Retiree Pension Payout Decisions Evidence from the Health and Retirement Study,

Transcription

1 Retiree Pension Payout Decisions Evidence from the Health and Retirement Study, Mark M. Glickman and Gene Kuehneman, Jr. U.S. Government Accountability Office * ABSTRACT The decisions that retiring workers make about how and when to draw down their pension plan assets determine in part whether they will have income that lasts throughout retirement. Individuals will need pension and other retirement income to sustain them over a longer period of time than in the past. Moreover, the continuing trend towards pension plans with individual accounts, which may not offer the option to take a life annuity as traditional pensions do, has increased participants' responsibility for managing their pension assets during retirement. Recent data show that about half of private sector workers who participated in defined benefit (DB) plans had a lump sum option at retirement, and over a third of their counterparts in defined-contribution (DC) plans had an annuity option. We use the waves of the Health and Retirement Study (HRS) to analyze the pension disposition choices employees make at retirement. We find that over the period most retirees chose to annuitize their pension benefits, although they increasingly selected benefit payouts other than or in addition to annuities. About 60 percent of retirees received annuities, 40 percent chose to directly roll over their lump sum benefits into an IRA or to defer their receipt by leaving them in the plan and 14 percent received a cash distribution. Restricting the analysis to retirees whose plans offered a choice of payout, 44 percent received annuities, 55 percent directly roll over their lump sum benefits into an IRA or deferred their receipt by leaving them in the plan, and 22 percent received a cash distribution. A logistic regression analysis of retirees with a choice of payouts indicates that participation in a DB plan explains much of the variation in the decision to annuitize by our sample of retirees. Because DB benefits are typically quoted in terms of income and DC benefits as a lump-sum account balance, this may indicate a reluctance of retirees to change the form of their benefits from how they are quoted. While few DC participants chose to annuitize their benefits, the annuity-equivalent price of benefits was strongly correlated with the decision to annuitize. JEL classification: J32; H55 * Senior Economists, Education Workforce and Income Security Issues, U.S. Government Accountability Office. Contacts: glickmanm@gao.gov, kuehnemang@gao.gov. The views expressed in this paper are those of the authors and do not necessarily reflect those of the U.S. Government Accountability Office. All remaining errors are the responsibility of the authors. 1

2 Introduction The decisions that retiring workers make about how and when to draw down their pension and retirement savings plan assets determine in part whether they will have income that lasts throughout retirement. Individuals are living longer on average once they retire and will need pension and other retirement income to sustain them over a longer period of time than in the past. Moreover, there has been a marked trend away from traditional defined benefit (DB) pension plans, which typically guarantee a stated level of income for life, towards defined contribution (DC) plans, in which participants accrue benefits in individual accounts. This trend has made participants more responsible for managing their pension assets during accrual and retirement. 1 Increasingly, retirees have access to their pension and retirement savings plan assets and the flexibility to choose how and when to invest and draw down these assets. The type of pension or retirement savings plan workers participate in could influence the benefit payment options they have available. Private employers may sponsor DB or DC pension plans for their employees. DB plans must make available a joint and survivor life annuity to retiring participants a series of periodic payments that begin at retirement and continue through the life of the participant (or other specified period) and at the death of the participant, to the surviving spouse. These plans may also offer a lump sum a cash amount as an alternative payout option to the annuity. While some DC plans are required to make available a joint and survivor annuity, 2 DC plans typically make benefits available as a lump sum 3 (i.e., the participant s account balance) or installment payments periodic withdrawals paid until account balances are exhausted. DC plans may offer to purchase an annuity. DB plans and DC plans fundamentally offer different benefits and risks to employees and sponsoring employers, in terms of participation, accrual of benefits, and asset management risk. DB plans offer a guaranteed benefit, and the employer is responsible for managing pension plan assets to assure the payment of these benefits. With DC plans, in contrast, individuals typically shoulder of responsibility of contributing to and managing their accounts, with many employers also contributing regularly. DC plans offer more flexibility and portability to employees, who may hold onto accrued account balances after leaving an employer, whereas DB plans typically reward workers who stay with a single employer for a long time. Whereas DB plans offer near universal participation to workers, employees do not necessarily participate in DC plans. 1 DB plans promise to provide a benefit that is generally based on an employee s salary and years of service. Under a DC plan, employees have individual accounts to which the employer, employee, or both make periodic contributions. DC plan benefits are based on contributions to and investment returns on individual accounts, and participants may access their accounts before, at, or during retirement. 2 Certain DC plans are required to make an annuity payout option available to participants. These plans are called money purchase plans. 3 In this report, we refer to lump sums as any pension disposition in which benefits are distributed as a stock of wealth, as opposed to a flow of income. Upon retirement, lump sums may be received directly by participants as cash settlements, rolled over into individual retirement arrangements (IRAs), or kept in the plan itself. 2

