For most of us, retirement planning is a mystery and retirement confidence is elusive. Retirement income comes in many forms, and the landscape has shifted. While Social Security provides only a base-level income, employer-provided pensions are much less common than they were a generation ago. Income from retirement savings through a 401(k), IRA, or other account-based retirement plan is critical but brings uncertainty. Furthermore, these account-based plans rely on voluntary contributions by employees and 15% of Americans have no retirement savings at all. For those who have saved for retirement, purchasing an annuity can provide some security, but most are discouraged by high costs due to low interest rates and fees that are loaded for profit and risk.

There are fundamental elements to improving retirement outcomes and retirement security. Most important is the availability of a retirement vehicle. Only about half of Americans working in the private sector have access to an employer-sponsored retirement plan. It is also critical that participants take advantage of the available plans.

In addition to access and participation, the structure of the retirement vehicle matters, both in terms of cost and benefit security. That is our focus here.

The best structures include two key features:

1. Longevity pooling to provide lifetime income
2. Variable benefit payments to provide investment and spending flexibility in retirement

Common structures and the big risks

While retirees face several financial risks in retirement, two stand out:

• Longevity risk: The risk of outliving their savings.
• Investment risk: The impact of investment losses on retirement savings, particularly large losses in an economic downturn.

There are essentially two retirement vehicles available:

• Annuities: Lifetime payments provided through employer pensions or insurance contracts.
• Account-based structures: Personal accounts provided through employer defined contribution (DC) plans or individual savings.

While each of these vehicles offer some advantages, neither is an ideal solution for addressing the two risks.

An efficient retirement vehicle should provide payments over the life of a retiree and their spouse, without the need for significant additional funds. The structure should facilitate investment options that support retirement income without excessive risk or unnecessary conservatism. As we discuss below, typical annuities and account-based structures don’t measure up to this ideal and it will take change to bring us closer.

Pensions and annuities

In many ways, lifetime pensions or annuities appear to be the ideal solution. Indeed, they provide lifetime income and limit investment risk for the retiree. When a retiree purchases an annuity, they effectively pay the insurer to assume the longevity and investment risks. This comes at a steep price, which is further exacerbated by high sales costs embedded in annuities. Experience shows that retirees balk at the cost, and don’t like investing in a vehicle where they don’t have access to their money, which is the case with an annuity contract.

Additionally, the purchasing power of a level annuity erodes over time due to inflation. Variable annuities and cost-of-living adjustments within a pension plan are sometimes used to protect retirees from this risk.

Like an annuity, an employer-provided pension also provides a lifetime benefit. Like annuities, the lack of control for retirees can be a concern. More importantly, employers have moved away from pensions to minimize their risk exposure.

Managing investment risk

The investment risk required to support guaranteed benefits is a huge burden for the benefit provider, whether an insurer or an employer. Managing this risk requires some combination of the following:

1. Targeting excess funding to provide sufficient cushion for periods of investment decline
2. Focusing investments on instruments to match assets with projected payments to limit volatility
3. Using future funding to offset periods of investment decline

For insurers, option 3 is difficult to manage. Typically, the design of the product does not allow for future funding to come from policyholders. They are required to maintain sufficient capital and reserves for option 1, but they must effectively focus on option 2 to limit their capital requirements. The result is a focus on fixed income investment vehicles. Historically, this has not been ideal - the inability to include higher-returning asset classes (e.g., equities) results in high costs relative to benefits. In the current world of very low interest rates, this dynamic is amplified. Insurers also need to make a profit. The need for capital requirements and a profit margin, coupled with low return investments, results in high annuity prices—prices that are not attractive for most retirees.

