Should Social Security Start Selling Annuities?

Social Security pays more than 60 million Americans vital benefits they need for their financial survival. One of the most important aspects of the Social Security program is that, unlike nearly every other type of retirement savings vehicle, Social Security makes monthly payments to retirees for the rest of their lives -- no matter how long they live. By contrast, most retirement accounts require you to manage your money wisely, and even then, it's possible to use up your savings entirely.

But one economic expert wants to change that. University of Chicago professor Richard Thaler recently suggested an idea that would allow ordinary retirement savers to use a portion of their contributions to 401(k)s or similar plans to generate a larger stream of monthly payments after the end of their careers. By using Social Security's own benefit formulas, Thaler argues, retirement savers could get a far better deal than they currently can by using annuity products from private insurance companies -- effectively putting the federal government in a position in which it's selling annuities.

What a Nobel prize winner suggests

Professor Thaler's reasoning for his proposal is pretty simple. People don't have enough good ways to ensure that their money will last as long as they live, and with longevity risk rising along with life expectancies, it's hard for people to accumulate enough in conventional retirement savings during their careers to handle worst-case financial scenarios.

To address that problem, Thaler would take advantage of the framework that Social Security already has for providing lifetime income to recipients. Under his plan, savers would be able to funnel a significant portion of their 401(k) savings of $100,000 to $250,000 toward Social Security. In exchange, the Social Security Administration would use formulas similar to those that determine monthly benefits under Social Security to determine how much extra in monthly income they could receive.

Thaler argues that Social Security has already done the actuarial work necessary to determine appropriate payouts based on retirement age and other factors. Unlike private insurance companies that have to earn profits, Social Security would be able to provide protection at a fair actuarial value.

Why Social Security annuities could be a bad idea

Thaler's proposal prompted substantial criticism from a number of corners. The most common surrounds the fact that with Social Security already in questionable financial condition, it's far from certain that the program would be able to take on the added strain of enhanced monthly payments. An inflow of upfront lump-sum payments would presumably help boost short-term trust fund balances -- but only at the expense of taking on liability for additional lifetime payments that could further exacerbate Social Security's financial woes.

Of particular concern is the threat of adverse selection. If only the healthiest people elected to take advantage of this new feature, then the underlying actuarial analysis would no longer be valid. Social Security would end up paying out more than fair actuarial value for these longer-lived recipients, potentially endangering not only future benefits under the expanded plan, but also Social Security's regular retirement benefits.

Meanwhile, private insurance companies argue that they're better suited to provide the protection that Thaler is trying to offer through a nationalized government solution. Instead, they favor making it easier for 401(k) plan sponsors to allow employees access to insurance products like annuities within their retirement plan accounts -- a practice that has until now raised concerns among plan sponsors that they'd potentially incur fiduciary liability if the insurance products didn't pan out the way participants expected.

What you can do right now

Interestingly, most retirees already have an option that effectively diverts a portion of their 401(k) balances toward Social Security. By choosing to start claiming benefits as late as age 70 rather than at full retirement age or earlier, one can boost the amount of their monthly payments by anywhere from 25% to 75%. Doing so might require spending down retirement savings in a 401(k) -- a move that could easily cost the $100,000 to $250,000 that Thaler is suggesting.

Whether that trade-off makes sense for most people is the same question every Social Security participant faces when deciding when to claim benefits. However, for those whose primary concern is maximizing lifetime income and reducing the risk of outliving their money, the strategy of deferring Social Security until 70 doesn't require a big change in the Social Security program in order to implement it today.

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