3 The form in which workers receive their pension benefits also offer distinct risks and advantages, with different implications for retirement security. A life annuity, whether received from a plan or purchased, generally provides insurance that a retiree will not run out of income no matter how long he or she lives. However, if a retiree dies soon after choosing or purchasing an annuity, he or she would likely receive considerably less than if he or she had taken a lump sum and will be unable to leave that asset as a bequest. Also, income from fixed annuities may not be adequate to pay for unexpected large expenses or provide protection against inflation. 4 Retiring participants who receive lump sums have the flexibility to preserve or draw down these assets as they wish, but could risk running out of pension assets if they live longer than expected, draw down assets too rapidly, lose tax-preferred status on their savings, or suffer poor investment returns on their assets. Events this decade have offered high-profile examples of the distinct risks of DC and DB pension plans. The collapse of Enron Corporation in 2001, and with it much of the value of its employees 401(k) plans, illustrated the risks of having employees manage the investment of their retirement savings, and in particular the hazards of overinvestment in employer stock. However, the recent termination of several large underfunded DB plans, concentrated in the airline and steel industries, which resulted in reduced benefits for many employees, showed that DB pension benefits are not a sure thing. They depend on the health of the sponsoring company, and perhaps that of the Pension Benefit Guaranty Corporation (PBGC), the federal insurer of private DB benefits whose single-employer pension insurance program was $23 billion in deficit as of the end of September This paper uses questions from the University of Michigan s Health and Retirement Study (HRS) to determine the form in which recent retirees covered by a pension have chosen to receive benefits. We examine the pension choices of 1,798 HRS respondents who reported that they left a job with pension benefits between 1992 and 2002 in order to retire. Of these retirees, we focus on the 1,073 retirees whose pension plans offered them a choice of how they could receive benefits. Finally, we use logistic models to determine what factors most influenced retirees to make a particular disposition of pension benefits. 4 Certain life annuities that plans and insurance companies may offer are available to address such needs. For example, life annuities with guarantee periods or refunds that pay the remaining balance to a beneficiary if an annuitant dies, as well as annuities that offer inflation protection are available. 5 The deficit figure measure the excess of the net present value of Peg s single-employer program s future benefit payments to participants of terminated plans, plus expenses, over the program s assets. PBGC operates a single-employer insurance program and a much smaller multi-employer program. The multiemployer program insures the DB benefits of many collectively-bargained contracts and was reportedly $335 million in deficit as of September 30,

4 Previous Studies Several other studies have used the HRS to answer questions about pension behavior and policy. Gustman and Steinmeier, in various studies, use the HRS to understand better the nature and definition of retirement, concluding that retirement has become almost fluid in recent years, with retirees shifting between various states of work and non-work. Engelhart (2001) uses the HRS to determine that pre-retirement lump-sum distributions have not resulted in significant erosion of wealth. Brown (2001) uses the HRS to examine the reasons for annuitization among participants in DC plans; he finds that an individual s annuity-equivalent wealth, or the premium over actuarially fair pricing an individual would be willing to pay for an annuity, is a key determinant in the annuitization decision, along with the individual s health status and financial time horizon. Brown and Warshawsky (2001) find that the shift from DB plans to DC plans among workers has caused a drop in annuitization rates. This is because fewer DC plans offer the option to annuitize benefits, and those that take lump-sum distributions would need to annuitize their savings on the private market, with prices that are skewed by adverse selection. Most directly related to this study, Panis and Hurd (2003) and GAO (2003) use the HRS to examine cash-out behavior by retirees. Panis and Hurd find that only 31 percent of pension entitlements settled their pension with a lump-sum distribution, and only about half of these cash out (thus losing the tax preferences they would have kept had they rolled the pension proceeds into an IRA). GAO (2003) focused on those HRS respondents from the waves who report leaving a job they held in the previous wave to retire. They found that retirees increasingly selected benefit payouts other than annuities. Retirees who received benefits from DB plans were most likely to receive annuities, while those who received benefits from DC plans were most likely to roll over benefits into an IRA or to defer receipt. In a related study of retiree satisfaction related to pension choice, Panis (2003) also has found that retirees choosing to annuitize express higher satisfaction with their lives than those that receive their pensions in other forms. In addition, several private institutions have conducted their own surveys of retiree pension disposition decisions. A 2004 study by Prudential found that 80 percent of working people with DC plans prefer to convert all or some of their pension savings into an income stream, instead of keeping all DC balances in lump-sum form (Prudential 2004). The study attributes this preference to people s familiarity with earning an income and living on a periodic budget during their working years. These preferences, however, were reflected in survey responses about future behavior, rather than in actual reported behavior. A study by the Investment Company Institute found that 32 percent of retirees with DC plan assets who could take benefits as an annuity chose this option, whereas 49 percent took a cash settlement and 38 percent elected to defer their benefit distribution (Investment Company Institute 2000). 4