Employers have a related set of challenges in providing guaranteed pension benefits. Historically, most employers invested pension assets in balanced and diversified portfolios with significant equity components. Applying option 1 above, accumulated excess assets in good years could provide a cushion for downturns. Over time, as plans matured, this became more challenging. Owners and shareholders reasonably questioned the effective use of resources and the volatility of accounting results when pension assets and liabilities became comparable in value to the organization itself. The ability to preserve excess returns in good years was often met with calls to use the surplus to increase benefits. Even more concerning, the ability to offset losses through higher employer contributions—effectively option 3 above—also becomes more challenging for a large and mature pension plan. The magnitude and volatility of the required contributions has become untenable, particularly after periods of prolonged investment downturns.

The result has been a steady decline in employer-provided pensions. Chief financial officers (CFOs) and shareholders have concluded that the volatility is unacceptable, and most employers have taken steps to exit the pension business. Those that remain often apply option 2 above and align assets with liabilities. This addresses the volatility concern, but again it comes with a high price. With the interest rates available today, investments focused exclusively on fixed income are not efficient, and the cost to the sponsoring employer, while stable, is also high.

Managing longevity risk

Unlike investment risk, insurers and employers are well positioned to manage longevity risk. In a diverse group of retirees, longevity risk can be effectively pooled. Some retirees will have long lifetimes, and some will not—in the end, it evens out. In general, the risk of varying lifetimes at the individual level can be diversified away with a group of some size, whether a block of annuities or a pension plan of sufficient size.

Some risk margins remain related to broad increases in the longevity of a population over time, but they are small relative to investment risk and can be incorporated into funding assumptions. In a group of sufficient size, the magnitude of mortality gains or losses in a given year is unlikely to approach 1%.

Account-based structures

Funding a retirement through individual accounts flips the risk profile entirely. Instead of risks being pooled under an insurance contract or pension plan, the retiree alone bears the full risk of both investment volatility and their individual longevity uncertainty.

If the account resides in an employer-provided defined contribution plan, (e.g., a 401(k) plan), the employer provides a fixed contribution benefit without volatility—an attractive structure for a CFO faced with many other uncertain commitments. If the account resides in an IRA or similar account, the entity holding the account bears no uncertainty at all—they simply hold the money and collect investment fees.

For individuals managing their accounts, the longevity risk is a real challenge. At age 65, a retiree understands that they might live only five more years, but they could also live another 30 years. Given this uncertainty, they must plan for the latter or risk outliving their assets. Any financial benefit of a shorter lifetime accrues to their heirs. This may be a positive financial outcome for the heirs but is an inefficient way to deliver a retirement benefit.

Individuals managing their accounts also bear the full risk of investment volatility. In many ways, this is like the risks for providers of annuity benefits. Asset diversification reduces investment risk but does not eliminate it. There have been improvements to address investment risk, such as target date funds. However, broad market declines still have an impact. Many retirees and plan managers still bear the scars of 2008. Furthermore, many individuals lack the investment experience to effectively manage their accounts—they invest reactively. Emotions drive decisions, often leading to reactive steps to move in or out of equity investments at the wrong time.

On the other hand, managing investment risk within an individual account has one critical advantage over pensions and annuities. That advantage is flexibility in payment amounts, because there are no requirements to withdraw or pay a guaranteed amount every year (other than Required Minimum Distributions for older retirees). While this brings some variability to the retiree’s income, it provides the advantage of investment flexibility. Most retirees can invest a bit more aggressively than insurers and pension plan sponsors, knowing they have some flexibility to bank investment gains and offset investment loss through reductions in their withdrawals. Over time, this less conservative investing strategy is likely to be more efficient, translating to higher returns and more bang for the buck for these retirees.

Retirees may also anticipate lower needs over the course of their retirement years. This view is supported by research on retiree spending habits and lower spending on leisure and travel at older ages. Retirees may incorporate this expectation into their retirement investment strategy. They may invest with more confidence in a diversified portfolio with the recognition that they can absorb downside volatility with lower income needs in later years, particularly with Social Security providing a base income that increases with inflation over time.

