Two professors have proposed a new kind of annuity; a product offered not by insurers, who can't promise they'll still be around to make payments when the annuitant wants them, but by the federal government.
In an op-ed piece published Feb. 26 in The New York Times,the authors, Terrance Odean, a finance professor at the University of California, Berkeley, and Henry T.C. Hu, a professor at the University of Texas School of Law, proposed a solution in which investors would "face no more risk of default than that associated with Treasury bills." Additionally, the annuity wouldn't cost the government anything, as it's an "incremental move" beyond issuing inflation-adjusted bonds.
"By allowing the government to tap a new class of investors, the cost of government borrowing over all would probably drop," the authors wrote.
"Economists agree that annuities make sense," Odean (left), told AdvisorOne on Thursday. "Defined-benefit plans are essentially annuities. If you die young, you collect less; and if you die old, you collect more."
The proposal, he said, is a "mechanism for turning defined-contribution plans into a retirement payout scheme."
The authors suggest that when individuals enroll in a qualified retirement savings plan, say, a 401(k), instead of investing in stocks, bonds and mutual funds, they would be able to choose an annuity option. Payouts would be based on bond interest rates, mortality tables, and administrative costs, among other things.
Purchasing an annuity from the government rather than an insurer can reassure investors that they will be able to collect. There's a "reasonable expectation that people don't trust rating agencies," Odean said, especially when trying to determine which insurers are likely to still be solvent when it's time for an annuity to pay out. "I'm a finance professor and I don't know," he joked.
There may be a general sense of mistrust of the government, but Odean argued that it won't be a factor in investors' decisions to choose a government annuity.
"This is a highly specific issue; you may not trust the government to do other things, like protect your privacy, or not tap your phones," Odean said. But, it's unlikely for Treasury to default. "Could they, yes," he said, "but it's not likely." Furthermore, "the rest of the world has shown a willingness to trust the United States to pay off debt."
The idea for annuities sold by the government arose when Odean and Hu noticed two serious concerns about defined-contribution plans, Odean told AdvisorOne. The biggest problem, he said, is that people simply aren't saving enough. The proposal doesn't address that issue, he admitted, but they were able to address the second problem: longevity.
Furthermore, expanding the pool of domestic investors would wean the government off reliance on foreign lenders. Even the risk of technological advancements extending life expectancies is a minor one, Hu and Odean wrote in The Times.
"That’s a risk that the government is already bearing implicitly: that is, a drastic enough increase could threaten the solvency of private issuers of annuities as well as the many retirees who don’t have annuities, creating pressure for government bailouts of insurers or individuals," the authors wrote. "Taking on the risk explicitly and pricing the fair cost of this risk into the annuities is a far preferable route."
Independent advisors can benefit from having a government annuity option because it sets clear limits on clients' needs, Odean told AdvisorOne. "When there's more money in the account than the cost of an annuity at the client's age, the annuity acts as a backstop," he said. "When the balance falls to the minimum, advisors can convert to an annuity to ensure minimum needs are always met."
One barrier, though, is investors' sometimes unrealistic expectations, Odean told AdvisorOne.
"Investors may be disappointed at their monthly payments given how much they paid," he said. But, he added, investors "like to know there's a level at which you are risk free. Some people would choose a government annuity, and manage the rest of their assets in a portfolio."
Another concern Hu and Odean address is that of potential competition between the government and private annuity carriers. They say that inflation-adjusted payments on government annuities would necessarily be low; to supplement meager income from nearly risk-free investments, retirees would likely purchase riskier annuities with greater payouts, as well.
"Our proposal is a winner for everyone," the authors conclude. "The Treasury could lower borrowing costs and diversify its investor base while acknowledging and budgeting for risk that it already bears. Individuals could eliminate the risk of living too long."