optimal distribution rules for defined contribution …...what can we learn from other countries?...
TRANSCRIPT
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Optimal Distribution Rules for Defined Contribution Plans:
What Can We Learn from Other Countries?
Professor Jon FormanUniversity of Oklahoma
Eighth International Longevity Risk and Capital Markets Solutions Conference
(Longevity 8)University of Waterloo
Waterloo, OntarioSeptember 7, 2012
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Outline
Defined Contribution Plans in the U.S & around the world
Longevity Risk Financial Products for Lifetime Income Optimal Distribution Rules
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Multi-pillar Retirement System
1st tier - Government pension 2nd tier - Occupational pension 3rd tier - Personal savings
Now, the 2nd and 3rd tiers are defined contribution plans and IRAs, not traditional monthly pensions
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A Simple Defined Contribution Plan
CONTRIBUTIONS
FUND BENEFITS
EARNINGS
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$
Stages of the Simple Economic Life Cycle Birth Age Age Death 20-25 60-65
Income
Consumption
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Tax Treatment of a Typical Defined Contribution Plan in the U.S. – eet
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CONTRIBUTIONS
FUND BENEFITS
EARNINGS
ZERO TAX ZERO TAX TAX
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Decline of Annuitization
An annuity is a financial instrument (e.g., an insurance contract) that converts a lump sum of money into a stream of income payable over a period of years, typically for life.
In 2010, for example, just 18 percent of private industry workers in defined contribution plans had annuities available to them.
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The Annuity Puzzle
People rarely choose to buy annuities voluntarily Financial literacy is low Bequest motive Adverse selection Social Security Little savings
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Australia - Superannuation
Age Pension Means-tested e.g., AUD$689 every fortnight for singles
Superannuation 9% of pay, going to 12% Lump sum distributions, not annuities
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Tax Treatment of a Typical Individual Account in Australia – tte
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CONTRIBUTIONS
FUND BENEFITS
EARNINGS
15% TAX 15% TAX ZERO TAX (payable by the fund) (from age 60)
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Annuitization Successes around the World
Chile – 2/3 of universal 10% DC plan participants purchase annuities
Switzerland – 80% annuitize default & peer effects
United Kingdom – must annuitize at least 75%
Singapore – moving towards mandatory annuitization
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Longevity Risk: People in the U.S. are Living Longer
Year Life expectancyat birth
Life expectancyat age 65
Men Women Men Women1960 66.7 73.2 12.9 15.92000 74.0 79.4 15.9 19.02010 75.8 80.5 17.5 19.92040 79.3 83.3 19.8 21.72080 82.9 86.4 21.9 23.8
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Lifetime Retirement Income Products
Systematic withdrawals Lifetime annuities Longevity insurance Guaranteed lifetime withdrawal
benefits
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SYSTEMATIC WITHDRAWALS
e.g., the 4 percent rule Set spending at 4% of savings Invest in a 50/50 stock/bond portfolio Each year, increase spending to keep up
with inflation e.g., $1,000,000 nest egg $40,000 in the 1st year $41,200 in the 2nd year (~ 3% inflation) etc.
Some possibility of running out of money14
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Lifetime Annuities
Depending on the retiree’s age, can provide cash flows of 7% of funds invested e.g., a 65-year-old man who purchased
a $100,000 immediate, level-payment annuity in 2011 – $6,732/year (6.73%)
65-year-old woman – $6,264/year (6.26%)
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Inflation-adjusted Annuities
Annual payouts start lower but can end up higher Level payment annuity $6,732/year for a 65-year-old man
Annuity with a 3-percent escalator $4,944 in the 1st year More in later years
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Longevity Insurance (e.g., Deferred Annuities)
e.g., a 65-year-old man could invest $100,000 in a deferred annuity & beginning at age 85, he would get $25,451/year
Instead, start at age: 80, get $17,069/year 75, get $11,649/year 70, get $8,133/year
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GUARANTEED LIFETIMEWITHDRAWAL BENEFITS (GLWB)
Variable annuity invested in a portfolio of stocks/bonds/etc. Portfolio grows (or shrinks)
Retirement: Guaranteed withdrawals Payouts come from the invested funds If funds are ever depleted due to long
life and/or poor investment returns, the guaranteed minimum kicks in
If funds do well, payouts can increase
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GLWB continued
The guaranteed withdrawal rate is determined at the time of the sale It might be set at between 4% & 6%,
depending upon the age when withdrawals are set to begin
Disadvantages Complicated Can have annual costs that exceed 3% Rarely have an inflation adjustment
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OPTIMAL DISTRIBUTION RULES
Encouraging annuitization Mandatory annuitization Up to the poverty level
Defaults Require DC plans to offer annuities Default participants into annuities
Financial education annuity values on benefit statements
Asset tests in public programs20
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OTHER THINGS GOVERNMENTCAN DO
Encourage workers to save more Help workers invest better Preserve benefits until retirement Raise the retirement age Make it easier to annuitize housing
and other forms of wealth
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About the Author Jonathan Barry Forman (“Jon”) is the Alfred P.
Murrah Professor of Law at the University of Oklahoma College of Law and the author of Making America Work(Washington, DC: Urban Institute Press, 2006).
Jon was the Professor in Residence at the Internal Revenue Service Office of Chief Counsel, Washington, DC, for the 2009-2010 academic year.
Jon can be reached at [email protected], 405-325-4779, www.law.ou.edu/faculty/forman.shtml.
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