Do Annuities Help Older Adults Manage Their Spending?

The nonpartisan Urban Institute publishes studies, reports, and books on timely topics worthy of public consideration. The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees, or its funders.

No. 14 in the Older Americans' Economic Security series.

Abstract

For the first time in history, many older Americans will likely retire with large stockpiles of money and will have to determine how to carefully manage these assets. Our study results suggest that converting retirement wealth into an annuity that guarantees a lifetime income may help retirees manage their spending and ensure they will not outlive their savings. This brief is related to the longer paper "Annuitized Wealth and Consumption at Older Ages."

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Introduction

For the first time in history, many older Americans will likely retire with large stockpiles of money and will have to determine how to carefully manage these assets. Our study results suggest that converting retirement wealth into an annuity that guarantees a lifetime income may help retirees manage their spending and ensure they will not outlive their savings.

What are Annuities?

Annuities are financial instruments that convert wealth into a guaranteed stream of lifetime income. The annual income generated depends on the age at which the annuity begins and on current market interest rates. Although annuities provide insurance against outliving one's resources, few retirees purchase them. Today's retirees typically rely on lifetime payments from traditional defined-benefit (DB) pensions and Social Security—which represent 55 percent of total wealth for typical married adults and 59 percent of total wealth for unmarried adults—to finance their retirement.

So far this strategy has served most retirees well, since only one-third of those married and one-quarter of those unmarried have financial assets of more than $100,000 per person. However, this is likely to change in the future due to the decline in DB pensions and the growth in Individual Retirement Accounts (IRAs) and defined-contribution (DC) pensions, which include 401(k) plans.

Traditional DB pensions, common for yesterday's retirees, provide lifetime annuities beginning at retirement and promise benefits typically as a multiple of years worked and earnings received near the end of the career. DC plans in which employers (and generally employees) make contributions to a retirement account in the participant's name, often specified as a particular share of salary or a given dollar amount, are now the most common type of retirement benefit. At retirement, workers receive the funds that have accumulated in their accounts. Most employers do not offer annuities to their DC plan participants, and although they can use the proceeds to purchase annuities in the marketplace, only 4 percent of workers in DC pension plans convert their account balances into annuities when they leave their employers (Hurd, Lillard, and Panis 1998; Johnson, Burman, and Kobes 2004). With DC plans replacing DB plans in the private pension system, more older Americans will enter retirement with large account balances and fewer will have DB payouts.

The full brief is available in PDF format.

The nonpartisan Urban Institute publishes studies, reports, and books on timely topics worthy of public consideration. The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees, or its funders.

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