annuities and
the well-known 4% rule.
As explained by Warshawsky, far more workers now rely on
401(k)-style retirement plans than in years past. He suggests this trend will
continue as more employers move toward DC-style retirement benefits.
“While we know how to pay into this new generation of
retirement plans, we have not yet determined how best to structure the
payouts,” Warshawsky writes. “Now that more workers with 401(k)s or individual
retirement accounts [IRAs] are retiring, it’s time to address this question
quickly and decisively to help retirees get orderly, lifelong payments.”
Relatively few plan sponsors and advisers today coach their
participants to strictly follow the 4% rule, by which participants spend down
4% of their retirement assets per year—increasing the percentage over time to
address inflation. But many advisers and sponsors put their own spin on
controlled withdrawal programs, which build off a similar philosophy; the main
benefit is that participants maintain control over their assets, he says.
“There are, theoretically, more complex strategies and
products on both sides of this debate, but—both practically and for policy
purposes—an empirical investigation into the basic choices is an excellent
starting point for discussion,” he notes.
Running his analysis, Warshawsky finds that lifetime
annuities “are preferable to withdrawals because their income flows are
generally higher and present less risk.” Even for those who do not wish to
annuitize their entire plan balance, he argues that strong positive benefits
accrue from purchasing an immediate life annuity with at least part of one’s
401(k) or IRA balance.
Many of his supporting reasons will be familiar to
retirement industry practitioners—first and foremost is that individuals tend
to underestimate their own lifespan, leaving them at a significant risk of
spending down assets too quickly in retirement. While the risk of individuals
dying before breaking even on an annuity purchase is real, they do not run the
risk of running out of money entirely.
Warshawsky says the data is pretty clear that, whatever the
withdrawal structure, participants need to save a substantial amount to have a
successful retirement. Both the value of annuity income streams and structured
direct withdrawals will be diminished over time by inflation. This is another
reason he believes annuities are preferable—they are subject to inflation risk
but not market risk.
Warshawsky “discourages government policymakers from taking
a strong stance and harming those who might be better served by setting up an
effective direct withdrawal.”