Given the nearly half-century trend away from defined benefit plans in corporate America, many experts are concerned defined contribution plans distributions will continue to be primarily lump sums.
A retiree taking a lump sum is faced with tough decisions — how much to periodically withdraw and how to invest the remaining assets. Withdrawing too much could mean having to reduce withdrawals in later years to avoid running out of money. Conversely, withdrawing too little could force a lower standard of living only to wind up leaving most of the assets to heirs.
To illustrate, assume a participant retiring at age 65 draws down equal amounts each year and that investment returns on the remaining balance will be 5% each year. The annual payment is the amount that results in the account running dry in 25 years, at age 90. If actual annual returns are only 4%, assets will run out three or four years earlier (at age 86-87 rather than 90). Conversely, if annual returns are higher than 5%, the retiree (if still alive) could continue to withdraw amounts beyond age 90.
These longevity and investment risks may be of little consequence to higher earners who have significant other assets that can be tapped or to lower earners who rely primarily on Social Security benefits to provide retirement income. However, those risks are meaningful for the largest group in the middle who have significant account balances that are needed to supplement Social Security.
Why is it then that a high percentage of DC plan participants elect lump sums? And why is it that even in DB plans where a life annuity is the default payment form and where lump sums are offered, lump sum take up rates typically are 80%, 90% or even higher?
The reason is simple: a lump sum payment is a bird in the hand. It gives the retiree the flexibility to invest the money as they see fit, to use the money as needed and to target some of the money to heirs. While many retirees see advantages to life annuities they also see drawbacks – loss of flexibility on withdrawal amounts and perceived loss of value if they die prematurely.
Because life annuities from DC plans must be provided through an insurance company, that has created impediments. Not only can the process be tedious, it can be expensive because insurers are required by state law to be risk averse, have significant overhead expenses (including salesforce costs) and are in business to make profits.
So where does that leave us? Given the obvious advantages of lifetime income to cover at least some of the retiree’s expenses, how can life annuities be offered without fully locking retirees in and without losing all of the flexibility they would have with a lump sum. As an alternative to placing restrictions on lump sums, a client could provide more distribution flexibility. Ideally, that would mean offering lump sums and at the same time encouraging or at least removing obstacles to electing annuities.
Most DC (and DB) plans preclude or greatly limit the ability for participants to take a portion of their benefits in one form and the remainder in another, or to begin a portion of the benefit at retirement and the remainder at some later date. Historically, these restrictions were justified both because of the administrative hassle of allowing multiple forms or start dates and because it was thought that few retirees would be interested in such arrangements. Today, there is good reason to believe that both of those factors are no longer present given the improvement in administrative systems and the greater diversity of retiree situations.
To facilitate longevity protection in DC plans, IRS regulations allow DC plans to offer qualified longevity annuity contracts to participants on a portion of their account balances. That would allow a retiree to elect a partial lump sum at retirement with the remainder of the account applied to purchase a deferred life annuity beginning as late as age 85.
Because such a deeply deferred annuity would be relatively cheap (as compared to a life annuity of the same dollar amount beginning at retirement), most of the account would be paid in a lump sum, and such lump sum would only have to last until the annuity starting date. This is a promising idea in theory, but so far not many DC plan sponsors have offered these arrangements. That could change as this line of business becomes more competitive among insurers.
Some DB plans already provide a “level income” option where a larger annuity is payable until age 62 (sometimes age 65) when Social Security benefits become available. And some DC plans allow for installment payments for a specified number of years, although that option normally applies to the full account, not a portion of it. Some retirees might prefer taking a partial lump sum or life annuity upon retirement and deferring the remainder of the benefit (which may be another lump sum or a life annuity). That arrangement could be attractive to participants who anticipate changing financial needs during retirement and like the flexibility of having some up-front cash to draw as needed. Adding this flexibility to both DB and DC plans will provide choices that were not previously available and should be viewed favorably by all participants, not just those who elect the split forms.
Finally, if the sponsor maintains a DB plan, that plan could allow a participant to transfer some or all of their DC account balance to the DB plan to provide an additional life annuity at pricing that is more favorable than from insurers. That should help increase the annuity take rate.
