A new paper published by the National Bureau of Economic Research investigates retirees' optimal purchases of fixed and variable longevity income annuities using their defined contribution plan assets and given their expected Social Security benefits.
The underlying analysis was put together by a trio of authors including Vanya Horneff and Raimond Maurer of the Goethe University Frankfurt, and Olivia Mitchell of the University of Pennsylvania.
According to Horneff, Maurer and Mitchell, the inclusion of deferred income annuities in DC accounts is welfare-enhancing for all demographic groups examined. They also conclude that providing access to well-designed variable deferred annuities with some equity exposure further enhances retiree well-being, compared to having access only to fixed annuities.
Overall, according to the analysis, a retiree who receives a substantial portion of their income through Social Security should consider deploying a significant portion of the remainder of their financial portfolio to risky equities, whether through mutual funds or via annuities whose payments are linked at least in part to the performance of an equity portfolio.
Notably, the authors suggest this conclusion must be squared with the practical and behavioral realities of retirement planning. In particular, those who are least educated (high-school dropouts, as defined by the analysts) — and thus less likely to be informed about the markets and more likely to make tactical investing mistakes — are probably best off delaying claiming Social Security as the primary means of improving their retirement outlook.
This is also true because the lowest earners tend to have more of their income replaced by Social Security, making the claiming decision a more powerful wealth-enhancement lever compared with deferred annuity purchases.
On the other hand, the most educated (defined by the trio as having at least some college experience) benefit more from using approaches that involve leveraging DC plan assets to purchase deferred annuities. This result is tied to their greater life expectancies, as well as the fact that Social Security payments represent a smaller proportion of their anticipated lifetime wealth.
Running the Analysis
As the authors explain it, the main goal of the new paper is to examine how two key retirement income sources — annuities and Social Security benefits — should be considered jointly to optimize household welfare.
"Understanding how these interact is of key importance in order to generate efficient retirement portfolios," the authors write.
According to Horneff, Maurer and Mitchell, such an analysis is also important because there is likely to be "substantial heterogeneity" in the demand for longevity annuities across the retiree population.
Put another way, any given individual's preferences and needs will depend on their assets inside and outside their tax-qualified retirement plans, as well as on their mortality assumptions, their accrued Social Security benefits, and their anticipated longevity given their own unique health history.
