automatic annuitization: new behavioral strategies for

The Ret i rement Secur i ty Pro ject

The RetirementSecurity Project

July 2009

Automatic Annuitization:New Behavioral Strategies forExpandingLifetime Incomein 401(k)s

J. Mark Iwry and John A. TurnerNo 2009-2

Advisory Board

Bruce BartlettWashington Times Columnist

Michael GraetzJustus S. Hotchkiss Professor of Law,Yale Law School

Daniel HalperinStanley S. Surrey Professor of Law,Harvard Law School

Nancy KilleferDirector, McKinsey & Co.

Robert RubinDirector, Chairman of the ExecutiveCommittee and Member of the Officeof the Chairman, Citigroup Inc.

John ShovenCharles R. Schwab Professor ofEconomics and Director, StanfordInstitute for Economic Policy Research,Stanford University

C. Eugene SteuerleSenior Fellow, The Urban Institute

Commonsensereforms,real worldresults

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The Retirement Security Project

is supported by The Pew

Charitable Trusts in partnership

with Georgetown University's

Public Policy Institute and the

Brookings Institution. This paper

is a part of the Retirement

Security Project's ongoing

project on promoting retirement

security through lifetime

retirement income, which is

funded by the Rockefeller

Foundation.

The Retirement Security Project • Automatic Annuitization: New Behavioral Strategies for ExpandingLifetime Income in 401(k)s 3

Introduction

Workers contemplating retirement face

significant financial risks. Inflation, anuncertain rate of return on investments,the insolvency of a former employer orfinancial provider—all these external factorscan deplete retirees’ assets and income.Personal risks such as unemployment,illness, disability, and even life span can lowerearning capacity or raise financial need.

A long life, a blessing in so many ways, isespecially hard to manage. Someunderestimate how long they will live orneglect to plan for the possibility of manyyears in retirement. Many find it difficult todevise and adhere to a plan for managingretirement assets over an uncertain, andpotentially long, time horizon.

Americans’ financial prospects for retirementnaturally depend on how much moneythey have saved during their workingyears. Equally important, but often anafterthought, is how they use it.

Traditionally, the most complete solutionto this problem has been to protectretirees from outliving their assets throughthe use of guaranteed lifetime income,

such as an annuity. Annuities and otherlifetime-income arrangements undertaketo make predictable payments for as longas annuitants are alive.

Yet in recent years annuitization rateshave fallen. Defined benefit pension plansat the workplace, a traditional source oflow-cost annuity income, have increasinglyoffered and made lump-sum (single cash)payments, either by adding a lump-sumoption to the plan’s array of payout optionsor by converting the entire plan to adifferent, lump-sum-oriented format knownas a hybrid. “Cash-balance” plans are themost common kind of hybrid. Many otheremployers have replaced their definedbenefit plans with 401(k) plans, whoseaccumulated wealth is typically returnedto workers upon retirement as a lump sumrather than as monthly payments for theduration of retirement. Only about 2 percentof 401(k) participants choose to converttheir savings into annuities upon retirement.

Despite these trends, the need for stableand assured income has increased alongwith longer life expectancies andretirement periods. The choice betweenan annuity and a lump-sum distributionmay be one of the most important

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Automatic Annuitization: New BehavioralStrategies for Expanding Lifetime Income in401(k)sBy J. Mark Iwry and John A. Turner

The Retirement Security Project • Automatic Annuitization: New Behavioral Strategies for ExpandingLifetime Income in 401(k)s


automatic features in 401(k) plans hasenjoyed striking success in expandingplan participation and improvinginvestment behavior.1 There is amplereason to think that the behaviorallyinspired strategies that have worked sowell to improve participation in 401(k)plans should be extended, as has longbeen intended, to 401(k) payouts as well.2

Currently the most common option inmost 401(k) plans is the lump sum;retirees typically receive their savings inthe form of a single check. For manyretirees, this may not be the best choice.One way to promote a better choice isto make an annuity the default option atdecision time. In the saving phase offinancing retirement, automaticenrollment in workplace 401(k) plans hasgreatly increased desired behavior—inthis case, saving for retirement. Webelieve the same principle can be put towork in the payout phase of retirementsaving: deciding what to do with theaccumulated savings. In a previousRetirement Security Project policy brief,Gale-Iwry-John-Walker (2008), putforward a single proposal providing thatwhen retirees cash out their 401(k) plans,the accounts would automatically beused to support an annuity unless theretirees explicitly said they wanted alump sum. 3 After receiving twenty-fourmonthly checks, retirees would be ableto switch out and take the remainingvalue of their retirement savings in theform of a lump sum. Presumably, manywould not do so.

4

financial decisions a person ever makes.Why more people do not chooseannuities has been something of a puzzlewithin the economics literature and forpolicy analysts. There are three broadclasses of explanations:

—Annuities may not inspire confidencebecause they are not sufficientlytransparent or simple to understand.Consumers find themselves mystifiedby annuities’ complex provisions andworry (based partly on warnings in thepersonal finance and consumerprotection literature) that insurancecompanies are pricing their productsunfairly. Comparison shoppingbetween annuities, let alone betweenannuities and lump-sum options, canbe a lot more complicated thancontrasting a Toyota to a Ford in anautomobile showroom.

—Annuities may appear to be a risky,high-stakes gamble with insurancecompanies about how long the retireewill live. Retirees who die young aredeprived not only of years of their lifebut also of years of annuity payments.

—Annuities may preclude importantalternative uses of retirement savings.

AAnn AAuuttoommaattiicc SSttrraatteeggyy ttoo EEnnhhaanncceetthhee AAppppeeaall ooff AAnnnnuuiittiieessTo encourage more retirees to put atleast some of their retirement savingsinto lifetime income, it would be naturalto consider the use of automatic (default)strategies. The intelligent use of


Gale-Iwry-John-Walker (2008) discussesthe factors limiting demand for annuitiesand outlines a promising proposal toincrease demand for and participation in401(k) plans: automatic trial income. Under this approach, which seeks to useinertia to overcome misconceptionsabout annuities, a 401(k) plan sponsorcould tell retiring participants that half (orsome other specified portion) of theiraccount balance was tentativelyearmarked for annuitization. Theannuitization would begin with regularmonthly payments for two years, unlessthe retiree opted out. At the end of thetwo-year trial period, retirees could electan alternative distribution option; but ifthey did nothing, regular monthlypayments would automatically continuefor life. The underlying assumption is thatonce workers had an opportunity to “testdrive” an annuity for a limited period oftime and become accustomed to itsadvantages, they would be more likely atthe end to accept it permanently. Theregular income stream (or “pensionpaycheck”), rather than the lump sum,might come to be seen as the statusquo or presumptive form of benefit.

