I’ve written previously about the SECURE Act, the House version of a measure designed to encourage employers to allow employees to gamble their retirement savings on the long-term financial stability of private insurance companies. The measure has since cleared the House but is currently being held up in the Senate for now by Ted Cruz who is trying to turn the 529 loophole into a piggy bank for the wealthiest Americans. With this terrible measure one step closer to passage, I want to use it to illustrate a particular problem raised by the cult of moderate centrism.
401(k) plans have enough bad investment options without adding annuities
Like many pieces of the American welfare state, 401(k) plans became a retirement savings tools for private sector workers more or less by accident. Consequently, they are governed by a mishmash of rules and regulations of different vintages. For example, while the investment options within a 401(k) plan have to be administered exclusively for the benefit of the contributing employee, the design of the plan and selection of investment options does not — employers can and do receive kickbacks from 401(k) custodians for filling their plans with high-cost investment options, for instance. Employee lawsuits typically revolve around this distinction: is the kickback an employer receives based on employees’ investment choices or based on plan design?
Every 401(k) plan I’ve seen has included 10-15 high-cost, actively managed mutual funds alongside 2-4 low-cost index funds. That’s not the exception: that’s the rule. When deciding on an asset allocation within a 401(k), there’s simply no alternative but to look up the ticker for each available investment option, record its benchmark and expense ratio, and try to cobble together an appropriate low-cost asset allocation from the options available. This is not terribly difficult for someone who knows what they’re doing and has the time and patience to do it, but it’s naturally overwhelming for the vast majority of people who have neither aptitude not interest in making these kinds of investment decisions.
Insurance companies want to add their annuities to your 401(k)
That brings us to the core policy goal of the SECURE Act: give employers a “safe harbor” from employee lawsuits when they include annuities offered by insurance companies that meet a rudimentary test of financial stability.
You might observe this is a very counter-intuitive way to frame the policy change, and you would be right. The SECURE Act is supposed to improve employee retirement security by preventing employees from suing when their employers offer them crappy retirement investment options? Surely it would make more sense to improve employee retirement security by increasing their legal recourse against employers who do not offer them appropriate and appropriately-priced retirement investment options!
But of course the circle is easy to square when you remember that annuities are sold, not bought. The issue is not that employers, let alone employees, are demanding access to annuities in their 401(k) plans. The issue, rather, is that insurance companies are clamoring to have their annuities included in 401(k) plans but are being stymied by the unwillingness of employers to take on the legal risk of vetting them. With that barrier removed through the “safe harbor,” insurance companies will be free to offer the same kickbacks investment companies do today to sell their confusing, expensive annuity contracts to 401(k) participants.
Annuities don’t eliminate risk, they transform and hide it
In theory I don’t have anything against single-premium immediate annuities as a method of converting a lump sum into a predictable stream of income upon retirement (or any other time), but it’s important to understand what is and is not happening when you do so.
When you hold an FDIC-insured bank deposit, or a SIPC-insured security in a brokerage account, you are roughly speaking entitled to some stream of income (interest, dividends, capital gains distributions), plus the value of the underlying asset. Both components of the asset will generally fluctuate: the interest you earn on your bonds will change as you reinvest coupons over time; dividends will rise and fall along with the profitability and capital allocation decisions of the underlying companies; the asset’s resale value will change along with the winds of capitalism. Even cash grows more or less valuable as inflation rises and falls.
When you exchange those real assets for an annuity contract, you receive a different kind of asset in exchange: the promise of an insurance company to pay you a fixed or variable sum described in the contract over some time period. You’ve now converted the variable stream of income and variable asset value of your stocks and bonds into a fixed income stream.
But there’s no sense in which you have eliminated your risk by doing so. Instead, you’ve simply transformed the risk you’re taking. Instead of being subject to the whims of inflation, interest rates, and the stock market, your income now depends on your insurance company being able to pay the promised stream of income over the promised time horizon.
To be clear: I’m not an insurance company analyst and I don’t have the tools to perform a comprehensive assessment of the creditworthiness of American insurance companies over the next 70+ years (a 40-year career followed by a 30-year retirement, for instance). Of course, your employer probably isn’t either, and that’s why they don’t offer annuities in your 401(k) plan. If passed, what the SECURE Act will do is relieve employers of that responsibility, so you won’t have any recourse if the annuity you select flounders and your contributions are lost or deeply discounted in your insurer’s bankruptcy.
Social Security has always been the answer
Social Security’s old age benefit is the only source of income security for the overwhelming majority of older Americans. It’s important to understand exactly what this means. Social Security is not the only source of income for older Americans. About 27% of Americans continue to participate in the labor force (i.e. work or look for work) between the ages of 65 and 74. Others receive passive income from rental real estate, farm, mineral, and gas leases, etc.
What distinguishes those sources of income from Social Security is that Social Security old age benefits are paid by the federal government and subject to annual cost of living adjustments, and they’re guaranteed to continue for as long as you live. Employment income in old age lasts as long as you’re employed, rental income fluctuates over time (just ask Detroit if you don’t believe me), and commodity prices go through long cycles of rise and decline. Social Security isn’t like that.
That means the first place you should look to improve income security is the only source of income security most people have, and the obvious place to start is allowing people to make additional, voluntary Social Security contributions. Since the only input into the Social Security benefit calculation is the average wage-inflation adjusted income reported in each year of a worker’s earnings record, a natural approach is to treat voluntary contributions as “increased income” for the year the contribution is made.
For example, a worker earning $50,000 in 2019 would ordinarily pay $3,100 in OASDI (the Social Security component of FICA), matched by their employer. An additional, voluntarily payment of $6,200 (conveniently close to the 2019 IRA contribution limit) could raise their recorded OASDI income for that year to $100,000. Note that this would not double their Social Security old age benefit, since each year of earnings only contributes 1/35 to a worker’s average earnings, and old age benefits increase at a graduated rate.
Centrists say personal responsibility when they mean risk
I’m all for “personal responsibility,” defined properly. I simply don’t know how a person can take personal responsibility for the trajectory of interest rates, or the performance of the S&P 500, or the rise and fall of US auto manufacturing, or the financial stability of America’s insurance companies. If you believe an important problem facing America is the problem of retirement security, by all means let us allow workers to reduce their present consumption in exchange for higher income in retirement.
But having decided to do so, why on earth would we then subject them to the cost, complexity, and vulnerability of private insurance companies?
Because when a centrist talks about personal responsibility, what they really mean is risk. Personal responsibility for the decision of whether to go to college, and what to study, means the risk of poverty. Personal responsibility for an unplanned pregnancy means the risk of homelessness. Personal responsibility for filing your SNAP application on time means the risk of hunger. Personal responsibility for your income in retirement means the risk of being taken advantage of by unscrupulous employers and insurers.
But there’s no way to take personal responsibility for what happens to us under a system that mechanically produces pain and trauma. Our personal responsibility is to fix the system.