Better structures

To provide more efficiency in delivering retirement benefits, we need a fresh look at retirement vehicle options. The overview above illustrates two central points that drive better outcomes with similar costs:

1. Longevity risks should be pooled
2. Benefit payments should incorporate some level of flexibility

Pooling longevity risks

Longevity risk can be effectively pooled with a group of reasonable size. This should not be left to an individual. Put simply, most individuals will not live to 100—so there is no reason that we should all plan as if we will. This pooling occurs in pension plans and insurance annuities. With modifications and new ideas, we can bring longevity pooling into individual accounts as well, lowering retiree anxiety and providing confidence to retirees to spend what they have saved for their retirement years.

Benefit flexibility

Benefit guarantees are appealing, but they come with a steep price. Guarantees limit investment options for the annuity provider, driving up the cost of an insurance annuity purchase. For employers, defined benefit pensions with no flexibility mean the employer must effectively choose between stable but high costs driven by investments in low-yielding fixed income, or costs with unacceptable variability driven by variable investment returns.

Retirees are more resilient than we believe. Mild benefit reductions, while certainly not ideal, can be absorbed. According to the U.S. Bureau of Labor Statistics, retirement spending often remains level or even declines with age.¹ As we previously discussed, allowing for some flexibility during periods of declining spending facilitates more investment options.

Delivering these structures

We have options now to deliver on these better structures. Given the deep feeling of unease, these options need more visibility. Regulatory change can further expand on them.

Let’s look at some of these current and potential options.

Variable annuity pension plans (VAPPs)

While employer pension plans have traditionally been structured to provide guaranteed benefits, variable plans are an option. In fact, these variable annuity pension plans, or VAPPs, are gaining in popularity among Taft-Hartley multiemployer plans (sponsored by unions and employers). The plans provide lifetime income for members while minimizing risks to the employers that contribute to the plan for their employees.

VAPPs already exist in several forms (Milliman has its own version called the Sustainable Income Plan (SIP)). They are pension plans designed to increase benefits (or decrease them, in some cases) according to the plan’s rate of investment return. Under a VAPP, the plan’s rate of return is compared with a “hurdle rate” (generally between 3% and 5%). If returns exceed the hurdle rate, benefits will increase; if they don’t, benefits go down. SIPs are designed to permit a plan’s surplus derived from good investment returns to fund benefits during lean years in order to avoid benefit decreases. Using the plan’s rate of return means that there is low risk of underfunding the plan and that employer contributions are more predictable. Because VAPPs provide lifetime income, retirees cannot outlive their benefits.

By design, these plans offer employers insulation from the investment risk faced by many pension plans. However, despite this design, these plans still are subject to high Pension Benefit Guaranty Corporation (PBGC) premiums, which may turn some employers away. These premiums are paid to ensure participants still receive a pension even if the plan sponsor goes insolvent.

VAPP activity in the single-employer space is currently moving slowly among plan sponsors. This may change over time as this plan design is better understood. Employers looking for a retention edge can promote a lifetime retirement benefit without taking on the investment risk associated with the typical defined benefit plan.

Pooled employer (multiple employer) pension plans

The Setting Every Community Up for Retirement Enhancement (SECURE) Act created pooled employer plans (PEPs), which allow unrelated small businesses to band together under one retirement plan, creating economies of scale and adding a provision protecting participating employers from the compliance failures of another.

The SECURE Act provides this opportunity for defined contribution plans, but a similar structure is needed for defined benefit pension plans. In combination with a VAPP or SIP structure outlined above, this would allow smaller employers to provide pension benefits to employees without the administrative complexity of sponsoring the plan or the funding risk of a defined benefit plan. This is essentially the structure that is gaining traction among many multiemployer plans. Its potential appeal is not limited to those groups and access should be broader.

Variable insurance annuities

Insurance companies currently offer variable annuities, which can provide lifetime income. The payment amount may vary based on the investment return, but there is a predefined guaranteed minimum level. This structure provides investment flexibility and ultimately higher income over the course of a retiree’s lifetime. Variable annuities have been a meaningful part of the retirement solution landscape, holding over $2 trillion of Americans’ retirement assets. In recent years, though, variable annuity sales have declined for a number of reasons, including: (1) insurers struggling to manage the balance sheet risk resulting from these products; (2) increasing regulatory reserve and capital requirements; and (3) increasing regulatory scrutiny around sales practices and processes. In addition, the high sales costs and adviser-driven sales processes associated with variable annuities can preclude their use for middle market customers.

