On Saturday morning, a Tweet from Brookings caught my eye. It suggested “Longevity Annuities” would be a great solution to the post-pension problem of longevity risk. This is such an unbelievably bad idea that my first thought was that some insurance company had corrupted Brookings. I see no evidence of that, however. It’s probably just a case of two Hamilton Project thinkers who are overly in love with private industry solutions to truly public problems.
The problem is that American employers have stopped offering pensions and Social Security benefits are too low to guaranty a reasonable standard of living for retired workers. The next generation of retirees will have only what they have saved through tax-deferred 401(k) and IRA accounts. A pension is a promise for life. If you get an extra 10 or 15 years on this genetic joyride and you have a pension, you’re covered. A savings account has limits and can be outlived. The only guaranteed, market independent, income stream that retirees can count on is Social Security and Social Security benefits are meager both on an absolute basis and when judged by what people pay into the system.
One way to make sure you don’t outlive your savings is to use the money to buy an annuity, which is a lifelong stream of payments in exchange for surrendering the principal to the investment company (usually an insurance company) who set it up. There are variations on the theme, but that’s the basic trade-off. You retire at 65 and hand over your savings in exchange for income. The company who sells you this product charges you fees and also tries to invest in such a way that they make more money than they have to pay you. If you die young, the investment manager wins.
A “longevity annuity” takes advantage of compounding over time by delaying the payment stream. If you’re 60 and you buy one, it doesn’t start paying until you’re 80. The idea here is that you know if you live a very long life that you will always have a paycheck. But if you die before 80 or soon after reaching 80, you have basically handed your estate to an insurance company for nothing. Obviously, talented actuaries set the prices for all these products. As in Vegas, the house always wins in aggregate, though your individual experience may vary. The Brookings study says that half of 60-year-old longevity annuity buyers will never see a single payment. I’m amazed that Brookings would endorse an investment product with coin toss odds.
No doubt, longevity is a real issue for financial planners. Over the last 15 years, mutual fund companies have offered target date retirement funds that gradually move your investments from stocks to bonds as your approach retirement. The best, from Fidelity, Vanguard and T. Rowe Price, are low-fee, well constructed and just generally decent. But T. Rowe stands out for moving more slowly into bonds on the assumption that most of its clients will live longer than they think. As equities are riskier but offer higher returns, T. Rowe’s planners believe that people should own more stocks than they think, even years after they stop working.
But the real solution here has nothing to do with investment and insurance companies. The problem of longevity past work is something that the market has not solved. Pensions were a decent solution but companies have stopped offering them. Market based solutions like tax sheltered 401(k) and IRA has advantages but they shift risk entirely to the individual. If you deplete a 401(k) account and still have years to live, you are in penury.
When markets fail, the government should step in. Rather than pushing costly annuity products, Brookings should be advocating for a massive expansion of the Social Security system. Payouts should immediately double and then, going forward, the inflation adjustment of payments should accelerate with the age of the recipient so that you get a larger and larger payout for living longer.
Another option would be to help people keep their nest eggs longer. Right now, you get to make tax-deductible contributions to a 401(k) or IRA plan. You pay taxes when you withdraw money in retirement. Because, as a retiree, your income is lower than it was when you were working, you pay a lower tax rate than you would have paid had you never contributed the money to your savings account. That’s nifty. But we could change the law to exempt all retirement savings from taxation. If retirees can withdraw their money tax free, their savings will last longer. Also, we could eliminate taxation of Social Security benefits, even if the retiree has another source of income. So, there you go -- expand Social Security and eliminate taxes on retirement savings and you won’t need expensive and restrictive longevity annuities.
Paying for this, by the way, would be simple: a small transaction tax levied on the stock, bond, and exchange traded futures and options markets would cover the costs nicely. The Brookings plan shunts fees towards Wall Street. My plan taxes Wall Street for everybody’s benefit.