5 Pension Coverage and Benefit Disposition Options According to the Employee Benefit Research Institute (EBRI), 6 of the million Americans working in 2004, 81.2 million had pension benefits through their employer; of these, 63.9 million, or about 42 percent of workers, participated in that plan. Because most full-time workers working for a DB sponsor are automatically enrolled in their plan, DC plans account for almost all of the non-participation in available plans. A higher percentage of public sector workers between the ages of participate in a plan, 75.8 percent, than do working-age private sector workers, 43.0 percent. For retirees, pensions represent an important component of income, representing about 19 percent of income age 65 and over. By comparison, about 39 percent of income for persons 65 and over came from Social Security income in 2002, 19 percent of their income came from pensions (Social Security Administration, 2004). One undeniable trend in pension coverage data is the decline of DB plans and rapid expansion of DC plans over the last 25 years. As of 2004, 44.4 million people, including retirees and separate vested workers, participated in approximately 31,000 DB plans sponsored by private-sector firms; these plan benefits are ensured, up to certain guarantee limits, by the Pension Benefit Guaranty Corporation (PBGC). 7 While the number of private sector DB participants has inched upward by about 1 percent per year since the late 1980 s, the number of tax-qualified plans has fallen from over 112,000 in the late 1980s to 31,000 in Further, PBGC coverage pool is aging: the ratio of active workers (workers participating in their current employer s plan) to retirees covered by PBGC-insured DB plans has also fallen steadily over the last two decades. As of 2004, active workers made up less than half of this population, with retirees comprising more than 25 percent (PBGC 2005). This compares with the doubling of tax-qualified DC plans sponsored by private employers from 1979 to 2000, from 331,000 to approximately 686,000. Over the same period, DC plan participation among active workers grew from 14.4 million to 50.9 million (EBRI 2005). According to the Bureau of Labor Statistics, 42 percent of private sector workers participated in a DC plan in 2005, compared to 21 percent in DB plans. According to Federal Reserve Flow of Funds data, in 2004 private DB plans had $1,811 billion, while DC plans had $2,662 billion; as recently as 1995, DB plans had more financial assets than did DC plans (Board of Governors 2005). Regarding the disposition forms available to workers, as of 2000 the BLS reported that all private sector workers who participated in DB plans had an annuity option available at retirement, while only 38 percent of their DC counterparts had this option. Almost all private sector workers who participated in DC plans (94 percent) had a lump sum option available and just under half (48 percent) of their DB counterparts had this option available. Additionally, over half of these workers in DC plans had an installment 6 Pension information is difficult to obtain because there are different repositories of information for DB vs. DC plans and private vs. public sector plans. In addition, the source of much pension information is the sponsors Form 5500 tax filings, which sponsors can file long after the end of a plan year and require a long time to process, with the result that publicly available pension information is frequently old. The U.S. Government Accountability Office has recently issued a report on timeliness issues with Form 5500 pension information (GAO 2005). 7 For plans taken over by the PBGC in 2005, this limit is $45,616 per year in benefits for a 65-year old. 5

