Expand Social Security with Supplemental Annuities

With Hillary Clinton acquiescing to pressure from the Sanders campaign, the Democratic Party is uniting around calling for Social Security expansion. Exactly what expansion would include remains unclear though with many proposals circulating. One that should be a high priority but has yet received little or no attention--perhaps because it is complicated--would be to allow retirees to use savings to purchase supplemental life annuities from the program.

Supplemental Social Security annuities would be a much better deal for retirees than what currently exists from private providers--mainly life insurance companies--and they would not require raising payroll taxes.

A life annuity is a financial product for which purchasers pay money in return for promises of income for the rest of their lives. The purchaser surrenders asset ownership--money or savings-- in return for the security of lifetime income. A 65 year old male today, for example, could pay a life insurance company $100,000 in return for a life annuity that would pay approximately $4800 a year for the rest of his life.

Sellers set costs of annuities by using a range of actuarial and other information to calculate how much they will likely have to pay out, leaving enough to still make a profit. They also set costs based on average life expectancies. Those who die before reaching average life expectancy pay more than they receive. Those who live longer than average pay less. In short, the short-lived subsidize the long-lived.

Life annuities, similar to Social Security retirement payments, provide income that cannot be outlived and income that is greater for most than would be provided by individually spending down savings.

The original idea of 401(k)s and other retirement savings plans was that the savings accumulated in them would be converted to annuities upon retirement, making them similar to receiving a pension.

In the 1980s, when 401(k)s were taking off, annuitization was attractive because high interest rates from the inflationary 1970s ensured relatively high payout rates. But interest rates have since gone dramatically down, severely undermining the annuity payouts that life insurance companies can promise. Life insurance company profits, commissions, advertizing, and other overhead costs further compromise the values of annuity payouts.

A still further problem is that private annuity purchases are voluntary unlike Social Security. No one is allowed to cash out Social Security contributions in lieu of receiving a life income. A 401(k)-like plan, to the contrary, can be cashed out rather than annuitized at retirement. The result is that healthy people who think they are going to live a long time are more likely to purchase annuities. And in fact that turns out to be the case: annuity purchasers do in fact live longer than nonpurchasers though, of course, it is not the act of purchase that makes them live longer.

In the terms of the life insurance industry, the pool of purchasers is biased by adverse selection. It contains disproportionately people who live longer than average. Consequently, to preserve their cost and profit margins, insurance companies must pay out less for a given purchase price.

In large part because payout rates have slid so low, relatively few retirees today purchase annuities. They instead employ a range of strategies to spend down their savings, running the risk of running out of money. In the weird language of the life insurance industry, they take on longevity risk--the risk they will live longer than their money holds out.

Even with low payout rates, purchasing annuities makes sense though since they at least make income more predictable and secure for the rest of life. The issue is not whether annuitization is a good idea but how to maximize annuity income.

This is where at-cost Social Security annuities would be very useful for retirees. Since Social Security does not need to make a profit, has the largest insurance risk pool in the country, does not have advertizing expenses, has the most efficient administrative system of any retirement program, and does not have the problem of adverse selection, if it sold supplemental annuities, those payout rates could be up to 20% or higher than what retirees can obtain on the commercial market. Who wouldn't want to start retirement with up to 20% or more income?

The designers of the original Social Security legislation in 1935 included a voluntary annuity purchase feature. But opposition from life insurance companies, which did not want the competition, caused the feature to be struck from the final bill.

It made sense then and it especially makes sense now with the growing retirement crisis to give retirees the option of maximizing their retirement incomes via at-cost Social Security annuities. Such an expansion would not cost the program anything since new payments would be financed by voluntary purchases of annuities rather than increased payroll taxes.