We believe this automatic trial-incomeapproach would go a long way towardaddressing many of the obstacles tobroader use of lifetime income in 401(k)s.However, it would not address all ofthem, and it would address some only toa limited degree, in part because itwould apply mainly at the point ofretirement (the start of the plan’s payoutphase). Accordingly, it may be that theuse of lifetime income would be

Given the success of 401(k) automaticenrollment, would making an annuity thedefault option at retirement similarlyincrease the percentage of pensionparticipants taking annuities? Theevidence suggests it would not.Although a useful element in a strategyto encourage the selection of annuities,the default approach by itself would befar from sufficient. For example, everycash-balance pension plan is required bylaw to make a lifetime annuity the defaultmethod of payment, but the vastmajority of participants in these plans optout of the annuity in favor of a lump sum.In these plans, the benefit is framed asan account balance or lump sum; andeven in traditional defined benefit plans,where the benefit tends to be framed asan annuity, participants often, though notas frequently, opt for a lump sum if it isavailable as an option.

The evidence suggests that when anannuity is the default and a lump sum isthe alternative, most participants opt outof the default in favor of the lump sum,at least where the annuity-versus-lump-sum decision is presented as amomentous, all-or-nothing, irreversibledecision affecting retirees’ entire accountbalance. The force of inertia that givesthe automatic or default strategy itspower appears to be weak in thesecircumstances, and even weaker whenthe plan has framed the presumptiveform of benefit as a lump sum. Couldarrangements be designed to enhancethe effectiveness of an automatic ordefault annuity and make participantsmore likely to accept it? We believe so.


The Retirement Security Project • Automatic Annuitization: New Behavioral Strategies for ExpandingLifetime Income in 401(k)s6

expanded through a complementaryapproach that could be used inconjunction with the trial-incomeapproach (or that could be offered toplan sponsors as another alternative,reflecting a similar behavioral strategy).

The complementary approach we havein mind would involve the phased orincremental acquisition of deferredannuities during the plan’s accumulationphase. Like the trial-income approach,this strategy is designed to eliminate ormitigate significant obstacles to theexpanded use of lifetime income, withoutpurporting to remove all of the obstacles.Even as innovative product designs haverecently come onto the market, eachapproach would help address anoverlapping set of concerns. In combination,the Gale-Iwry-John-Walker (2008) trialincome approach and the strategyoutlined here are designed to address, ina mutually reinforcing manner, much ofwhat currently limits 401(k) participants’demand for lifetime income.

PPhhaasseedd oorr IInnccrreemmeennttaall AAccqquuiissiittiioonn ooffDDeeffeerrrreedd AAnnnnuuiittiieessBased on our analysis of the factorsinhibiting demand for lifetime income, astrategy that would make the automatic(default) approach a more powerful tool topromote lifetime income should incorporatethree simple but important elements.

—Avoid all-or-nothing decisions. Insteadof requiring retirees to use all, or none,of their savings to buy lifetime-incomeinstruments, the new approach couldallow them to use only a portion of

their balance to purchase an annuity.New retirees could take possession ofthe balance of their retirement savingsas a lump sum. The relative amountsof savings devoted to provide regularincome and to fund a lump-sumpayment would presumably vary fromone household to the next dependingon circumstances.

—Avoid now-or-never decisions. Planparticipants could be allowed tochoose incremental annuitization overtime, rather than being confronted witha single moment of truth when thedecision of whether or not to take anannuity is thrust upon them. Thestress that accompanies making sucha decision is not only unpleasant butalso an incubator of baddecisionmaking. We would divide thedecision not only in amount (throughpartial annuitization) but in time(through incremental annuitization).

—Avoid never-or-forever decisions. Today’spractice generally forbids retirees toreverse any or all of an annuitypurchase, at least for a while. Thiscompounds the stress related to theinitial decision; retirees who get itwrong do not have another crack at it.

These three elements effectively lowerthe stakes so that someone who passivelyaccepts the default has almost nothingto lose. On any given day, the incrementalcost of postponing an active decision andgoing along with the default is de minimis.


We would give effect to these threeprinciples in a system in which aspecified portion of worker and employercontributions to 401(k) accounts wouldbe invested in units of deferred annuity.This portion would grow with time andwith additional contributions. (This wouldnot be the traditional deferred annuitythat has often been used only as aninvestment vehicle, without ultimatelybeing paid out in regular installmentsover the owner’s lifetime. Instead, itwould be designed mainly to providelifetime guaranteed income beginningafter retirement.)

Instead of making a single purchasedecision at retirement, the employeewould acquire an annuity incrementally,beginning either in mid-career (at age 45or 50, for example,) or earlier, andcontinuing until retirement distributionsbegan.4 The employee could opt out ofthe arrangement entirely (although thedefault would be renewed from time totime, requiring an employee who was notinterested in acquiring annuity-incomeunits to opt out periodically). Alternatively,the employee could choose to dedicatea different percentage of current contributionsto the incremental acquisitions.

AAnnnnuuiittiieess’’ AAddvvaannttaaggeessIncremental purchases through regular,small contributions over a period ofyears should promote a fundamentalreframing of the way 401(k) benefits arepresented to participants. They wouldcome to see the benefits not as a lumpsum in a single account but as anincome stream. They would regard each

payment to them as a pensionpaycheck—deferred compensation forwork done. The reframing could beaccomplished in two ways: throughregular benefit statements, and byaccumulation. The benefit statementapproach, which could apply in 401(k)plans and other defined contributionplans as well as to individual retirementaccounts (IRAs), cash-balance plans,and other hybrid plans that presentbenefits as an account balance, isdescribed in Gale-Iwry-John-Walker (2008):

“To help reinforce a sense of ownershipof the income stream rather than ofonly the lump sum, DC plan sponsorsand IRA providers should be requiredto present the participant’s benefits asa stream of monthly or annual lifetimepayments in regular statements and insummary plan descriptions, in additionto presenting the benefits as anaccount balance in accordance withcurrent practice. It may be possible todevelop an industry-wide method ofcomputing and presenting the stream

“Over time, this change may helpencourage account owners to becomeaccustomed to thinking of theirretirement resources as monthlyincome. Taking the distribution asmonthly payments would seem“natural” – that is, it would beequivalent to maintaining the statusquo. The intent is to reposition theirframe of reference so that consumersdo not feel a “loss” when they receivean income stream rather than a lumpsum. Portraying the payments from



an annuity as a consumption streamhas been found to be a useful andmore illuminating way of presenting thebenefits of annuities. . . .”

