Annuities in 401(k) Plans Are Not All They’re Cracked Up To Be – Center for Retirement Research
Emergency expenses eat up a lot of money for retirees.
A few months ago, a colleague asked me what I thought about annuities in 401(k) plans. Before Harvard could get a Ph.D. my, let me put the merits of the income. Annuities are contracts that provide a series of monthly payments in exchange for a premium. A pension not only protects people from using up their resources but also allows for more annual income than many could provide on their own, because the provider pools the knowledge of a large group of people and pays benefits to those who live longer than expected with premiums paid by those who die prematurely. Annuities also protect consumers from the market risk associated with investing in stocks and bonds, and make people feel more comfortable knowing that they will have regular income to cover their necessary expenses.
That said, my response to my colleague’s question about income from 401(k)s was mild – at best. First, by design, they redistribute money from the low-paid – who die early – to the high-paid – who live forever. Second, my favorite financial advisor never recommends annuities because they are usually not indexed to inflation. Third, no good studies exist on how much retirees need to have in an emergency fund.
Interestingly, the Institute recently released a study on the emergency costs of retirees. To be fair, the authors are concerned about the size and frequency of emergency expenses and people’s ability to pay for these expenses. They are not really focused on how many people have assets to buy a pension once they have set aside an emergency fund. Still, all of the study’s findings are interesting, and shed some light on the 401(k)/annuity issue.
Data is from 2000-2020 Health and Retirement Study (HRS) and 2001-2019 associated with it Survey of Mail Usage and Activities (CAMS). Based on this data, the authors calculated how much retired families spend each year on unexpected expenses in three broad categories: 1) “rainy day” expenses for a house, car, and appliances; 2) family-related evictions from parents or children or in response to death or divorce; and 3) health care costs, including long-term care.
The results show that, in any given year, 83 percent of all households will have unexpected expenses. About 60 percent of all households will experience the shock of rainy days; 29 percent will have unexpected family-related expenses; and 58 percent will face unexpected health care costs (see Figure 1).
Quantitatively, the findings also show that these unexpected costs are significant. As shown in Figure 2, the average household – in any given year – is predicted to spend 10 percent of its annual income on unexpected expenses. This number suggests that in retirement at age 25, the average family should set aside 2.5 times their average income as an emergency fund. If we take the average income of $85,000, we are talking about $212,500. In the group of high income earners, the percentage of the salary is small (7 percent), but the income may be $ 250,000, so the emergency fund needed would be $ 437,500.
The bottom line is, according to this much-needed new study, emergency costs are common and important. In a given year, 83 percent of all households will experience at least one type of cost shock, and on average, these unexpected costs equal 10 percent of annual income. Covering these expenses over a 25-year retirement period requires a cash fund of $200,000 to $400,000. The need for an emergency fund, combined with the fact that the very wealthy cannot insure themselves against bankruptcy, reduces the potential market for annuities. The 2022 data shows that only 28 percent of households have financial assets in the appropriate range of $200,000-$5 million, where people can protect themselves. With this limited market, annuities should not be the default investment in 401(k) plans.
