The U.S. Government Accountability Office (GAO), a non-partisan federal agency focused on reducing wasteful government spending, has released a report entitled Ensuring Income throughout Retirement Requires Difficult Choices. The two most important choices involve:

1. Delaying the age when you elect to start receiving Social Security payments; and
2. Converting your cash-balance defined benefit pension into a lifetime income annuity rather than take a lump-sum payment upon retirement.

Social Security is Not Enough for Retirement

For those of you that think Social Security will meet your retirement needs, wake up! Given the massive debt overhanging the U.S. economy, the current generous benefits being paid out to retirees is not sustainable. As the GAO report states:

The cost of Social Security benefits is projected to exceed sources of funding, and the program is projected to be unable to pay a portion of scheduled benefits by 2036. In 2010, for the first time since 1983, the Social Security trust funds began paying out more in benefits than they received through payroll tax revenue.

Due to the long-term fiscal challenges facing Social Security, options for reform may result in lower benefits and reduced replacement rates from Social Security. As a result, reforms to the Social Security system may increase the need for retirement income from other sources such as private pensions.

Even under the current generous benefit schedule, social security cannot be relied on to fully replace a person’s pre-retirement salary. According to the GAO report, for low-wage earners (i.e., 45% of national average) social security replaces only 55.2% of pre-retirement income and for high-wage earners (i.e., 160% of national average) the replacement rate is only 33.9%. 

Do Not Elect to Receive Social Security Early

Pretty depressing, but even these replacement numbers are only valid if you delay receiving Social Security benefits until you are eligible to receive full benefits. For people born after 1960, full benefits don’t accrue until you reach the age of 67. Although you can elect to start receiving benefits at 62, you receive 25% less per month than you would if you waited until the full retirement age of 67 and 57% less than you would if you waited until age 70.

Unfortunately, our instant-gratification culture has resulted in the vast majority of retirees electing to receive Social Security benefits early, thereby significantly reducing their payments. According to the GAO report, 43.1% elect to take Social Security benefits at the first available opportunity upon reaching the age of 62. Even more astounding, 85.9% of retirees start taking benefits before they reach full retirement age!

If you don’t expect to live very long in retirement, taking early benefits makes sense, but most people are living a long time after retirement – sometimes decades. A husband and wife both aged 65 have a 47 percent chance that at least one of them will live to a 90th birthday and a 20 percent chance of living to a 95th birthday. The extra cash you get between ages 62 and 67 begins to be outweighed by the value of the full-benefit payments you would receive by waiting until 67 if you survive retirement over a 12-year or longer period.

Lifetime Annuities Are an Important Part of Retirement Planning

The other big piece of advice in the GAO report is that middle-class retirees should convert at least half of their retirement savings into a lifetime income annuity. I wrote about the importance of lifetime income annuities in Retirement Investing Part 4: Product Allocation and Sequence of Returns Risk. An annuity pays out for as long as you live — and even longer if you accept a lower payout in exchange for a spousal survivorship benefit or the guaranteed return of your initial cash investment. Furthermore, annuities offer higher payouts than you could get investing the money yourself because recipients receive “mortality credits” from the other annuity participants who die early. Other benefits of annuities – besides higher payments – are insurance against general stock market declines and stupid individual investment decisions, as well as freedom from the burden of managing your own investments as you get older and less capable.

According to the GAO report, a majority of people with defined benefit retirement plans choose to annuitize at least a portion of their retirement cash balances rather than take a lump sum. The problem is that only a third of retirees have defined benefit plans (and most of these are in the public sector). The remaining two-thirds of workers either don’t have access to a retirement plan or are limited to a defined contribution plan like a 401K. And the vast majority of employers that offer these 401K plans are not offering an annuity option. A main reason for employer reluctance is uncertainty over whether the employer would remain liable for retirement payments in the event that the annuity provider fails. The U.S. Treasury Department has promised to remove this employer-liability uncertainty in new regulations to be released soon.

Retirement Education About Annuities is Needed

Of course, even if an employer retirement plan only offers a lump-sum payment, retirees can go to an insurance company and buy their own annuity. However, statistics show that most retirees who are required to put in the effort themselves to find an annuity do not do so. Impediments include a lack of financial education about the benefits of annuities, the lower payments available to individuals outside of company-sponsored annuity plans, and minimum-distribution requirements in 401K plans after age 70 and ½. that make deeply deferred annuities non-compliant.  J. Mark Iwry, deputy assistant Treasury secretary for retirement and health policy, recently announced that the Obama administration wants to “make options for annuitized income more attractive than lump sums,” so hopefully many of these regulatory impediments will not exist much longer.

With regard to financial education, a bill is stalled in Congress entitled the “Lifetime Income Disclosure Act” (S. 267 and H.R.677) that would require employers to provide employees with information on what their lump-sum retirement distributions would look like in annuity form. Keep in mind that this legislation would not require 401K plans to offer an annuity option, but requiring annuity education is better than nothing! There are also bills (S. 2577 and H.R. 4049) that would direct the Treasury and Labor Departments to conduct a study on the feasibility of including a lifetime income annuity option to “automatic IRA” plans.

U.S. Retirement System Does Not Measure Up to World Standards

Taking a global view, the U.S. retirement system is below average. According to the Melbourne Mercer Global Pension Index, The U.S. ranks 9^th out of the 18 countries evaluated with an index value of 59.0, which is below the average value of 61.0:

An “A” rating, which signifies a “first class and robust” pension system, requires a score of 80 or above, something only Denmark was able to achieve. To receive a “B” rating, which means the pension system has a “sound” structure, the minimum score is 65. The U.S. ranks in the “C” rating category (between 50 and 64.9), which is described as:

A system that has some good features, but also has major risks and/or shortcomings that should be addressed. Without these improvements, its efficacy and/or long-term sustainability can be questioned.

Because some data is imprecise, pension systems with rating differences of less than two points should be considered equivalent. Also keep in mind that while the United Kingdom’s pension system is rated higher than that of the U.S., the U.K.’s “sustainability” index value is only 46.5, so the chances of its rank remaining higher than the U.S. in the future are small. However, the U.S. pension system’s sustainability sub-index value is getting worse, falling slightly from 59.0 in 2010 to 58.4 in 2012.

Bottom line: relying on the U.S. social security pension system to provide adequate monthly income for one’s entire lifetime is a bad bet given the country’s huge debt load and trillion-dollar fiscal deficits. Converting at least a portion of a lump-sum retirement-plan payout into a lifetime income annuity may substantially increase the odds of achieving a comfortable retirement.