The gradual acquisition of annuity-incomeunits would also circumvent the wealthillusion or “sticker shock” that tends todiscourage individuals from paying a“large” amount to an insurance companyin exchange for an ostensibly “small”regular monthly payment. This is true formany of the same reasons that 401(k)payroll deduction contributions tend towork effectively as a saving mechanism:Participants would not see a large sumbeing transferred out of their account toan insurance company. Instead, they wouldpay small amounts over time, which shouldinflict little or no psychological pain.Incremental annuitization would avoidsticker shock not only because it isgradual but because it takes place yearsbefore the annuity is fully acquired,meaning that smaller contributions canbe set aside to acquire the annuity giventhe additional time for tax-freeinvestment earnings.5

Whether or not incremental accumulationof annuity-income units began bydefault, it would continue withoutrequiring the participant to take anyinitiative or make any decision.6

Individuals confronted with the initialdecision of whether to opt out of thegradual use of a portion of their contributionsto acquire deferred annuity units wouldfind the stakes at that moment to be low.It should be easier for individuals to

accept the default with respect to anygiven contribution because it representsonly a small amount. For example, whetherto opt out of having 20 percent of currentcontributions automatically placed in acrelatively stable investment for the nextfew pay periods should not present itselfas a momentous decision. (The planmight provide that, over the next five orten years, the percentage would gradually,but automatically, increase to 30 or 40percent.) Procrastination would be easybecause the decision would bereversible. One could always decide toopt out later, before very much had beeninvested in the annuity units.

In addition, incremental acquisition couldinclude an “unwind,” or cash-surrender,option permitting the participant to optout retroactively subject to a surrendercharge. Such an unwind arrangementshould be designed to encourageparticipants to engage in or acceptincremental acquisition, because it is notirreversible, but should be set at a levelthat would discourage most participantsfrom actually using it.

The incremental acquisition of annuityunits would mitigate the interest rate riskassociated with a point-in-time acquisition.Because individuals would face differentinterest rates throughout the purchaseperiod, the rate in any single periodwould be averaged over time with otherrates (much like an investment usingdollar cost averaging).

For some participants, accepting theannuity-income default would mean

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postponing receipt of much (for example,half) of their lump-sum distribution fortwo years. They might not be willing todefer gratification in this way. In fact, theevidence shows that the vast majority ofretiring or terminating cash-balance planparticipants override the default annuityin favor of a lump-sum payment. Bycontrast, participants in the accumulationphase might not perceive the incrementalacquisition of annuity income asimposing a similar sharp trade-off or asrequiring deferral of gratification.

Many plan participants may be drawn tothe annuity option as a “safe” and stableinvestment, especially when markets areturbulent. While investors generally arewarned not to act on emotion or attemptto time the market, many—especially thoseclose to retirement—worry understandablyduring times of market volatility about therisk associated with equity investments.These individuals might welcome aninvestment strategy that is not centeredon money market or stable-value funds(neither of which is a perfect solution).Investment in fixed annuities or invariable annuities with sufficient payoutguarantees or floors could be part of theresponse to a potential and actual “flightto safety” in 401(k) plans.

Incremental acquisition of annuity incomeduring the accumulation phase might beparticularly responsive to these concerns.Fixed annuities or variable annuities withguarantees could serve as a “safe”investment composing a portion of abalanced, diversified portfolio. This particularadvantage—the stability of a fixed or

guaranteed annuity as an investmentduring periods of market volatility—is morelikely to be demonstrated to participantsover a decade or several decades ofaccumulation (spanning at least onemarket cycle, including at least oneperiod of depressed or volatile marketvalues) than at a particular point in time.

HHoollddiinngg CCoossttss DDoowwnn For several reasons, the gradual acquisitionof deferred annuities through an employerplan should also help reduce cost.

—Group annuities (or annuities purchasedthrough a group purchase) are less costlythan those purchased on the individualmarket because the group (through theplan sponsor) has greater bargainingpower and can bring a greater degree ofknowledge (including the help of anoutside consultant) to the negotiating table.

—Group purchase should be lessexpensive insofar as it is less subjectto adverse selection (althoughindividuals with shorter lifeexpectancies could be expected toopt out of the lifetime incomeapproach and be underrepresented inthe pool). But retirement annuitiespurchased earlier in life, when peoplehave less information about theirhealth status at retirement, might entailless adverse selection than purchasedecisions at retirement and to thatextent should be less expensive thanannuities purchased at retirement.


62, 65, and 70. (This approach mightencourage some workers to postponeretirement, depending in part on howthey interpret the relative value of thehigher annuity dollar amounts beginningat the later ages.)

In the specific context of 401(k) plans,two particularly promising vehicles couldencourage participants to accumulatedeferred lifetime income over the latterpart of their working lives. We suggestthese as alternatives, each of which mayappeal to a different subset of plan sponsors.

TTaappppiinngg tthhee EEmmppllooyyeerr MMaattcchhMost 401(k) plans provide employermatching contributions. A plan sponsorcould make phased acquisition ofannuity-income units more likely to occur(or ensure that it would occur) bydedicating its employer matchingcontributions to this purpose. A plansponsor could choose to make such aninvestment mandatory or could make itthe default, allowing participants to optfor a different investment. Eitherapproach would be permissible undercurrent law. The sponsor could evenbegin by using only a portion of theemployer match to purchase annuities,gradually increasing to all of the matchover time. The logic of a “bright line”segregation of employer matchingcontributions used to accumulate anannuity from other contributions investedin other ways should reinforce the“framing” of participant expectations thata portion of their account balance wouldbe used to provide lifetime income.

