Putting the Pension Back in 401(k) Plans: Optimal Versus Default Longevity Income Annuities
Many defined contribution plans pay benefits as a lump sum, putting retirees’ lifetime income security at risk. Longevity income annuities address this concern.
Longevity income annuities (LIAs), whose payouts begin no later than age 85 and continue for life, provide an effective way to hedge longevity risk for a relatively low price. The authors of this paper build a life cycle portfolio framework for evaluating the welfare improvements of including LIAs in defined contribution retirement plans. Their model accounts for uncertain capital market returns, labor income streams, mortality, taxes, Social Security benefits, and 401(k) plan rules.
The researchers use dynamic stochastic programming to determine ways to maximize individuals' consumption and welfare in retirement. Based on five variables – wealth, total value of fund accounts, LIA payments, permanent income and time – they gauge how a college-educated female optimizes her financial outcomes in retirement with and without an LIA. They also expand their model to gauge consumption and welfare gains under several alternative scenarios.