Take it or Leave it?

By Nevin Adams, EBRI
Nevin Adams

Nevin Adams

While each situation is different, in my experience leaving a job brings with it nearly as much paperwork as joining a new employer. Granted, you’re not asked to wade through a kit of enrollment materials, and the number of options are generally fewer, but you do have to make certain benefits-related decisions, including the determination of what to do with your retirement plan distribution(s).

Unfortunately, even in the most amicable of partings, workers have traditionally lacked the particulars to facilitate a rollover to either an individual retirement account (IRA) or a subsequent employer’s retirement plan—and thus, the easiest thing to do was simply to request that distribution be paid to him or her in cash.

Over the years, a number of changes have been made to discourage the “leakage” of retirement savings at job change: Legal thresholds for mandatory distributions have been set; a requirement established that distributions between $1,000 and $5,000 on which instructions are not received either be rolled over into an IRA or left in the plan; and even the requirement that a 20 percent tax withholding would be applied to an eligible rollover distribution—unless the recipient elected to have the distribution paid in a direct rollover to an eligible retirement plan, including an IRA. All these have doubtless served to at least give pause to that individual distribution “calculus” at job change.

Indeed, a recent EBRI analysis¹ indicates that workers now taking a retirement plan distribution are doing a better job at holding on to those retirement savings than had those in the past. Among those who reported in 2012 ever having received a distribution, 48.1 percent reported rolling over at least some of their most recent distribution into another tax-qualified savings vehicle, and among those who received their most recent distribution through 2012, the percentage who used any portion of it for consumption was also lower, at 15.7 percent (compared with 25.2 percent of those whose most recent distribution was received through 2003, and 38.3 percent through 1993).

As you might expect with the struggling economy, there was an uptick in the percentage of recipients through 2012 who used their lump sum for debts, business, and home expenses, and a decrease in the percentage saving in nontax-qualified vehicles relative to distributions through 2006. However, the EBRI analysis found that the percentage of lump-sum recipients who used the entire amount of their most recent distribution for tax-qualified savings has increased sharply since 1993: Well over 4 in 10 (45.2 percent) of those who received their most recent distribution through 2012 did so, compared with 19.3 percent of those who received their most recent distribution through 1993.

The EBRI report also notes that an important factor in the change in the relative percentages between the 1993 and 2012 data is the percentage of lump sums that were used for a single purpose. Consider that among those who received their most recent distribution through 2012, nearly all (94.0 percent) of those who rolled over at least some² of their most recent distribution did so for the entire amount.

There is both encouraging and disappointing news in the EBRI report findings: The data show that improvement has been made in the percentage of employment-based retirement plan participants rolling over all of their LSDs on job change, along with less frequent pure-consumption use of any of the distributions. However, the data also show that approximately 55 percent of those who took a lump-sum payment did not roll all of it into tax-qualified savings.

In common parlance, “Take it or leave it” is an ultimatum—an “either/or” proposition that frequently comes at the end, not the beginning, of a decision process. However, as the EBRI analysis indicates, for retirement plan participants it is a decision that can (certainly for younger workers, or those with significant balances) have a dramatic impact on their financial futures.

Notes
¹ The November 2013 EBRI Notes article, “Lump-Sum Distributions at Job Change, Distributions Through 2012,” is online here. 
² Two important factors in whether a lump-sum distribution is used exclusively for tax-qualified savings appear to be the age of the recipient and the size of the distribution. The likelihood of the distribution being rolled over entirely to tax-qualified savings increased with the age of the recipient at the time of receipt until age 64. Similarly, the larger the distribution, the more likely it was kept entirely in tax-qualified savings.

