Research Examines Retirement Risk, Role of Annuities

A new research brief finds that pension plans have effectively managed key retirement security risks and that shifting to annuities would be a more expensive approach.

Public Pensions Manage Risks with Varied and Effective Strategies

Annuities Provide Lifelong Income to Retirees But Transferring Longevity Risk to Insurance Companies Has High Cost with Fewer Consumer Protections

WASHINGTON, D.C., September 1, 2015 – A new research brief finds that most public defined benefit (DB) pension plans have effectively managed key retirement security risks – investment, adequacy, longevity and inflation risks. 

The research also finds that a shift to funding retirement benefits from public pensions to fixed annuities would be a more expensive approach – with 57 to 175 percent higher costs. The public workforce also could face diminished consumer protections if their benefits were provided as annuities.

These findings are explained in a new Issue Brief from the National Institute on Retirement Security, Retirement Security Risks: What Role Can Annuities Play in Reducing Security Risks in Public Pension Plans? is available here.

“This research is particularly important as policymakers closely examine risks and the most cost-effective ways to provide retirement benefits for the public workforce,” said Diane Oakley, NIRS executive director. 

“For states interested in limiting their retirement costs for the public workforce, the research makes it clear that turning to annuities likely will increase costs,” Oakley explained.

During the last decade, managing investment risk has posed challenges while life expectancies have also increased. Yet, the research indicates that most public DB pension have successfully managed investment, adequacy, longevity and inflation risks appropriately as described below:

• Investment Risk: Public pension plans have demonstrated their ability to invest retirement assets and achieve target returns over their long time horizons. Pensions take advantage of the risk premium generated by equity investments in their diversified fund portfolios over time.
• Adequacy Risk: The fundamental principle underlying the appropriate and sustainable funding of retirement benefits is ensuring that sponsors pay the actuarial determined contribution (ADC). While a few states have failed to adequately pay their ADC, most states have paid 95 percent or more of the ADC.
• Longevity Risk: DB pensions protect retirees from out living their savings even thought retirees are living longer. Advised by professional actuaries, public pensions appear to anticipate changes in mortality experience successfully.
• Inflation Risk: Over time, the purchasing power of a fixed income stream diminishes even at low rates of inflation. Cost of living adjustments (COLAs) protect the purchasing power of retirees. State retirement systems manage inflation risk with limits on COLAs and using investment strategies designed to produce real rates of return.

In the private sector, fewer DB pensions are available to employees, and the trend has been to switch to defined contribution (DC) accounts. 

This shift places more responsibility and risks on individuals. As such, there has been an increased focused on the role of annuities in the retirement security equation. 

Annuities are products offered by insurance companies whereby an individual or a retirement plan pays money up front to the insurance company. The insurance company makes regular payments to retirees for the remainder of their lives or for a set number of years.

In the public sector, DB pensions remain the predominant retirement plan to help to attract and retain employees while enabling employees to retire with a monthly income. 

The research brief finds that if DB pension benefits were paid as fixed annuities, this approach would be more costly, and the public workforce also would face diminished consumer protections. 

With regard to annuities, this NIRS Issue Brief finds that:

• Annuities cost more than current DB pension benefits. Because fixed annuity products deliver investment returns related to bond investments, it costs more to generate a given level of monthly income from fixed annuities than from DB pensions. Depending the pricing of the annuity, the cost of using fixed income annuities to fund DB pension benefits can be anywhere from 57 percent to over 175 percent more than the cost under a public pension’s diversified portfolio.
• Annuities do not provide the same consumer protections as public pension benefits. Public pension benefits are protected by state constitutions, state laws, court decisions on contract law, and collective bargaining agreements, depending on the state. Annuities are protected by the financial strength of the insurance company, which is monitored by the state regulators, and are backed up by state guaranty funds.
• Longevity annuities focus on the insurance value and are less expensive than fixed income annuities. By starting annuity income payments at a much older age, individuals can capture most of the insurance value of immediate annuities, but at a fraction of the cost by using longevity annuities. Further analysis with actual participant data, would be needed to help public plans consider if longevity annuities would be a helpful tool for plans considering ways to manage longevity risk. 

The National Institute on Retirement Security is a non-profit, non-partisan organization established to contribute to informed policymaking by fostering a deep understanding of the value of retirement security to employees, employers, and the economy as a whole. 

Located in Washington, D.C., NIRS’ diverse membership includes financial services firms, employee benefit plans, trade associations, and other retirement service providers. More information is available at www.nirsonline.com . Follow NIRS on Twitter @nirsonline.