Just before Easter, and (ahem) while some of us were travelling, the Brookings Institute hosted a panel on the topic, “Can retirement plans provide safe income?” for which the video and transcript are both available. The sessions featured economist Richard Thaler, known for his concept of the “nudge” and behavior economics, for which he was awarded the Nobel Memorial Prize in Economics in 2017, so he gets attention when he makes proposals, as was the case here, when he suggested that Social Security have a “buy-in option.” Thaler said:
What I’m proposing is that people would be allowed to take a portion of their 401(k) benefits when they retire and send it to the SSA, up to some cap, say, 250,000 — 100,000 actually would do a lot that’s more than something like two-thirds of the current account balances in 401(k) plans, so 100,000 would do a fair amount of good.
Now what would this get you? It would get you the only indexed annuity — so price adjusted — that’s guaranteed by the Federal Government. It would get you that at fair actuarial value. No one in the private sector is prepared to do either of those things, or as far as I know there are no indexed annuities, and certainly none guaranteed by the government.
Thaler rejected the prospect of the private sector offering annuities on a large scale, because they wouldn’t be able to handle a “major change to longevity” and because consumers would then be at the mercy of ” the fly by night insurance company in Mississippi” (a characterization I suspect that mainstream highly-rated insurance companies would take issue with).
As it happens, the bulk of this panel was much more technical and focused on topics such as tontines, retirement account spend-down, annuity purchases from 401(k) accounts, and so forth, rather than a detailed presentation of the specifics, but it’s not the first time that someone’s proposed expanding the role of Social Security in this way.
Forbes Contributor Teresa Ghilarducci herself criticizes Thaler’s proposal for lacking sufficient nudges to encourage low-earners and for benefitting the high earners who are disproportionately likely to be interested in annuities and who simultaneously have higher life expectancy than the poor, at the expense of Social Security finances. But given the sparse details in Thaler’s proposal, the fact that he’s made a career out of more-or-less inventing behavioral economics, and that he specifically said in the panel discuss that his concern is with those who have relatively small retirement account balances, these criticisms aren’t particularly useful. One imagines that, were he to flesh this out, he would include significant design elements to reach exactly his target moderate-savings annuitizers.
What’s more, while it’s true that higher income folk generally have longer life expectancy, there is a remedy which is at least conceptually a decent solution to the problem, even if despite all such nudges and defaults, it is those who are most well off who are most keen on annuitizing. The Social Security Administration has a record of individual earnings over one’s lifetime. The IRS has the same record for household income. If you pair these with existing data on longevity, it’s possible to give lower-income folk an actuarially-appropriate annuity bonus that’s in line with their statistically-lower life expectancy. Problem solved!
In any case, Thaler himself addresses that concern:
I’m not as worried about the adverse selection problem at this stage, and remember, my proposal is that people be able to contribute a relatively small amount of money into Social Security, for most people, since most people start claiming at 62, it would be equivalent to them having waited until they’re 70, which they are already illegally [sic] allowed to do.
Remember, this is a transcript of his off-the-cuff comments but at the core of what he’s saying, if I understood correctly, is that we already use a one-size-fits-all adjustment factor to give people an increase in their Social Security benefit if they wait until age 70 to retire, and the magnitude of his new proposal is not any different, so we shouldn’t overthink it and discard what would otherwise be a useful program because of it.
(As it happens, a bit over a year ago I suggested going even further and allowing workers to defer Social Security benefits to age 75, to boost benefits further, though I acknowledged that adverse selection would be an issue — again, varying age adjustment factors by income, to reflect the correlation between lifetime earnings and life expectancy, would help remedy this.)
But the problem isn’t adverse selection, and it isn’t whether or not we could effectively nudge low-earners into the system. The fundamental problem is that of calling on the federal government to become an annuity provider.
Thaler labels existing insurance companies as “fly by night” but insurers follow a tight set of regulations and professional practices to stay in business, and annuities are protected by FDIC-like government backstops. They build significant expectations of future life expectancy improvements into their pricing calculations, and are very careful with the risks they take with their investments. In addition, they hedge their business by simultaneously providing life insurance — if longevity increases more than expected, they pay out more than projected in annuities, but less in life insurance claims.
But life expectancy isn’t the only variable — the other key variable is the future returns on assets. Annuity providers try to protect themselves with fixed income investments. Investors who don’t like the low returns that generate might choose variable annuities instead, with higher return and higher risk. Other proposals for future types of retirement income provisions look to places such as the Netherlands with their “Collective Defined Contribution” and industrywide pension plans, which, as a trade-off for allowing return-seeking investments, are very strict in requiring benefit cuts if they fall below a very strict full-funding requirement.
But in the United States?
In the United States, we have the sad story of multi-employer plans, which have been so hampered over the years by faulty federal legislation that the multi-employer PBGC federal guaranty fund is forecast to become insolvent in 2025. What’s more, even absent the crisis in the PBGC fund, the Central States (Teamsters) plan and a sizeable number of other plans face insolvency, or have already become insolvent, and the fund replaces only a fraction of retirees’ pension payments.
And in Illinois in particular, we have the College Illinois prepaid tuition program. The Capital Fax website summarizes the state of the situation as of late April, with a series of links/quotes. The program, which promised parents that their tuition would be covered in full in return for their lump sum payment, significantly underestimated tuition growth and overestimated asset returns, so much so that the state is now looking at a $500 million bailout of the program.
So bearing that in mind, how, concretely, would the federal government actually run a program of providing annuities? Would they convert lump sums into monthly benefits based on the low rates of a TIPS treasury security? Would Congress demand that the Social Security Administration smooth the rates with an assumption that rates will rise again in the future? Will the SSA act as a true annuity provider and invest the money in the market, and, if so, will they use the same sort of conservative investments of a private-sector annuity provider, or will Congress (or federal bureaucrats) believe that unfairly deprives recipients of money they deserve and set return expectations at some sort of long-term stock market average? Or, in a sort of worse-case scenario, will the money be directed into the Social Security Trust Fund but nonetheless be used to provide annuities with generous (to the recipient) annuity conversion factors? Thaler simply said that the government would provide a “fair actuarial value” but that’s not something with a single universal definition – it’s a matter of defining who bears the risk and at what cost.
This is not an easy issue to solve, but it’s all the harder to do so in a government program. (Ghilarducci uses this proposal as a means to tout her alternative proposal for “catch-up contributions” which, per my review of the concept a year ago, has its own problems with actuarial soundness.)
To this actuary, it makes far more sense to focus government programs on meeting the basic needs of retirement-age folk. In this way, if there is a dramatic, wholly unforeseen extension of life expectancy, which will have all manner of effects on the economy and social welfare program spending, the federal government can balance spending needs for old and young, rather than being locked into promises made that unexpectedly require unsustainable levels of spending.
And as an alternative to a government-run annuity program, existing proposals for a U.S. version of the Dutch industry funds/collective DC plans, in which designers attempt to balance benefit stability with adequate responsiveness to funding levels, by building in provisions to reduce benefits if needed, are overdue for moving beyond the drawing board and into legislation and, eventually, implementation. If such programs were made widely available, this would achieve Thaler’s goals without placing the government in the position of making promises it can’t (or might not be able to) keep.
As always, you’re invited to share your thoughts at JaneTheActuary.com!