—The deferral period should also reducethe perceived cost. A lengthy intervalbetween purchase and payment meansthat the annuity value should have timeto build up with investment earnings sothat the annuity provider could offer alarger nominal monthly payment foreach dollar of contributions.7

More generally, strategies such as theone outlined here – which could be usedin conjunction with, or as an alternativeto, the trial income approach described inGale-Iwry-John-Walker (2008) — have thepotential to expand the market sufficientlyto make lifetime income a staple withinthe 401(k) universe. As discussed inGale-Iwry-John-Walker (2008), this shouldlead to a better functioning market, withgreater opportunities for standardizationand transparency, and ultimately lower costs.

IImmpplleemmeennttiinngg IInnccrreemmeennttaallAAccqquuiissiittiioonnTypically 401(k) plans entail a strongframing of the benefit as a lump sum;indeed, the account balance itself can beand is viewed as a presumptive lump-sumbenefit. It is not surprising, therefore, thatonly about 2 percent of 401(k)participants elect annuities. To competewith this deep-seated framing and strongparticipant bias in favor of lump sums,401(k) plans could be required (as notedearlier) to regularly report accumulatingbenefits as an annuity equivalent, inaddition to an account balance. (A similarapproach might be considered for IRAs.)In fact, it might be especially useful toshow the annuity equivalent at threealternative annuity starting ages, such as


We see three main potential advantagesof using employer contributions in thisway. First, the notion of the employermatching contribution being directed toa particular investment, either by dictateor by default, is a familiar one in the401(k) universe. Traditionally, theprospect of obtaining Employee StockOwnership Plan tax advantages, savingemployer cash flow, enhancing workerincentives and productivity, and fendingoff hostile takeovers led many 401(k)plan sponsors to make employercontributions in the form of employerstock (or to provide for them to beinvested in employer stock), subject, inmany cases, to participants’ ability toelect otherwise. Now that Congress haslimited employers’ ability to forceinvestment of matching contributions inemployer stock, there is an opportunityto use a similarly assertive approach withrespect to the investment of employercontributions in the interest of expandinglifetime income.8

Second, participants who are skepticalabout turning their assets over to aninsurance carrier may be more acceptingof “employer money” being invested inannuity income.9 The difference betweenemployers, as opposed to employees,bearing the cost of funding the benefitsexists in employee and even employerperceptions, if not reality. (This policybrief does not explore the issues relatingto the actual differences betweenemployee and employer contributions,which are beyond the scope of thisdiscussion.) Because employees andemployers perceive an important

distinction between employee andemployer contributions, employees mayfeel that their employer is entitled todecide how “its own contributions” areused. This should be even more true inthe case of employer nonmatching(“nonelective”) contributions.

Third, this use of employer contributionsavoids presenting the employee with anall-or-nothing choice and spares theemployee the need to decide exactlywhat portion of his contributions toinvest in deferred annuity units. Employermatching contributions often account forabout a third of the account balance (orslightly less). To many employees, thismight feel like a reasonable or acceptableportion to devote to lifetime income.

The accumulated annuity income unitsacquired with employer matchingcontributions could be used as analternative to the two-year trial annuityproposed in Gale-Iwry-John-Walker(2008). Alternatively, plan sponsors mightchoose to use both approaches asdefault strategies. Plan participants whodeclined the investment of employermatching contributions in incrementalannuity units might be willing to acceptan automatic two-year trial annuity for aportion of their account balance atretirement, in part because of the earlierframing of a portion of benefits as apotential annuity. (However, for participantswho accepted the investment of theemployer match in annuity units, a two-yeartrial annuity is less likely to be necessaryor appropriate; and plan sponsorspurchasing annuity income for


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participants long before retirement mayget a better price from annuity providersthan those purchasing trial-income annuities.)

The employer contribution strategy mayhave special appeal to two types of plansponsors. The first are companies thathave previously made or investedemployer contributions in employer stockand are now interested in reducingparticipants’ (and the plan fiduciaries’)exposure by reducing the amount ofemployer stock in the plan.10 The secondare those that have recently frozen,terminated, or otherwise reduced a definedbenefit plan. Such sponsors often try tomitigate the expected loss to employeesof an employer-funded defined benefit bymaking certain improvements in their 401(k)plans. To partially compensate employeesfor losing the advantages of the definedbenefit, the sponsor might, for example,increase the employer match in the 401(k),add a nonmatching employer profit-sharingtype contribution to the 401(k), or introduceautomatic enrollment and automaticincreases in employee contributions. Usingemployer 401(k) contributions to buyannuity-income units would have theadvantage of replacing some of the expectedretirement income that was lost when thecompany reduced its defined benefit plan.

EEmmbbeeddddiinngg LLiiffeettiimmee IInnccoommee iinn aa LLiiffee--CCyyccllee FFuunndd oorr AAnnootthheerr QQDDIIAAAs an alternative to dedicating the 401(k)employer matching contributions to thephased purchase of lifetime-incomeunits, plan sponsors and financialproviders might consider incorporatingthe phased purchase of deferred annuity

units into a qualified default investmentalternative, or QDIA, specified by theDepartment of Labor. In regulationsinterpreting the 2006 Pension ProtectionAct, the Labor Department has specifiedseveral types of default investments that401(k) and similar plans could offerwithout losing the degree of protectionfrom fiduciary liability that results fromallowing participants to select amongcertain investment options defined bythe plan. Typically in conjunction withautomatic enrollment, the 401(k) markethas been moving briskly to incorporatethese automatic or QDIA default investments.