6 payment option (55 percent) available. A study by the Investment Company Institute of DC participants between 1995 and 2000 reported that 70 percent of these retirees had multiple disposition options at retirement; of these, 94 percent reported they could take a lump-sum distribution, and 72 percent said they could take benefits as an annuity. Table 1: Various Pension Plan Statistics DB Plans DC plans Private sector participants 44.4 million (2004) 50.9 million (2000) Private sector plans 31,000 (2004) 686,000 (2000) % of private sector 21% (2005) 42% (2005) participating Total financial assets $1,811 billion (2004) $2,662 billion (2004) Annuity available 100% (2000) 38% (2000) Lump sum available 48% (2002) 94% (2000) Sources: Bureau of Labor Statistics, PBGC, Federal Reserve Why Do Retirees Choose to Annuitize or Not? Model Like other studies that have examined the disposition form of retiree pension wealth, this paper fundamentally extends from Yaari s seminal 1965 work, which concludes that in the absence of a bequest motive a rational person would annuitize all of her wealth at actuarially fair prices. Since then, various studies have abstracted from Yaari s basic model to explain why we observe pensioners who annuitize only partially or not at all. Our empirical analysis of retiree annuitization decisions derives from a simple lifecycle model of the behavior of a potential retiree who has pension wealth that can be accessed only upon retirement. The individual maximizes expected utility from lifetime consumption starting at retirement at time τ over his remaining lifespan, given personal characteristics X: subject to wealth constraints = T ( t τ ) β U ( c t t ) * pt / X τ it (1) W + τ = W p + Wa Wl (2) where β is the personal discount factor, c t is periodic consumption, T is the maximum attainable age, p t represents the probability of the retiree being alive in period t, W p is pension wealth, W a non-pension annuitized wealth, and W l non-pension lump-sum wealth. The vector X it describes not only characteristics of the retiree, but also external factors such as economic variables, plan characteristics, etc. We assume that at retirement the retiree can convert an amount of lump-sum pension wealth L l into a stream of constant annuitized benefits A per period, starting at retirement: T t L = p A(1 + ), (3) t t r = τ t 6

7 or a unit price Pτ in terms of lump-sum wealth foregone to produce a $1 immediate life annuity benefit starting at time τ of LA P τ = ) T p ( t t 1+ r = τ τ t (4) where r τ is the market interest rate at the time of retirement. In addition to actuarially fair pricing, we assume the annuity benefits are indexed to inflation, with no joint or survivor benefits, and are irreversible once taken. At retirement, a retiree with pension benefits accrued in annuity form can convert this stream into a lump sum at the same conversion rate. In the absence of other wealth, a retiree annualizing all pension wealth would face a constant consumption constraint until death, with no wealth to bequeath to heirs. As Hurd (1987) and others have shown, the mortality hazard in the annuity price creates a consumption premium for annuities, compared to the budget constraint in the absence of annuities. Thus, a retiree with a sufficiently small discount rate, access to an actuarially fair annuities market, and no bequest desire would choose to annuitize all pension wealth in order to maximize utility. Of course, these assumptions generally do not hold true in the real world. Adverse selection in private annuities markets greatly reduces the chances of getting an actuarially fair annuity price, and most people express a desire to leave bequests. 8 Further, as Hurd and Panis (2003) illustrate, a declining optimal consumption path (from a sufficiently high personal discount rate) reduces the marginal utility of additional annuity income. Thus, the presence of other annuitized wealth at retirement, such as Social Security benefits, may also reduce the marginal utility of taking pension benefits as annuities, as the utility premium for future consumption declines relative to the value of current consumption. In the presence of these market implications and preferences, the retiree would maximize utility by annualizing pension wealth until the marginal rate of substitution of annuitized wealth for non-annuitized wealth equaled the annuity price available to the retiree: T ( t τ ) β p U t ( ct ) LA t= τ P τ = (5) U ( cτ ) or, if we assume actuarially fair annuity pricing, 8 We would expect adverse selection to be less of a market impediment for group annuities, such as those disposed directly from employer plans. See Poterba (2001) for more on adverse selection in private annuities markets. 7

8 T t= τ p t ( 1+ r) t = T t= τ β ( t τ ) U p U t ( c ) τ ( c ) t (6) At the margin, in other words, the tradeoff of the gained marginal utility from additional annuitization for the loss of utility from foregone lump-sum wealth equals the annuity price at equilibrium. To the extent that the annuity price P LA τ an individual faces differs from actuarially fair pricing, or the individual believes that his life expectancy (reflected in p t ) differs from the mortality hazard used in the annuity pricing, this will alter the optimal proportion of annuitized wealth from the actuarially fair pricing scenario. Several other factors may cause a rational retiree to take at least part of his pension wealth as a lump sum, either through affecting the relative monetary value of annuities vs. lump sum wealth, personal preferences that affect the marginal rates of substitution between these options, or external constraints. 9 o Mortality perceptions (or inside mortality information). If a retiree has private information about his life expectancy (say, family history or the presence of a disease), this will alter the value of an annuity and represent an arbitrage opportunity with respect to an actuarially-fair annuity price for a pool of retirees. Further, because some plans must use a unisex mortality table in converting lump-sum benefits to annuity value, men (with generally lower life expectancy than women) may actually receive an annuity premium above what would be actuarially fair. o Marital status. Families may be able to pool longevity risk better than individuals, and hence we might expect married persons to value annuities less highly than single retirees. o Liquidity constraints. Since receiving an annuity requires the foregoing of a lump sum, large expenses (such as health care expenses) may present liquidity constraints to an annuitant. Greater concern over or perceived likelihood of such potential expenses may cause a retiree to prefer lump sums. o Option value of lump sums and risk preference. Retirees differ in how they value an actuarially fair annuity path, depending on tolerance for risk, the expected return on self-invested assets, the inherent value of the longevity insurance provided by annuities, or the option value of holding onto a lump sum (perhaps if the individual feels he can earn a higher return on investment than that implicitly provided by the annuity). Alternatively, the perceived risk of converting one s assets into an irreversible annuity and then dying prematurely may outweigh the perceived risk of outliving one s retirement assets. 9 Brown (2000) discusses many of these factors that may influence annuitization decisions. 8

