As companies have slowly moved their retirement plans from defined benefit pensions over to defined contribution plans, thereby shifting the risk onto individuals, they have gotten away from offering insured products to help protect employee assets. The situation has begun to shift back, however, as corporations increasingly look to the expertise of insurers to manage longevity risk in the DB plans and begin to offer guaranteed lifetime income products within their DC plans, according to a report by Prudential.
Individuals also are looking to insurance products to protect them against the possibility of outliving their retirement savings.
“While most plan sponsors have become attuned to the investment risk that is inherent in their pension plans, longevity risk is a significant, yet often underestimated risk which cannot be addressed through investment strategy. Longevity risk is real, not theoretical, as the retired lifetime of the average U.S. male has increased 34 percent over the last 40 years. For females, the increase has been 20 percent over the same period. Despite this increase in longevity, widespread awareness of longevity risk within DB plans is still lacking. However, that is very likely going to change,” the report stated.
DB plan sponsors now have the ability to customize their de-risking strategies by choosing how much longevity and investment risk to retain, and how much to transfer to a third party.
Longevity risk is an issue for employers sponsoring DC plans as well, despite the fact that the plan participants (rather than the employer) bear the longevity risk. DB plans more efficiently manage longevity risk than DC plans, as the risk in DB plans is typically pooled across thousands of individuals. (Insurers can pool longevity risk even more efficiently because their risk pools, typically in the hundreds of thousands, are significantly larger than those of DB plans.) Absent the use of an insurance product, namely an annuity, individuals are subject to significant longevity risk within the DC plan construct, since there is no assurance that the accumulated retirement savings will last for a lifetime.
As a result, workers must save larger amounts to self-insure their longevity risk, and will likely need to work for more years to accomplish this goal. In a recent survey of financial executives by Prudential and CFO Research Services, 69 percent indicated that they believe employees will have to delay their retirement due to inadequate savings. Employees who participate in DC plans are also vulnerable to investment risk. Should individuals suffer significant investment losses in their retirement savings prior to retirement, they may need to extend their working careers even further.
Delayed retirements may create workforce challenges for employers, as older employees who cannot afford to retire translates to fewer advancement opportunities for younger employees. Employee morale may suffer. Delayed retirements may also result in higher workforce costs. Older workers typically command higher salaries than younger workers; healthcare costs for older workers are much higher as well.
For workers retiring without the benefit of guaranteed lifetime income from a DB plan, solutions are available that enable individuals to replicate this longevity protection on their own. Immediate annuities allow individuals to purchase a guaranteed lifetime income stream through a one-time premium payment. Although immediate annuities have been available to individuals either through their DC plans or through the retail market, they have not proven to be a popular product with consumers.
The reasons for this include a “loss of control” of retirement assets as well as an inability to access the funds in case of an emergency. Individuals may also be viewing the purchase of immediate annuities as a bet on their own lives that they do not feel comfortable making.
Newer products, in the form of variable annuities with optional lifetime income benefits, have much more consumer appeal. These optional lifetime income benefits are available for an additional fee. Unlike immediate annuities, these products do not require retirees to surrender control of their assets to the insurance company. Rather, the retiree maintains access to the assets invested in the variable annuity, while still receiving guaranteed income for life. The financial assets can typically be invested in a wide selection of investment portfolios.
Income can be stopped, started, or adjusted at any time. Also, unlike immediate annuities, any assets remaining in the variable annuity account upon the death of the annuity contract holder are passed to a beneficiary, provided that the assets had not already been annuitized.
Variable annuities with optional lifetime income benefits have grown rapidly since being introduced in 1996. The flexibility they afford, along with the decline of guaranteed lifetime income available through traditional DB pension plans, is reflected in the popularity of these products. When optional lifetime benefits are available, nearly 90 percent of variable annuity purchasers consistently elect these additional benefits.