Probably the most prevalent form of QDIAcurrently available is the target-date maturityfund, also known as the life-cycle fund.Often structured as a composite “fund offunds,” the life-cycle fund generally holdsa mix of asset classes, largely diversifiedequities, and fixed-income investments.A life-cycle fund for people who aredecades away from retirement typicallyinvests a majority of its assets in diversifiedstocks. As individuals approach theirassumed target retirement date, theasset mix shifts gradually away from thepotentially higher-return but higher-riskequities to a higher percentages of lessvolatile or more conservative investmentssuch as bonds or other fixed-incomeinvestments (this process is oftenreferred to as a “glide path”). Thus far,these target-date or life-cycle fundsgenerally have been well accepted byemployees as a means of achievingasset allocation and diversification thatreflects a fairly broad consensus withinthe expert financial advisory community. 11


The phased purchase of annuities wouldfit neatly into the life-cycle-fund rubric;and a new kind of life-cycle default fundcould facilitate the phased purchase ofannuities. The steadily growing fixed-income component of the life-cycle fundmight be composed of fixed annuity-incomeunits that accumulate over time and thatwould be paid out as an annuity atretirement. Thus, fixed deferred annuityunits could substitute for the bondcomponent of the life-cycle fund, eitherentirely or in part. (Whereas variableannuities are invested in equities, fixedannuities tend to be backed up, at leastindirectly, by insurance companyinvestments in bonds.) As a result, thepercentage of 401(k) contributions beingused to purchase deferred annuity-income units would grow as employeesapproached their expected retirementdate. These new life-cycle or target-datefunds would go beyond the funds currentlyoffered insofar as they would not onlyserve as an investment but would alsohelp participants manage the postretirementspend-down of their 401(k) assets.

If 401(k) plan sponsors chose to offersuch funds, they would enlist inertia inthe cause of persuading employees toallow a portion of their account balanceto be invested in deferred annuities.Employees would have the usual abilityto opt out of the default life-cycleinvestment fund. However, there isreason to expect that the current patternwith respect to conventional life-cycleQDIAs—a high rate of employeeacceptance, as opposed to opt-outs—might well hold in the case of such newQDIAs. For most employees, the

nonequity components of the default life-cycle fund are largely a “black box.”Employees are unlikely to be highlysensitive to differences in the compositionof the conservative portion of the assetmix, absent a meaningful reduction inexpected return, a perception that thenew type of investment was risky, or anincrease in expenses. (This paper doesnot investigate potential expenses toplan sponsors or employees associatedwith the use of deferred annuities instandard QDIA investments.)

We obviously are not suggesting thatannuities “stow away” in the currentlypopular life-cycle default funds withoutfull and effective advance disclosure toparticipants. However, some of the sameemployees who might resist purchasingan annuity at retirement with their entire401(k) account balance may be far morewilling to accept partial deferredannuitization purchased incrementally—far more willing to accept the incrementalchoices involved in not opting out of adefault life-cycle fund that includesdeferred annuity units as its fixed-incomecomponent. Such a plan also would helpthem manage their assets after retirementand spread the risk that low interest ratesat the time of purchase would reduce theamount of annuity that could be purchasedwith a given dollar of contributions.

Plans using this new kind of life-cyclefund as a QDIA could, of course, alsooffer other investment options includingmore conventional life-cycle funds thatuse fixed-income investments instead ofannuity-income units. Conversely, thephased acquisition of deferred annuity


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units could be incorporated in any of thethree principal QDIAs—not only thetarget-maturity or life-cycle fund but alsobalanced funds that do not change theirasset mix over time, and managed accounts.

CCoommpplleemmeennttaarryy AApppprrooaacchheessThe automatic phased or incrementalannuity acquisition strategy could serveas an alternative to, or be used incoordination with, the automatic trial-income approach proposed in Gale-Iwry-John-Walker (2008).

First, viewing the incremental strategy asan alternative or a precursor to the trial-income annuity strategy addresses thefact that not all plan participants are insimilar circumstances or are driven bythe same considerations or concerns.Each approach might appeal to adifferent subset of the participantpopulation; if each is effective with adifferent group, together they mightencourage more lifetime income thaneither alone. In a rough, schematic way,table 1 shows the specific concernsinhibiting demand for lifetime income that

Trial IncomeConcern/Obstacle

√√√

√

√

√

√√√√√

√

√√√√√

√√√

√√√√√√

√√√√√√

√√√√√√

√√√√√√

√√√√√√

PhasedAccumulation

Phased AccumulationUsing QDIA or ER Match

I. Many Consumers Lack Confidence in Annuities: Not Sufficiently Transparent, Simple or Well Priced Lack of knowledge Mistrust Nontransparent costs High prices Ostensibly unfav. terms of trade Loss of sense of ownershipII. To Some Retirees, Choosing an Annuity Seems Risky Risk of losing to insurance co. All or nothing choice Irreversibility Market timing interest rate risk Insurance company insolvencyIII. Annuity Purchase Seems to Require Giving Up Important Alternatives Bequests Liquidity Financial flexibility Loss of equity premium Loss of investment control Loss of current consumption

Table 1. How Policy Options Address Concerns Affecting Demand for Lifetime Income

√ = addresses concern to some degree √√ = strongly addresses concern

Source: Authors’ compilation.a. For a description and discussion of these concerns inhibiting demand as well as factors inhibiting the supply of lifetime income, see Jeffrey Kling and others, “Why Don’t People Choose Annuities? A Framing Explanation,” Research Brief (Washington: Retirement Security Project, March 2008).QDIA = qualified default investment alternative.

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are intended to be addressed by each ofthe two incremental purchase strategiesdescribed here (employer match andQDIA), by the Gale-Iwry-John-Walker(2008) trial period income strategy, andby a combination of these strategies.The table suggests that each of thestrategies addresses a wide range of theissues that have been identified asinhibiting demand, and each appearslikely to do better than the others in oneor more areas. In the aggregate, theyoffer a range of possible strategies toplan sponsors, some of whom might feelmore comfortable with one or another (ora combination) of these approaches.

Second, participants’ choice (explicit orby default) to purchase annuity-incomeunits for a period of years before retirementcould make the trial-income approachmore effective. While regular statementsof benefits in annuity, as well as account-balance, form certainly promise to behelpful, they are only descriptive; reinforcingthe effect of those statements throughthe incremental purchase of annuity-incomeunits is experiential (as is the two-yeartrial of regular income) and thus potentiallymore powerful. Incremental annuitypurchases would likely go far towardreframing participants’ expectationsregarding their plan benefits as anincome stream rather than a presumptivelump-sum payment.