9 o Inflation. Most annuities do not adjust periodic benefits for inflation, and hence the real value of benefits declines as the retiree ages, providing uncertainty about the sufficiency of pension wealth to sustain consumption. Holding assets in lumpsum form may allow the retiree to invest them in order to earn an inflationadjusted return, such as equities may provide. o Perception of wealth. Some retirees may be influenced by the perception that a seemingly large stock of wealth in lump-sum form, as accrued DC benefits are typically quoted, is more valuable than smaller periodic streams of income, even if the two are actuarially equivalent in present value terms. Such a perception would tilt retirees toward lump-sum distributions. o Plan defaults. Recent studies (Choi et al, 2001) have shown the powerful effects of a plan s default options in employees participation in and management of pension plans. Similar defaults regarding the distribution of plan assets might also drive pension dispositions, with DB benefits (typically quoted in terms of annuitized income) likely received as annuities and DC benefits (typically quoted as an account balance) as a lump sum. o Lumpy disposition choices. It may be impossible, or very costly, for an individual to take a single pension benefit partly as an annuity and partly as a lump sum, leading to all-or-nothing dispositions. Data Set Issues and Assumptions Used in Empirical Analysis The HRS is a panel data set that asks questions of the same from respondents every two years starting in The most recent compiled survey that we used for our report was 2002, and thus we used data from 6 questionnaires, or waves, from 1992 to The HRS questions are broken into different topics. Employment issues usually covered three sections in each HRS wave: a main employment section, a section on the respondent s last job, and one on the respondent s job history. We relied on information exclusively from the main employment section, because this section covered any job that the respondent had during the prior wave and allowed us to pinpoint those that had retired, in accordance with our definition below. In addition, the section on the respondent s last job sometimes asked questions only of the respondent s spouse, and thus didn t provide consistent data on the respondent. We do not use information from the job history section because we are unable to tell from these questions if the pensioner had a choice of payout form for each pension (see section on Choice below). Thanks to its target demographic group (primarily people born between 1931 and 1941, although the HRS has added several other cohorts), the HRS provides a rich source of data to examine questions regarding retirement. Our analysis employs several key assumptions, primarily concerning the definition of the sample of retirees, the categorization of pension dispositions (across different responses in the HRS survey and across different plan types), and the decision of which retirees can choose among different pension disposition options. 9

10 Defining Retiree Based on the information the HRS provides, we choose to define retiree as someone who reports that they left a job since the previous wave of the HRS in order to retire. For example, in Wave 3 we consider someone as retired in that wave if they report that they left a job that they had in Wave 2 in order to retire. The HRS asks this question at various points in each wave regarding workforce status, and we compiled information at each such point. We thus compile a data set of four waves of retirees, starting with those who retire in Wave 2 through Wave 6. We only consider the first such retirement for each respondent later retirements are not counted. 10 The HRS also provides an alternative way to define retiree, which is based on a self-reported labor market status by the respondent, which we do not use for our sample because we focus on recent retirees. Benefit Disposition Categories For each respondent in each wave who reports disposing of a pension, the HRS asks a series of questions about the form in which the respondent received his or her pension or pensions. The response choices differ for those who participated in a DB and DC plans. For DB participants, the HRS asks if respondents 1) expects future benefits; 2) are receiving benefits now; 3) received a cash settlement; 4) rolled benefits into an IRA; or 5) lost benefits. For those with DC plans, the survey asks if the respondent 1) withdrew the money; 2) rolled assets into an IRA; 3) left plan assets to accumulate; or 4) converted assets to an annuity. We group these responses into four disposition categories that combine DB and DC participants: 1) Annuitize. This group includes DB respondents who said they are receiving benefits and DC respondents who said they took benefits as an annuity. 2) Take a cash settlement. This comprises DB respondents who said they took a cash settlement and DC respondents who said they withdrew the money from their accounts. 3) Roll benefits over. This group includes DB and DC respondents who said they rolled benefits or assets into an Individual Retirement Account (IRA). 4) Defer benefits. This last group includes DB respondents who said they expect to receive benefits in the future and DC respondents who said they left plan assets to accumulate. For the first three disposition categories, the form of the pension payout is similar for DB and DC plan holders. There may be differences for DB and DC participants who defer benefits at retirement. DB participants may elect not to take benefits upon retirement if they are retiring before the age at which they could collect full benefits (the normal retirement age ), and may elect to wait until they can. DC participants, on the other hand, simply leave their accrued account balances under the management of the employer plan; this decision is not materially different than rolling the balances over to an IRA. We do not observe if either DB or DC participants in this category eventually 10 This discrete definition of a one-time and permanent retirement may conflict somewhat with the findings of Gustman and Steinmeier (2001), who determine from the HRS that there may be considerable flows between states of full-time work, partial retirement, and full retirement. Further, they find considerable variation in measured retirement depending on the particular definition of retirement. 10

