Fixed and variable longevity income annuities in defined contribution plans: Optimal retirement portfolios taking social security into account

• Published date: 01 December 2023
• Author: Vanya Horneff,Raimond Maurer,Olivia S. Mitchell
• Date: 01 December 2023
• DOI: http://doi.org/10.1111/jori.12440

Received: 16 December 2022

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Revised: 27 May 2023

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Accepted: 5 July 2023

DOI: 10.1111/jori.12440

ORIGINAL ARTICLE

Fixed and variable longevity income annuities

in defined contribution plans: Optimal

retirement portfolios taking social security

into account

Vanya Horneff

1

|Raimond Maurer

1

|Olivia S. Mitchell

2

1

Finance Department, Goethe

University, Frankfurt am Main, Germany

2

NBER & Wharton School, University of

Pennsylvania, Philadelphia,

Pennsylvania, USA

Correspondence

Olivia S. Mitchell, NBER & Wharton

School, University of Pennsylvania,

3620 Locust Walk, 3000 SH‐DH,

Philadelphia, PA 19104, USA.

Email: mitchelo@wharton.upenn.edu

Funding information

Pension Research Council/Boettner

Center; TIAA Institute; German

Investment and Asset Management

Association

Abstract

This paper investigates retirees' optimal purchases of

fixed and variable longevity income annuities using

their defined contribution (DC) plan assets and

given their expected social security benefits. As an

alternative, we also evaluate using plan assets to boost

social security benefits through delayed claiming.

Using a calibrated life‐cycle model, we determine that

including deferred income annuities in DC accounts

is welfare‐enhancing for all sex/education groups

examined. We also show that providing access to

well‐designed variable deferred annuities with some

equity exposure further enhances retiree well‐being,

compared to having access only to fixed annuities.

Nevertheless, for those facing the highest mortality

rates, delaying claiming social security is mostly

preferred, whereas those anticipating living longer

than average will benefit more from using accumulated

DC plan assets to purchase deferred annuities.

KEYWORDS

annuity, delayed claiming, household finance, life‐cycle model,

longevity, retirement plan

Journal of Risk and Insurance. 2023;90:831–860. wileyonlinelibrary.com/journal/JORI

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831

This is an open access article under the terms of the Creative Commons Attribution‐NonCommercial License, which permits use,

distribution and reproduction in any medium, provided the original work is properly cited and is not used for commercial purposes.

© 2023 The Authors. Journal of Risk and Insurance published by Wiley Periodicals LLC on behalf of American Risk and Insurance

Association.

JEL CLASSIFICATION

G11, G22, D14, D91

1|INTRODUCTION

As the population ages, many argue that people will find increasingly attractive the opportunity

to purchase longevity income annuities, which are financial contracts between insured persons

and insurers providing income benefits for as long as the policyholders are alive. The US social

security program pays retirees a lifetime income annuity with fixed real benefits that depend on

peoples' earning histories as well as claiming ages. The program also offers the option to delay

one's claiming age, in exchange for a higher lifetime benefit thereafter. Accordingly, if a retiree

receives a substantial portion of her income through a social security annuity, it stands to

reason that her remaining financial portfolio should include substantial exposure to risky

equities, through a target date fund or with annuities whose payments are linked at least in part

to the performance of an equity portfolio. Since social security replacement rates are

progressive, they pay relatively higher benefits to lifetime low‐earners, and relatively lower

ones to lifetime high‐earners. As a result, low lifetime earners receiving higher replacement

rates may wish to devote a greater proportion of their remaining financial wealth to buying

risky equities, either through target date funds or direct stock holdings. Conversely, higher

lifetime‐earning retirees receiving a relatively low social security replacement rate may seek to

buy larger privately sold annuities using their tax‐qualified retirement accounts, to receive a

predictable income stream sufficient to cover later‐life necessities.

There have also been important regulatory changes over the last decade making purchases of

income annuities more attractive to retirees. US legislation in 2014 provided retirees an opportunity

to buy longevity annuities contracts using their assets held in tax‐qualified employer‐sponsored

defined contribution (DC) plans and Individual Retirement Accounts (IRAs), currently worth $21

trillion (Investment Company Institute [ICI], 2022). In 2019, the SECURE 1.0 Act gave plan

sponsors “safe harbor”rules if they offered such longevity protection in their investment menus,

which has heightened interest in such longevity protection products. A further push to make

income annuities more attractive was recently embedded in the SECURE 2.0 Act of 2022, which

boosted tax‐protected contribution limits for such products.

This paper focuses on how retirees can optimize household welfare by delaying claiming

and thus enhancing their social security benefits, versus buying longevity income annuities

using DC plan assets. Understanding how these two opportunities interact is of key importance

to generate efficient retirement portfolios. Additionally, we investigate whether there is

heterogeneity in the demand for longevity annuities across the retiree population, depending

on peoples' assets inside and outside tax‐qualified retirement plans, their mortality

assumptions, their accrued social security benefits, and longevity expectations. Throughout

this paper, we define a fixed annuity as a contract with constant lifelong payments in real

rather than nominal terms, as only the former are comparable to real social security payouts.

1

1

The idea of using deferred life annuities as an instrument to finance retirement is not new. For example, Milevsky

(2005) suggested using relatively small amounts of accumulated assets to purchase advanced‐life delayed annuities

paying real lifetime benefits, which he favored over a more costly single premium immediate annuity. The key

development in 2014 had to do with the tax treatment of qualifying life annuity contracts (QLACs), in particular, their

exclusion from the calculation of Required Minimum Distributions (RMDs).

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HORNEFF ET AL.