Puzzle Picture

By Nevin Adams, EBRI

Adams

Adams

One of my favorite memories of visiting my grandparents over the holidays was working on jigsaw puzzles. These were generally large, complicated affairs—whose construction was spread over days, as various family members would stop by to work on a section, to build on a border, or sometimes contribute a single piece they would spot as they drifted by on their way to another activity. Perched in a prominent place throughout would be the puzzle lid with that all-important picture of what we were working toward to help keep all those individual, and sometimes fleeting, efforts in the proper perspective, that made it possible to differentiate the blue of what would appear to be sky from what would turn out to be an important, but obscure section of mountain stream.

In retirement plans, one of the more intransigent concerns for policy makers, providers, and plan sponsors alike is what has been called the “annuity puzzle”—the reluctance of American workers to embrace annuities as a distribution option for their retirement savings. What economists call “rational choice theory”(1) suggests that at the onset of retirement individuals will be drawn to annuities, because they provide a steady stream of income, and address the risk of outliving their income. And yet, given a choice, the vast majority don’t.

Over the years, a number of explanations have been put forth to try and explain this reluctance: the fear of losing control of finances; a desire to leave something to heirs; discomfort with entrusting so much to a single insurer;, concern about fees; the difficulty of understanding a complex financial product; or simple risk aversion—all have been studied, acknowledged, and, in many cases, addressed, both in education and in product design, with little impact on take-up rates.

As defined contribution programs have grown, those frustrated with the tepid rate of annuity adoption have sought to bring employers into the mix by providing them (and the plans they sponsor) with a range of alternatives: so-called “in- plan” retirement income options, qualified default investment alternatives that incorporate retirement income guarantees, and expanded access to annuities as part of a distribution platform. In recent years, regulators have also entered the mix, among other things issuing a Request for Information (RFI) regarding the “desirability and availability of lifetime income alternatives in retirement plans,” conducting a two-day hearing on the topic, and (as recently as last year) issuing both final and proposed regulatory guidance.

Yet today the annuity “puzzle” remains largely unsolved. And, amidst growing concerns about workers outliving their retirement savings, a key question—both as a matter of national retirement policy and understanding the potential role of plan design and education in influencing individual decision-making—is how many retiring workers actually choose to take a stream of lifetime income, vs. opting for a lump sum.

As outlined in a new EBRI Issue Brief,(2) the evidence on annuitization in workplace pension plans has been mixed. But the EBRI report provides an important new perspective to a 2011 paper titled “Annuitization Puzzles” by Shlomo Benartzi, Alessandro Previtero, and Richard H. Thaler.(3)  In that paper, they analyzed 112 different DB plans provided by a large plan administrator and, focusing on those who retired between ages 50 and 75 with at least five years of job tenure and a minimum account balance of $5,000, and noted that “…virtually half of the participants (49 percent) selected annuities over the lump sum,” further observing that “When an annuity is a readily available option, many participants who have non-trivial account balances choose it.”

The study’s authors went on state that “The notion that consumers are simply not interested in annuities is clearly false,” explaining that “…the common view that there is little demand for annuities even in defined benefit plans is largely driven by looking at the overall population of participants, including young and terminated employees and others with small account balances who are either required to take a lump-sum distribution or simply decide to take the money.”

Mixed Behaviors?

In essence, Benartzi’s “Annuitization Puzzles” study says that much of the existing research draws inaccurate conclusions by mixing the behaviors of younger workers with smaller balances with those who might, based on their age and financial status, be expected to choose an annuity. However, as noted in the EBRI Issue Brief, that study failed to take into consideration what has long been known to be a key element in retirement plan behaviors: retirement plan design. In effect, the Benartzi study blends the behaviors of participants who have the ability to choose an annuity with those who have either no choice, or one restricted by their plan.

What kind of difference might this make? Well, taking into account the same types of filter on tenure, balance, and age employed by the Benartzi study, as well as a series of plan design restrictions, EBRI found that for traditional defined benefit plans(4) that imposed no restriction on doing so, fewer than a third of those with balances greater than $25,000 opted for an annuity, as did only about 1 in 5 whose balances were between $10,000 and $25,000. Those with balances between $5,000 and $10,000 were even less likely to do so.(5)  In sum, even filtering to focus on the behaviors of individuals seen as most likely to choose an annuity distribution, we found that, given an unfettered choice, the vast majority do not.