11 decided to annuitize all or part of their benefits. We compile this information for each retiree in each wave and then merge the information for the entire period. We also keep track of the number of dispositions in each category, since several retirees make more than one disposition, as well as total dispositions and total dispositions by DB or DC. For each pension, we also record the amount of benefits. Disposition Choice Among Different Payout Forms For our analyses, we need to know which retirees had a choice regarding the form of their pension benefits, as opposed to having to take them in a specific way. Since all DB plans must offer an annuity, we use the HRS to determine which DB participants could choose a lump-sum distribution, and therefore had a choice of options. However, it does not ask DC participants, who almost universally have a cash settlement or rollover option available to them, if they had the option to choose benefits as an immediate annuity. We reason that because all DC participants have the option to use their accrued benefits to purchase an annuity, we consider all DC participants as having a choice of pension dispositions, imperfect as this definition might be. Unfortunately, the HRS asks only DB participants who took benefits as a cash settlement what they did with the cash, so we do not know for sure if DC participants who purchased an annuity would categorize this disposition as a lump-sum distribution or an annuity purchase. This assumption for DC participants makes it likely that we undercount DC participants who annuitize benefits. However, the private market for individual immediate annuities is considered to be small. Poterba (2003) reports that about $6 billion of non-qualified, immediate annuities are purchased in the United States annually. 11 We define choice of pension disposition as the option to take a pension in lump-sum form or as an annuity. We include in this definition: all DC participants, because all of these people have the option to take a rollover IRA, almost all have the option to take a cash settlement, and all have the option of purchasing an annuity on the private market. 12 DB participants who annuitize and who report in the prior wave that they had the option of taking a pension as a lump sum or in installments. DB participants who take a cash settlement or IRA rollover, because almost all DB plans must offer an annuitized payout of benefits. Thus, the only retirees we categorize as not having a disposition choice are: 1) DB participants who elect to receive an annuity and who, in the previous wave, report that this plan did not offer a lump-sum distribution; 2) DB participants who report deferring taking benefits upon retirement and who, in the previous wave, report that this plan did not offer a lump-sum distribution; and 3) DB who report taking a cash settlement worth 11 Poterba estimates that the size of the group annuity market is comparable to that for individuals. 12 It is not entirely clear that if a respondent were to use a cash settlement to purchase an annuity if that person would classify his pension disposition in the HRS as a cash settlement or as an annuity. Because the option is available and some might classify this as annuity in the HRS, we choose to count all DC retirees as having a choice. This likely undercounts DC annuities and over counts DC cash settlements. 11

12 less than $5000 ($3500 before August 1997), because employers can force participants with such de minimus accounts to take a cash settlement, even if otherwise they would have to offer an annuity from the plan. We also remove from our data set any responses that claim pension benefits in annuity form that exceed the legally-allowed limit for qualified plans ($160,000 per year as of 2002). We also limit our sample to those who retired at the age of 50 or older because younger retirees would almost certainly have reduced DB benefits if they elected to take them upon retirement. Finally, we note that other economists using the HRS for studies have noted the likelihood of mistakes in the data, either from participants who are uninformed or unaware of their pension plans or choices, or from inconsistencies in responses from year to year. We attempt to make sure that responses are consistent in any given survey year and remove any subjects from our data set if we cannot reconcile any discrepancies. When possible, we also use several variables that RAND constructed by cleaning up and combining responses from across HRS waves. Pension Disposition Statistics All Retirees, With One or Multiple Payout Options Our results on dispositions from 1992 to 2002 shows a surprisingly high percentage of retirees who took their pension benefits in the form of an annuity, though those taking an annuity overwhelmingly participated in a DB plan. As Table 2 below shows, over 60 percent of the entire HRS retiree sample who had pension benefits received them as an immediate annuity, with the annuitization rate changing very little over the period. However, less than 8 percent of those with a DC plan choosing an annuity, also a rate that remained fairly constant except for a temporary uptick in wave. Only about 14 percent of our sample reported cashing out pension benefits. About 15 percent of retirees report rolling over their pension proceeds to an IRA, with the majority of these coming from retirees DC plans. About 25 percent left their benefits in the plan, again with most of these dispositions coming from DC plans. Note that a retiree may have multiple pension dispositions, and hence the percentages add up to greater than 100 percent. 12

