Apples and Oranges: Understanding Lifetime Income Options

Secure lifetime income is a top wish-list item for defined contribution plan participants, and it has benefits for plan sponsors too. But there are very different ways to deliver it.

The first step in choosing a retirement-income solution is understanding the differences—which can be substantial—across the broad array of options. Let’s look at four categories of typical solutions, with a high-level view of how they work, as well as their costs and risks, summarized in the Display below.

1) Self-Insurance: The Non-Guaranteed Approach

One way to pursue retirement income is what many participants do today: they invest in a diversified solution, such as a target-date strategy, and forgo insurance—often managing withdrawals on their own. Participants keep full ownership of and liquidity in their retirement savings, have growth potential based on their asset allocations, and can pass remaining account balances to their beneficiaries at death.

The drawback of self-insurance is uncertain income, and participants tend to overestimate or underestimate their sustainable withdrawal rates. As a result, they may have to reduce the percentage of assets they withdraw, lowering their amount of income and their living standard as a result. Or they can continue withdrawing the same amount of income and risk running out of assets. Participants who don’t want these risks are more likely to favor income insurance—a feature of the next three solutions.

2) Single Premium Immediate Fixed Annuity (SPIA)

A SPIA, also referred to as an income annuity, is among the most well-known annuities. At retirement, participants surrender their assets to an insurance company (a decision that can’t be revoked). In exchange, they receive guaranteed fixed payments that start right away and continue for life. SPIAs have no explicit annual insurance premium or fees, because participants no longer own any assets.

Outcomes for participants depend heavily on their age of death; half will die before the median life expectancy, failing to reap the full income benefit. Adding death-benefit riders can reduce the loss from dying early, but at the cost of a lower income rate. Participants living longer receive bond-like returns for decades: they no longer risk outliving their assets, but they sacrifice the liquidity and growth potential of target-date funds.

Retirement-Income Solutions Key Features