Annuities within individual account plans

The SECURE Act provided a gateway to getting annuities into 401(k) and other defined contribution plans, but fewer than 10% of plan sponsors currently offer annuity options. The addition of annuity options would bring peace of mind to the large percentage of people who are concerned about outliving their savings. The option to elect an annuity for a portion of a retiree’s account may gain more popularity, especially when interest rates are higher. This allows the retiree to gain some certainty on lifetime benefits, while retaining investment flexibility. It also allows assets remaining after death to pass to heirs. Options for annuities with a period certain may reduce concerns about the complete loss of value if the retiree died shortly after the annuity commenced.

Deferred annuities within individual account plans

The purchase of a deferred annuity provides much of the lifetime income protection at a much lower cost. As an example, offering a deferred annuity option would allow someone retiring at age 60 to use some of their savings to buy a lifetime annuity beginning at age 85 and budget the rest of their savings to support their retirement for 25 years. Availability and effective communication of this option should drive the demand from individuals and the supply from insurers. This can be an effective and efficient use of insurance to address longevity risk, especially when interest rates are higher.

Longevity plans

Similar to the deferred annuity described above, a longevity plan is a defined benefit pension plan designed to provide a lifetime income beginning at a later age, like age 85. Payouts would occur over a much shorter period of time than under a traditional defined benefit plan, translating into a lower cost for employers. Retirees would have the assurance of lifetime income in their older years and would only need to budget their defined contribution account to last for a specified period.

Individual accounts with a longevity pooling component

A group of sufficient size could effectively add a pooling concept to mitigate longevity risk. Under this structure, upon death some or all of an individual’s account is allocated to a fund to provide longevity protection for the remaining participants. This works like an insurance plan, while avoiding annuity contract purchase fees.

This is effectively a tontine structure. A tontine is a pooled fund that pays benefits to its participants. As participants die, the remaining funds are reallocated to the remaining participants. Tontines can be modified to include payments to a surviving beneficiary and are easy to administer. Once popular in the United States, the tontine provided inexpensive and meaningful protection against longevity risk. They were phased out because lack of regulation led to corruption, but the concept is regaining interest as a source of longevity protection.

Combined benefit structures

It’s likely that the solution to the retirement crisis will come from a combination of different ideas, possibly from some of those listed above. What’s clear is that the investment and longevity risks are not being addressed by the structure of the predominantly used retirement vehicles.

Important legal and regulatory changes are needed

In order to give employers and retirees the flexibility they need to address these risks, legal requirements and regulations should be updated to:

• Eliminate PBGC guarantee and premiums for VAPPs VAPPs are specifically designed to be fully funded. Therefore, there is no need for PBGC insurance coverage.
• Provide flexibility for deferred annuities within account balance plans Participants should be able to allocate a portion of their accounts to insure against outliving their savings in the distant future.
• Provide easy options for pooled employer (multiple employer) pension plans Pooling pension funds would help smaller employers provide the security of a defined benefit pension plan to their employees without as much risk or administrative burden.
• Facilitate structures to allow longevity pooling within individual account plans Pooled retirement accounts would allow defined contribution plans to provide annuities without individual longevity risks.

This white paper was written as part of GUTSI—the Ground-Up Think Tank for Social Impact—an employee-led initiative that draws on Milliman’s entrepreneurial culture to find innovative solutions to global challenges.

¹Foster, A.C. (March 2016). Beyond the Numbers: A closer look at spending patterns of older Americans. U.S. Bureau of Labor Statistics. Retrieved January 7, 2022, from https://www.bls.gov/opub/btn/volume-5/spending-patterns-of-older-americans.htm.