The ‘Three-Legged Stool’ of Retirement Is Missing a Leg

Wishful Thinking

Once, the tale goes, American workers relied upon a three-legged stool for their retirement income: 1) Social Security, 2) pensions, and 3) personal savings. That metaphor was always rickety, as even at their peak pensions covered less than half of private-sector workers. Today, that figure is 15%. (Government employees are another matter, although those with college educations pay for the pension privilege by receiving lower ongoing wages.)

To switch analogies, the middle ground is vacant. Social Security provides subsistence for retirees, while personal savings contribute a risky supplement. Absent is an asset that lands between those extremes, supplementing Social Security benefits, but with relative safety.

A Failed Attempt: Personal Annuities

Insurance companies address the retirement income gap by selling fixed-rate annuity contracts that convert investment assets into guaranteed payments. The promises made by insurers are less ironclad than those from the US government, and the “income” from fixed annuities (the quotes signify that such payments include the return of the owner’s capital) is rarely adjusted for inflation. But without question, they are less risky than equities.

So, you may ask, why does this column exist? Two reasons. To start, fixed annuities aren’t typically used to prepare for retirement. They are wielded tactically rather than strategically, either as bond/cash substitutes (deferred annuities), hedged equities (indexed annuities), tax-protected investments (variable annuities), or as income-management tools for those who are already retired (immediate annuities). All young workers know about Social Security benefits and 401(k) plans. They are, however, unlikely to have heard of fixed-rate annuities.

The bigger issue, though, is that investors aren’t interested. Although the annuity industry’s overall sales are healthy, relatively few buyers choose fixed-rate contracts, opting instead for riskier options that operate differently.. Insurers have had decades to furnish the third stool leg through fixed-rate annuities, but investors by and large have rejected their wares. The marketplace has rendered its verdict.

Prospective Answer 1: Workplace Annuities

Maybe the problem rests not with the product itself but with its marketing. Annuities are notoriously complex. Almost nobody can explain the difference between deferred fixed, deferred variable, immediate fixed, variable, and fixed-index annuities. Even those who do understand struggle to explain all the contracts’ optional features. Nor are the official documents much help. Go ahead: Read this 112-page prospectus. Somebody should, at least once.

An alternative is to supply annuities through 401(k) plans, thereby making the companies do the research instead of the employees. As has been established by target-date funds, which are extremely popular within 401(k)s but scarcely held outside of them, a corporate stamp of approval greatly alleviates investor resistance. By moving within the workplace, products that have languished may at long last find their customer base. At least, that is the hope.

The 401(k) industry has gradually been planning for that event. In 2019 and then again in 2022, Congress passed legislation that eased the regulatory burden for annuities within 401(k) plans. Consequently, some providers have begun to dip their toes into those waters. Three years ago, a consortium of companies founded Income America 5ForLIfe. This January, Fidelity went national with its pilot program, called Guaranteed Income Direct, while in May BlackRock BLK announced its LifePath Paycheck series.

Each service operates differently. The Income America and LifePath Paycheck series bolt retirement-income options onto a target-date fund chassis, although not in an identical fashion. For its part, Fidelity’s program does not supply new investments, but instead the possibility of annuitizing across the firm’s existing fund lineup. As evidenced, 401(k) providers have not yet settled on a model for annuitization within the workplace as they have with target-date funds (which are very similar, particularly among the major players). Such experimentation will slow adoption, owing to buyer confusion, but ideally will lead to a stronger solution.

Two notes. First, while personal annuities are often costly, workplace annuities will be relatively cheap thanks to competitive pressures. Second, because 401(k) plans by law must offer gender-neutral terms, workplace annuities are a particularly good deal for women, because they will receive the same annuity payments as men while having longer expected life spans.

Prospective Answer 2: Federal Programs

Businesspeople look to the marketplace, academics to the government. Each view has contributed one leg to the US retirement structure, with 401(k) plans invented and promulgated by capitalists while the Social Security system was inspired by university commentary. It is therefore no surprise that academics have proposed federal schemes.

One of these I have previously discussed. In 2019, Nobel Laureate Richard Thaler recommended that 401(k) participants be permitted to convert some of their assets into additional Social Security credits. This concept prefigures BlackRock’s product, with the critical differences being that: 1) the payments would be guaranteed by the US government rather than an insurance company, and 2) even better, they would be inflation-adjusted.

While there is much to like about this proposal, it does contain a drawback that I overlooked in my 2019 article but was pointed out by another academic, The New School’s Teresa Ghilarducci. Because most people who annuitize have above-average life spans, this scheme would weaken the Social Security Administration’s finances by offering the standard payout rate to people who will collect more paychecks than their actuarial expectations. (Such is adverse selection.)

Another Nobel Laureate’s suggestion is already live. For several years, Robert Merton and a co-author, Arun Muralidhar, have suggested a product they call SeLFIES: Standard-of-Living indexed, Forward-starting, Income-only Securities. The name is awkward, but the service is sensible. Pay a given amount today, and receive government-guaranteed, inflation-adjusted future payments. Unlike most fixed-annuity products, SeLFIES targets investors of all ages.

In January 2023, Brazil debuted a modified version of SeLFIeS, called RendA+ bonds. Professor Merton reports that several other countries, including the US, are evaluating the results of that program. Of course, while Brazil was eager to reform its retirement system, progressing from concept to launch in less than four years, most nations will take far longer to reach a decision.

Wrapping Up

None of these suggestions bring new money to the table. Instead, they move assets from the savings leg of the stool (represented in this article by 401(k) accounts, but of course they often include other sources) to a leg that provides greater stability. Such a trade-off is to be expected. After all, the same principle holds for pensions, which consume cash that at least in theory would otherwise go to salaries—thereby increasing savings rates.

Finally, this article is descriptive rather than prescriptive. It outlines the problem of the missing retirement leg and presents various potential solutions. But it only hints at their merits and/or drawbacks. For the moment, such evaluations are the readers’ responsibility. Perhaps future columns will amend that omission.