Third, a plan that has an incrementalaccumulation-phase element in its overallincome strategy might, for example,make the actual commencement ofannuity-income the default, but not

mandatory, and combine the incrementaloption with the two-year trial approach.Participants who have accumulatedannuity units might be more likely to goalong with the initial default (precedingthe two-year period) and experience thetwo-year trial, especially if theaccumulated annuity units were used toprovide the two-year trial payments.These participants might also be morelikely to go along with the subsequentdefault (at the end of the two-yearperiod), choosing permanentannuitization, again especially ifaccumulated annuity units were sufficientto fund some of those annuity benefits.(In fact, such participants might evenultimately annuitize portions of theaccount balance that do not representaccumulated annuity-income units.)

Fourth, plan sponsors may feel morecomfortable actually requiring the two-yeartrial (rather than merely making it adefault option) for annuity-income unitsthat plan participants have purchasedover a period of years on the understandingthat they will presumptively be annuitized.The sponsor might, for example, allowparticipants to opt out of annuitization ofsuch long-accumulated annuity-incomeunits after the two-year trial period butmay not feel constrained to offer the opt-out choice at the start of the two-yeartrial as well (assuming, as we do forcurrent purposes, that the planqualification rules would not requireotherwise). As a result, more participantsare likely to experience the two-year trialinstead of opting out of it.



In addition, as discussed earlier,annuities (whether acquired through trialincome or incremental accumulation)may be more attractive to manyhouseholds in times of economic turmoil,especially because fixed annuities canprovide stability of investment returns,assuming the long-term solvency of theprovider. Incremental acquisition ofannuity income during the accumulationphase may be particularly responsive tothese concerns, insofar as the safetyand stability of fixed annuities is likely tobecome more evident to participantsover a long period of accumulation thanduring a two-year trial-income period.

NNeeww PPrroodduucctt FFeeaattuurreess AAddddrreessss SSoommeeKKeeyy CCoonncceerrnnssMany concerns have been or are beingaddressed to some degree by traditionalfeatures or by innovations in annuityproducts or other competing financialproducts, although each additional featureinevitably comes at a price. Following aresome examples.

—Variable annuities have long providedthe option to make equity investmentswithin an annuity and the option forthe annuitant to exercise control overthe investments (while exposing theannuitant to investment risk).

—Some of these products combine equityexposure with certain kinds of guaranteesor floor values, including features thatmay lock in certain equity gains. Thecombination provides participants withupside potential together with a measureof protection against the risk of loss.

—Joint-and-survivor annuities that providelifetime protection to an annuitant’ssurviving spouse, term-certain and lifeannuities that promise payments for afixed number of years even if theannuitant is deceased, and annuitiesthat provide lump-sum death benefitshave been longstanding options designedto deal with annuitants’ concern thatan early death will leave the insurancecarrier with most of their money. However,death benefits and cash-surrenderoptions dilute the longevity riskprotection by reducing the mortalitycredit for long-lived annuitants.

—Some annuities offer cash-surrenderfeatures that essentially allowannuitants or potential annuitants tochange their minds and get much oftheir purchase price back, at leastwithin a specified time frame, or allowpartial ad hoc withdrawals to meet“economic shocks” or for otherpurposes. (However, annuity providersneed to protect themselves againstthe risk of adverse selection byannuitants who discover their lifeexpectancy has suddenly shortened.)

—Some annuities offer inflation protectionfor an additional premium. Theinflation-protected annuity amount couldbe indexed to cost-of-living indexes orcould increase by predeterminedpercentages designed to providerough, partial inflation protection.

—Mutual funds and other financialinstitutions outside the insuranceindustry have developed products that

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provide regular monthly income at apredetermined or variable level, withgreater flexibility than many annuityproducts but without the lifetimeguarantee or longevity risk sharing of alife annuity.

Many of these results can be achievedsimply by purchasing an annuity with onlya portion of one’s retirement savings andusing the remainder to provide survivorprotection, equity investment opportunities,spending flexibility, inflation protection,and the like.

Several insurance companies are offeringproducts to 401(k)s that would permitparticipants to purchase deferred annuityunits on an incremental basis. However,these products have yet to be widelyadopted. We believe that strategies suchas those described here and in Gale-Iwry-John-Walker (2008) may be neededto spark greater employee demand forlifetime income – including the use ofemployer matching contributions to funddeferred annuities, QDIAs to incorporatedeferred annuities, and a “trial income”arrangement to try out annuities. We areencouraged to learn that one providerhas gone to market with a product thatembeds an annuity in a life-cycle fund,similar to the concept outlined above.

SSoollvviinngg tthhee PPoorrttaabbiilliittyy PPrroobblleemmThe strategy outlined here raises anumber of important issues andconfronts several key challenges. Themost significant challenges are how to

—ensure reasonable portability of thelifetime income arrangement asemployees change jobs;

—ensure that the cost of the annuity orother lifetime income is reasonable,given market imperfections;

—manage the risk that the annuityprovider will become insolvent orotherwise go out of business duringthe many decades over which theindividual will be relying on the lifetimeincome promise; and

—protect plan sponsors from unduefiduciary risk, while protectingemployees from unduly risky lifetimeincome providers or arrangements.

We address the first of these issuesbelow because the portability problem isgenerally unique to the preretirementaccumulation strategy outlined here. Theother three issues are discussed in Gale-Iwry-John-Walker (2008), as they arealso raised by the post-retirement trialincome approach outlined there. Inaddition, using 401(k) plans as a vehiclein the manner described here raises avariety of regulatory and other issues,including unisex pricing of annuities andthe application of the survivor protectionand spousal consent requirements. 12

We intend to pursue these issues infuture work and hope others will do soas well.

The phased or incremental acquisition ofdeferred annuities presents a significantchallenge to pension “portability.”