13 Table 2: New Retirees Pension Dispositions (Percent of Retirees, Except Where Indicated) Size of disposition (2001 $), Retirement Period Left job to retire (N) 2, Made pension disposition from that job Had DB plan only Had DC plan only Had DB and DC Annuitized Benefits Among DB 76.5 $1, Among DC 7.6 $2, Cash Settlement Among DB 10.7 $132, Among DC 15.0 $48, Direct rollover to IRA Among DB 3.7 $246, Among DC 34.4 $125, Benefits Left in Plan* Among DB 15.7 N/A Among DC 38.3 $142, Retirees Making Multiple Dispositions Source: Authors analysis of HRS, Sums of sub-categories may exceed 100 percent because some respondents report multiple pension dispositions. * Includes respondents who report that they expect to receive DB plan benefits in the future or reported leaving their assets in a DC plan account. Compared to national averages, our HRS sample of recent retirees has very high rates of pension coverage, and in particular coverage by DB plans, which may explain the high rate of annuitization among new retirees. Over 70 percent of those retiring from 1992 to 2002 had a pension, and 18 percent reported more than one pension disposition over this period. While only about 20 percent of private sector workers have a DB plan today, in our sample over 76 percent reported leaving a job with DB benefits. This compares with 13

14 only 39 percent with self-reported DC benefits over the period. The number of retirees reporting dispositions from DC plans rose from 33 percent in to 45 percent in , perhaps reflecting the expansion of DC plans over this period. The DB coverage rate by retirees remained fairly steady from wave to wave at around 70 percent of retirees per wave. Dispositions Among Retirees with a Choice of Pension Payout Form Since we are most interested in the pension dispositions made by retirees who could choose among different payout forms, we now limit our sample to include those who report having such a choice. By our definition of choice, approximately 60 percent of our retiree sample who made a pension disposition from reported having the option of taking benefits in annuity form or in some lump-sum form (including rolling pension proceeds into an IRA). Primarily, this eliminates from our sample DB participants who reportedly had lump-sum option available to them upon retirement. We also eliminated 48 retirees from for whom the HRS did not allow us to distinguish whether an annuity came from, as well as some DB participants with benefits below $5000, an amount below which an employer can cash out the employees benefits. We keep all DC participants in our sample of choosers, since they could use their benefits to purchase an annuity, leaving us with a sub-sample of 1,073 such retirees between 1992 and Our results find that annuitization was the most popular form of pension disposition over the period, even among the subset of retirees with a choice of disposition (see Table 3). In each wave, on average 43 percent of retirees chose to receive annuities benefits. This compares with 22 percent reporting they chose a cash settlement; 25 percent rolling benefits into an IRA; and 32 percent opting to leave benefits in the plan for a future decision. However, we see sharp differences in decisions between those with different plan types. The overwhelming majority of annuitizations came from those with DB plans. About 77 percent of retirees with DB plan benefits received an annuity from those plans, while only approximately 8 percent of those covered by DC plans chose to convert their account balances into an annuity. In contrast, rollovers and deferring benefits were much more popular among DC participants than those with a DB. Cash settlements were more evenly split among DB and DC participants, with 22 percent of retirees reporting cashing out of their pension plans. Perhaps most striking is the stability of these percentages over the period: annuitization rates for DB participants remained between 63 and 70 percent for each wave and between 5 and 10 percent for those with DC plans, except for the wave when retirees with DC plans reported higher annuitization rates. 14

