Monday, February 28, 2011

FLG Learned Something

FLG was reading through a debate over whether public employees should shift into defined contribution retirement plans like pretty much everybody else. The first argument FLG clicked on was Monique Morrissey's, from the Economic Policy Institute, because FLG figured that would be the one he disagreed with the most. And better to read somebody with whom you disagree than to cluck along reading likeminded people.

Anyway, FLG did disagree. He's heard the 401(k)s just increase Wall Street's profit line a million times. Nothing new. But then FLG clicked a link to a paper that Morrissey wrote about making retirement universal, secure, and adequate. Usual shit in there too. 401ks are risky and expensive. People don't put enough money into them and don't have the financial skill and knowledge to manage their investments properly. Low-income workers don't have access.

All stuff FLG has heard before. Much of this can be ameliorated with small tweaks here and there, such as opt-out instead of opt-in. On the larger point that the market is risky, but government-backed, defined benefit plans aren't, is not, seems a bit questionable to FLG. In finance and accounting, when the ownership of an asset is somewhat ambiguous, then you look to who has the control and bears the risk. By shifting the financial risk for retirement funds onto corporations or government you are shifting the financial risk, but the individual is still the one who wants to retire and so they still bear the risk. They are merely trading financial risk for political and legal risk, which is to say contracts can help you transfer risk, but there's still counterparty risk. That worries FLG, especially counterparty risk with the government. It's purely political risk at that point. Since he's the one who wants to retire, he'd much rather have complete control over the assets he'll be using to retire. Then he'll diversify away all the risk he can. To be honest.

But let's get back to the title of this post, what FLG learned:
Adverse selection in annuity markets
401(k) participants can convert account balances into lifetime streams of income at retirement by purchasing annuities. However, this is expensive because insurance companies assume that only someone with a higher-than-average life expectancy would purchase a life annuity. This problem is exacerbated by the fact that the annuities market is difficult for nonexperts to navigate, so unsophisticated investors can be at the mercy of unscrupulous sales practices. The situation is analogous to health insurance, where similar problems cause individual plans to be much costlier than group plans. For this reason, many countries require annuitization for most retirement account balances. Even the United Kingdom, which is similar to the United States in its reliance on voluntary defined contribution plans, requires that at least 75% of account balances be annuitized.

FLG was aware of the annuitization requirement in the UK, and it always bugged him. Going back to the control aspect, FLG might not want to annuitize his investments at the moment he retires for any number of reasons, including the counterparty risk issue, but namely that the rates offered might be atrocious at that moment. Maybe FLG'd want to wait a couple of years before annutizing or spread the money into several annuities purchased every couple years.

But to tell you the truth, FLG never understood the requirement. He means, yes, he understands the idea that there's the risk people will outlive their money, longevity risk. And he understands why governments would want to ensure that people take measures to avoid it. But FLG never understood why the requirement was so high. 75% is a big chunk of change. In the context of adverse selection problems it makes more sense. Those never occurred to FLG.

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