Evaluating the Benefits of Hedging Longevity Risk Using Life Annuities with Liquidity Options

This project was part of the team project "Liquidity and Longevity Risk Management of Households and Life Insurance Companies in an Aging Society".

Topic & Objectives

Many defined contribution pension plans pay benefits at retirement as a lump sum, thus imposing on retirees the risk of outliving their assets. Nevertheless, the US Treasury has recently sought to encourage employers to protect their retirees from outliving their assets by converting a portion of their plan balances into longevity income annuities (LIA). These are deferred annuities which initiate payouts not later than age 85 and continue for life, and they provide an effective way to hedge systematic (individual) longevity risk for a relatively low price. Our paper builds a life cycle portfolio framework to evaluate the welfare improvements of including UAs in the menu of plan payout choices, accounting for mortality heterogeneity by education and sex.

In this setting, we show that introducing a longevity income annuity to the plan menu is attractive for most DC plan participants who will optimally commit 8-15% of their plan balances at age 65 to a LIA that starts paying out at age 85. Optimal annuitization boosts welfare by 5-20% of average retirement plan accruals at age 66 (assuming average mortality rates), compared to not having access Lo the LIA. We also compare the optimal LIA allocation versus two default options that plan sponsors could implement We conclude that an approach where a fixed fraction over a dollar threshold is invested in LIAs will be preferred by most to the status quo, while enhancing welfare for the majority of workers. These implications also apply to Individual Retirement Accounts.

Key Findings

• We evaluate the impact of "putting the pension back" in 401(k) plans via deferred income annuities.
• Our life cycle model helps us measure how much peoples' wellbeing is enhanced by including these deferred annuities in the retirement plan menu. The model accounts for stochastic capital market returns, labor income streams, and mortality, and we also realistically model taxes, Social Security benefits, and 401(k) rules.
• We show that both women and men benefit in expectation from these products, as do the less-educated and lower-paid subpopulations.
• Plan sponsors wishing to integrate deferred lifetime annuities as defaults in their plans can do so to a meaningful extent, by converting as little as 10% or 15% of retiree plan assets, particularly if the default is implemented for workers having plan assets over a reasonable threshold.