Participants in a 401(k) who begin toaccumulate a deferred annuity and thenleave their job often have no opportunityto continue their 401(k) accumulation.The employee who takes a new jobwould be unable to add to the annuity-income units unless the new employeroffered a 401(k) plan that happened tooffer a comparable annuity accumulationopportunity with the same provider—nota high probability—and that was willingto accept a transfer or rollover of thepreviously accumulated units. If theaccumulated amounts were small, eitheror both the employee and the newemployer might question whether it wasworth the administrative burden to takethem as rollovers and whether expenseswould threaten to erode their value overtime. Some might argue that the portabilityconcern militates in favor of providingthat larger amounts of contributions bedefaulted toward incremental purchaseof annuity units. However, this wouldhelp only to the extent amounts hadaccumulated over a sufficient period,and it might well reduce participants’willingness to go along with the default.Before suggesting potential solutions, itis worth noting that the magnitude of theportability problem, while considerable,should not be overstated. First, incrementalaccumulation of lifetime income, asproposed here, generally would notbegin until middle age. By that point in aworker’s career, the typical frequency ofjob changes has declined significantly,especially for employees covered by a401(k) plan. 13 Second, the prospect ofreceiving lifetime income from severalproviders, as opposed to a single,consolidated source, is messy but not

impossible or necessarily ineffective.Retirees fortunate enough to have accruedbenefits under more than one definedbenefit plan may be in a similar situation.

Several approaches might mitigate thispotential lack of portability:

Top up or tap out. Beginning witharrangements that are currently in effect,some employees could “top up” adeferred annuity account by making anad hoc transfer of assets from other401(k) or IRA investments. Topping upmight be effective in some circumstances,but many workers will lack other resourcesthat would be available for this purpose.For those who have the resources, countingon them to top up would depart from the“behavioral” assumptions and strategyoutlined here by requiring employee initiativeto make what may be a difficult decision.

As a last resort, deferred annuityaccounts that are deemed unlikely togrow and too small to be worthannuitizing might be converted to otherinvestments. This approach may besimilar to accumulating funds in anaccount for future purchase of annuityunits only if and when the accountreaches a designated critical mass. Suchan approach might be viewed as givingthe employee a claim to purchase futureannuity income rather than actuallypurchasing the future income. However,it is unclear how much of a differencethere would be between a purchase witha surrender option and a claim with apurchase option. In either case, thefunds would need to be appropriatelyinvested in the meanwhile and, to give


the employee the benefit of interest-rateaveraging, steps would need to be takento lock in interest rates during the interimperiod. The degree to which a moretentative or contingent arrangement,short of the actual purchase of annuityunits, would be more efficient and worthdoing presumably would depend largelyon the transaction costs of surrenderingand liquidating the small annuity-incomeaccumulation. (This issue is somewhatanalogous to the question, discussed inGale-Iwry-John-Walker (2008), of whetherthe two-year trial income should constitutethe first 24 monthly payments of an annuitypurchased from an annuity provider andsubject to surrender after 24 months or isbetter structured as a 24-month installmentpaid directly by the 401(k) from theassets held in the individual’s account.)

IRA rollover. Another alternative that canbe pursued using arrangements currentlyin effect is to roll over the original deferredannuity to an IRA (in this case, an individualretirement annuity). The IRA would besponsored by the same annuity providerthat provided the 401(k) accumulationannuity and would offer a similar option toinvest in deferred annuity units. Individualscould then continue contributing to buildup their deferred annuity. Yet for manypeople the IRA contributions would“compete” with the opportunity to contributeto a new employer’s 401(k) plan. Theterms of that competition could beunfavorable to the IRA insofar as

—the employee’s 401(k) contributionstypically would be matched by theemployer up to a specified percentageof pay;

—the employee would be entitled to anexclusion from income or tax-favored Rothtreatment for contributions to the 401(k)but might not be eligible for a correspondingIRA deduction or Roth IRA treatmentfor contributions to the IRA; and

—absent the regular payroll deductionmechanism used in 401(k) plans, thecontributions to the IRA would beunlikely to begin or continueautomatically and therefore would beless likely to be made.

Greater standardization. Widespreadadoption of similar arrangements in401(k) plans could mitigate the portabilityproblem. However, this would likely beeffective only to the extent that annuityproviders were willing to facilitate like-kindexchanges of annuity products that allowedindividuals to transfer and consolidatedeferred annuities with a single annuityprovider in a manner analogous to rolloversto IRAs. This in turn would seem unlikelyto be efficient or to minimize transactioncosts unless providers offered sufficientlyhomogeneous products. Standardizationwould be in tension with competitiveinnovation and, to some degree, with theoffering of annuity features designed torespond to consumers’ desire for greaterflexibility and risk protection (such asdeath benefits, surrender options, inflationprotection, and the ability to share inpotential equity returns).

These obstacles might be addressedthrough a structured marketplace orplatform on which competing income-accumulation products could be offeredto plan sponsors. Products would be



permitted to compete on the platform oncondition that they met specificationsassuring uniform features, pricetransparency, and sufficient transferabilityamong products to achieve reasonableportability. At least one private firmoffers a somewhat similar arrangementto plan sponsors, which makes it easierto offer and compare annuities forretiring employees. Ultimately, providersmight be encouraged to participate inconsolidated, standard industrywideproducts that would not only facilitateportability but spread insolvency riskamong all participating providers. In viewof these features, such omnibusmultiprovider arrangements might qualifyfor some form of federal governmentreinsurance or guarantee that would bemore uniform and effective than existingstate guaranty funds (see Gale-Iwry-John-Walker (2008).

A multiprovider product that spreadinsolvency risk could also make plansponsors more willing to offer lifetimeincome options by significantly reducingthe fiduciary risk they otherwise facewhen choosing among annuity productsoffered by competing providers. Ifimplemented on a large scale, such anarrangement would increase manyfoldthe odds that an employee moving to anew employer could continueaccumulating deferred income units.

CCoonncclluussiioonnWith increased reliance on 401(k) plans,an important challenge facing the U.S.retirement system is how to help retireesmanage the risk of outliving their assets.In the past Americans frequently met this

problem using private pensions thatguaranteed a particular monthly benefitfor life. That approach shifted risk ontoemployers, many of which reacted byreplacing defined benefit pension planswith 401(k) plans, which define aparticular contribution, leaving it to theworkers to invest that money well and tofigure out how to use it to see themthrough their retirement years.

Each of the “automatic” or default strategiesoutlined here—including acquiring lifetimeincome incrementally through the use ofemployer contributions or embedding adeferred annuity in a QDIA, as well asthe Gale-Iwry-John-Walker (2008)automatic trial income proposal —isdesigned to draw on experience andinsights from behavioral economics tohelp replicate, within the 401(k), one ofthe valued features of the traditionaldefined benefit pension. That feature isguaranteed lifetime income at grouprates (combined, in most cases, withprofessional investment management).

