Recent research released by Morningstar addresses the potential benefits of annuities in defined contribution (DC) retirement plans. This is a much-needed analysis at an important time when many employers and/or advisors are considering whether to add an annuity to a DC plan.
The authors primarily judge the benefit of annuities using a failure rate method, which measures the probability of running out of savings. Failure rate analyses are an imperfect measure not commonly used by economists to estimate optimal retirement income strategies.
The Morningstar report provides an excellent overview of retirement income planning options, and we wholeheartedly agree with the conclusions that more Americans should bridge spending to delay claiming Social Security.
We agree with many of the broad conclusions of the report, but question the analytic findings that compare the value of annuities to investments for most retirees — especially mass affluent investors for whom Social Security cannot come close to replacing their pre-retirement lifestyle. The report concludes that annuities "do not add much value when a participant is already well-prepared for retirement."
These findings are not consistent with our own analyses, nor do they reflect findings from the existing economic literature on optimal annuitization.
One of the most widely cited articles in this literature, "Annuities and Individual Welfare" (co-authored by Nobel laureate Peter Diamond) finds that partial annuity strategies are optimal and the failure to annuitize is likely driven by "psychological or behavioral biases."
Another Nobel laureate, Richard Thaler, described the low rates of annuitization among American retirees as the "annuity puzzle."
The consensus among economists is that retirees would be better off with more annuitized income.
The Consequences of Failure
Failure rates merely show the probability of running out of money while ignoring the consequences.
