Blogging Employee Benefits

October 25, 2006

Working on Solving the Annuity Puzzle

Filed under: Distributions — Fuguerre @ 7:04 am

As traditional pensions go through a sea change of global freezing from defined benefit pension plans to individual account defined contribution plans, three main issues have required attention: (1) participation rates of employees in defined contribution plans, which typically have been more voluntary in nature than their defined benefit predecessors; (2) investment risk on retirement savings, shifted to employees during their working life; and (3) mortality risk during former employees’ retirement years, the danger that individuals and their spouses will outlive their defined contribution plan accounts.

We’ve seen the first two of those issues addressed by Congress in recent years, most recently in the Pension Protection Act of 2006, which included measures aimed at facilitating automatic enrollment and enhancing participant investment education, among other provisions reflecting the DB-to-DC transmogrification. But as yet, the annuity puzzle – how to encourage the converse of lump sum distributions from a DB plan – exists only in the form of white papers and preliminary legislative proposals.

An excellent summary of the annuitization issues is presented in Lifetime Annuities for US: Evaluating the Efficacy of Policy Interventions in Life Annuity Markets, written by William M. Gentry and Casey G. Rothschild for the American Council of Capital Formation. The paper focuses on the potential value of two different porposed tax incentives designed to encourage voluntary annuitization of retirement savings: one, exclusion of a portion of annuity income from taxable income; and two, refundable tax credits for life annuity income. Although empirical analysis is nonexistent regarding annuitization response to tax incentives, the study’s benchmark results suggest substantial potential effect of the amount of voluntary annuitization in the U.S. economy.

Side note: Although this paper did not touch on the truly diabolical annuity puzzle that will be presented if the Social Security system is ever even partially privatized, let’s put that cousin of this paper’s annuity puzzle off to the side of our desk. Annuities serving Social Security privatization would likely be under a protected market, even if commercial annuities are involved, thus would involve far more mind-bending math formulas than this paper already has.

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