Ultimately, the EBRI analysis shows that, to a large extent, plan design drives annuitization decisions.(6)  We know that plan design changes have been successful in influencing participant behavior in DC plans via auto-enrollment and auto-escalation, and the new EBRI study suggests that plan design can also play a critical role in influencing distribution choices.

It also shows the importance of taking into account the whole picture when you’re trying to solve a puzzle.

Notes

(1) “Annuitization Puzzles,” by Shlomo Benartzi, Alessandro Previtero and Richard H. Thaler is online here.

(2) According to Investopedia, it is “…an economic principle that assumes that individuals always make prudent and logical decisions that provide them with the greatest benefit or satisfaction and that are in their highest self-interest.”

(3) See the January 2013 EBRI Issue Brief, no. 381, “Annuity and Lump-Sum Decisions in Defined Benefit Plans: The Role of Plan Rules,” online here.

(4) Participants in cash balance plans were even less likely to choose annuities than those in “traditional” final-average-pay defined benefit plans.

(5) The Benartzi study filtered only on individuals with a balance greater than $5,000.

(6) The EBRI analysis also found that annuitization rates increase steadily with account balance for older workers (but not for younger workers), and that annuitization rates also increase with tenure. See “Annuity and Lump-Sum Decisions in Defined Benefit Plans: The Role of Plan Rules,” online here.

Annuity Choice Driven by Pension Plan Rules

EBRI_IB_01-13.No381.Pg1_Page_01Why do some retiring workers with a pension choose to take a stream of lifetime income, while others cash out their entire benefit in a lump-sum distribution?

Amidst growing concerns about workers outliving their retirement savings, this has emerged as a key issue—and it depends to a large extent on whether the individual pension plan allows or restricts lump-sum distributions (LSDs), according to new research by EBRI. A better understanding of these decisions stands to shed light not only on the outcomes for traditional pensions, but also for defined contribution plans, where LSDs are the rule rather than the exception.

EBRI’s research, the first time this level of analysis has been done on this scale, reveals that differences in defined benefit (DB) plan rules or features result in very different annuitization rates. In fact, the results show that the rate of annuitization—the rate at which workers choose to take their benefit as an annuity—varies directly with the degree to which plan rules restrict the ability to choose a partial or lump-sum distribution. In choosing an LSD, the individual takes on the investment risk and responsibility for managing the distribution, and, ultimately, arranging his or her own income flow in retirement from those funds.

Analyzing data from more than 80 different pension plans, EBRI compares the “annuitization rate” among individuals at various age, tenure, and account balances, along with the rules and distribution choices within individual pension plans. EBRI found that between 2005 and 2010, pension plans with no LSD distribution options had annuitization rates very close to 100 percent. In contrast, the annuitization rate for defined benefit and cash balance plans with no restrictions on LSDs was only 27.3 percent.

“Whether people annuitize depends to a large extent on whether or not they are allowed to choose some other option,” said Sudipto Banerjee, EBRI research associate and author of the study. “Any study of annuitization that fails to take into account the impact of plan design on participant choice will likely lead to misinterpretations.”

The report notes that through the 1960s DB pension plans offered mainly one distribution choice: a fixed-payment annuity. That changed beginning in the 1970s, as some DB plans began to offer the option of full or partial single-sum distributions, and as “hybrid” pension plans expanded in the 1980s, so did distribution options. Today, most DB pension plans offer some type of single/lump-sum option, in addition to the traditional annuity choice.

The full report is published in the January 2013 EBRI Issue Brief no. 381, “Annuity and Lump-Sum Decisions in Defined Benefit Plans: The Role of Plan Rules,” online at www.ebri.org