We do not hold the view that annuitizationof 401(k) balances is necessarilyappropriate for all 401(k) participants. Wedo believe, however, that biases andother obstacles to lifetime and otherlong-term income options are responsiblefor the low annuitization rate. This policybrief presents a strategy for reducingthose obstacles and thereby improvingretirement security. Further work isneeded to resolve a number ofsignificant issues relating to cost,solvency protection, portability, employerfiduciary responsibility, and otherimplementation questions.

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1. Brigitte C. Madrian and Dennis F. Shea,“The Power of Suggestion: Inertia in 401(k)Participation and Savings Behavior,”Quarterly Journal of Economics 116, no. 4(2001), pp. 1149–87; William G. Gale andothers, “Improving 401(k) InvestmentPerformance,” Issue Brief 2004-26 (BostonCollege, Center for Retirement Research,2004); William G. Gale and J. Mark Iwry,“Automatic Investment: Improving 401(k)Portfolio Investment Choices,” Policy Brief2005-4 (Washington: Retirement SecurityProject, 2005).2. A related goal would be to encourageportability through rollovers. This relatedtopic is addressed by J. Mark Iwry andDavid C. John in, “Pursuing UniversalRetirement Security Through AutomaticIRAs,” Policy Brief 2007 – 2 (Washington:Retirement Security Project, 2007). 3 Gale, William G.; Iwry, J. Mark; John,David C. and Walker, Lina. “IncreasingAnnuitization in 401(k) Plans with AutomaticTrial Income.” The Hamilton Project,Discussion Paper 2008-02, June 2008.4. Ideally, employees who change employersbetween age 45 or 50 and retirementwould continue their gradual acquisition ofannuity-income units, but they generallywould find it more cumbersome to do so.5. A thoughtful experiment by Jeffrey Klingand others, “Why Don’t People ChooseAnnuities: A Framing Explanation,”Research Brief (Washington: RetirementSecurity Project, March 2008), providessome evidence that consumers mightrespond positively to framing annuitybenefits as a consumption stream ratherthan as an investment. The reframing wepropose, especially by embedding theannuity purchase in the life-cycle orbalanced default fund (QDIA), presents theannuity both as a secure and convenientincome stream and as an attractive

investment. There is no need to run awayfrom the investment dimension of adeferred annuity that is assigned its“rightful” place in an asset-allocatedportfolio (whether self-constructed or abalanced or life-cycle fund). We believe thatthe deferred annuity that makes up only aportion—potentially the fixed incomeportion—of a diversified portfolio can beeffectively presented as such to consumerswhile also touting its advantages as asecure and predictable income stream afterretirement. In addition, framing a deferredannuity as a default incremental purchaseopportunity applicable to a portion ofcurrent 401(k) contributions shouldincrease the likelihood of acceptance byplan participants. We would welcomefurther experimentation by Kling andothers, building on the excellent work theyhave done thus far, to test this hypothesis. 6. This approach has similarities to someplans offered through TIAA-CREF (TeachersInsurance and Annuity Association, CollegeRetirement Equities Fund), an insurancecompany which is a major retirementprovider for academics and teachers. In theTIAA plans, workers generally incrementallypurchase units of annuities while they areworking, rather than making a singleannuity purchase at retirement.7. By the same token, the lengthy deferralperiod may require protection againstinflation (at least unless the deferredannuity is a variable annuity, investedlargely in equities, which entails greaterrisk). The deferred aspect of an annuitypurchased gradually with contributionsresembles the deferred annuity sometimesknown as longevity insurance, which maybe purchased at retirement but does notbegin payment until an advanced age,such as 85.



8. As a broad generalization, we believe that401(k) participants on average would bebetter served by less employer stock andmore lifetime income.9. Economic analysis suggests that, in thelong run, most employer contributions andbenefits can be expected to come out ofthe overall employee compensationpackage, and thus most of the cost mightultimately be borne by employees. Theextent and timing of this shift, however,depend on the company’s specificcircumstances, including the dynamics ofthe labor market. Labor and managementtend to take it for granted that, at least inthe short run, there is an importantdifference between “employee” and“employer” contributions in manysituations.10. For more on the risks of excessiveconcentration in employer stock, see J.Mark Iwry, “Promoting 401(k) Security,” TaxPolicy Issues and Options 7 (Washington:Urban-Brookings Tax Policy Center,September 2003); Gale and others,“Improving 401(k) InvestmentPerformance”; and Gale and Iwry,“Automatic Investment: Improving 401(k)Portfolio Investment Choices.” 11. Katie Benner, “Life-Cycle Funds Not aRetirement Cure-All,” TheStreet.Com, Sept.4, 2006, notes that most of the clients of T.Rowe Price that use automatic enrollmentuse life-cycle funds as the defaultinvestment. 12. Regulatory issues are described in twovery thoughtful papers by Robert Toth:“Distributing Annuities from DefinedContribution Plans: The Qualified PlanDistributed Annuity,” CCH Pension PlanGuide, Benefit Practice Portfolios(Riverwoods, Ill.: CCH Incorporated, June2008); and “Annuitizing from 401(a) DefinedContribution Plans: A Technical Overview”ERISA Compliance and Enforcement

Strategy Guide (Washington: Bureau ofNational Affairs, July, 2008).13. Alan L. Gustman and Thomas L.Steinmeier, Pension Incentives and JobMobility (Kalamazoo, MI: Upjohn Institute,1995).


JJ.. MMaarrkk IIwwrryy completed this paperduring his time as Principal to theRetirement Security Project. He iscurrently Senior Advisor to theSecretary and Deputy AssistantTreasury Secretary for Retirementand Health Policy, United StatesTreasury Department.

JJoohhnn AA.. TTuurrnneerr is Director of thePension Policy Center. He has aPhD in Economics from theUniversity of Chicago.

Acknowledgements: The authors would like tothank Bill Gale, David John,and Lina Walker for helpfuldiscussions and commentsat various stages of the paper.

The opinions expressed inthis report are those of theauthors and do not necessarilyreflect the views of the PewCharitable Trusts, theRockerfeller Foundation,the Brookings Institution, orany other institutions withwhich the authors and theRetirement Security Projectare affiliated.

Copyright © 2009.


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