15 Table 3: New Retirees Pension Dispositions, Among Those Reporting a Choice of Payout Form* (Percent of Retirees, except where indicated) Retirement Period Made pension disposition (among different options) from that job (N) 1, Had DB plan Had DC plan Had DB and DC 20.7 N/A Annuitized Benefits Among DB Among DC Cash Settlement Among DB Among DC Direct rollover to IRA Among DB Among DC Benefits Left in Plan** Among DB Among DC Retirees Making Multiple Dispositions Source: Authors analysis of HRS, Sums of sub-categories may exceed 100 percent because some respondents report multiple pension dispositions. * Choice of payout form includes respondents with pensions from DB plans who report that they had the option to take a lump-sum distribution and all retirees with DC plans (since these participants can take a lump sum and use it to purchase an annuity). Cash settlement group also excludes DB respondents who report taking a lump-sum of less than $3500 ($5000 after August 1997), levels below which employers could force employees to cash out of the plan. + Excludes 48 respondents from this wave for whom we could not tell if their disposition was from a DB or DC plan. ** Includes respondents who report that they expect to receive DB plan benefits in the future or reported leaving their assets in a DC plan account. Any concern about the cash-out rate of pensions among retirees can be somewhat mitigated by the responses to follow-up questions the HRS asks about what retirees do with the proceeds from a pension cash settlement. (Unfortunately, the HRS asks this 15

16 question only of DB participants who report taking a cash settlement.) As Table 4 shows, over the period about 39 percent of these retirees report rolling the cash into an IRA. Only 14 percent reported that they spent the money. It is unclear if those that report rolling over a cash settlement into an IRA have done anything differently than those who report executing a direct rollover with their DB benefits, or whether this is merely a question of semantics for some respondents. Table 4: How Retirees Who Took a DB Cash Settlement Directed the Proceeds (As Percent of Retirees Choosing DB Plans Cash Settlement) Retirement Period Spent the Money % 9.4% 8.6% 7.7% 25.9% Saved the Money % 31.3% 28.6% 19.2% 37.0% Paid Down Debt % 21.9% 5.7% 11.5% 11.1% Rolled the Proceeds Over into an IRA % 46.9% 42.9% 26.9% 37.0% N Source: Authors analysis of HRS, Sums of sub-categories may exceed 100 percent because some respondents report multiple directions of cash settlement proceeds. Payout Forms Chosen as a Percentage of Dispositions Made Considering that over one-fourth of the retirees in our sample report multiple dispositions, it is sometimes difficult to tell if a retiree receiving pensions in a certain form made this disposition from a DB or a DC plan. We therefore also look at the breakdown of disposition choices made by retirees as a percentage of all dispositions, as shown in Table 5. 16

17 Table 5: Distribution of Payout Forms Among Total Dispositions by New Retirees Reporting a Choice of Payout Form* (As Percent of Total Dispositions by New Retirees, except where indicated) Retirement Period Total Pension Dispositions (N) 1, From DB plan From DC plan Annuitized Benefits Among DB Among DC Cash Settlement Among DB Among DC Direct rollover to IRA Among DB Among DC Benefits Left in Plan** Among DB Among DC Source: Authors analysis of HRS, * Choice of payout form includes respondents with pensions from DB plans who report that they had the option to take a lump-sum distribution and all retirees with DC plans. Cash settlement group also excludes DB respondents who report taking a lump-sum of less than $3500 ($5000 after August 1997), levels below which employers could force employees to cash out of the plan. + Excludes 48 respondents for whom we could not tell if their disposition was from a DB or DC plan. ** Includes respondents who report that they expect to receive DB plan benefits in the future or reported leaving their assets in a DC plan account. Similar to the results shown in Table 3, we see a declining share of all dispositions made coming from DB plans over time, reflecting the trend toward DC plan coverage in the general population over the period. While Table 3 reported that 43.5 percent of retirees annuitized at least one pension, Table 5 shows that only 34.9 percent of total pension dispositions were in annuity form. This suggests that among retirees making multiple dispositions, those choosing to annuitize one pension benefit often take another benefit in lump-sum form, whether as a cash settlement, IRA rollover, or as a deferred benefit, perhaps reflecting a desire to diversify the form of pension benefits. This supports the conclusion of the basic annuitization model that the marginal value of additional annuitization declines as annuitized retirement income rises. 17

18 Analysis of Determinants of Disposition Choice Conditional Means To try to determine what factors might cause retirees to favor annuitization over lumpsum dispositions, or vice-versa, we run different statistical tests. First, we compare the simple means of several potentially influential characteristics of retirees who chose an annuity, those who did not, and the entire sample of retirees with a choice of disposition. We also do a Wald test to see if the differences in the values of these means are significantly different from one another. We present these conditional means in Table 6; in Table 7, we present the same information for binary independent variables, with the reported percentage being the likelihood of observing the characteristic conditional on the choice to annuitize. 18

19 Table 6: Means of New Retiree Characteristics, Conditional on Annuitization of Pension Benefits Variable Retiree Chose Annuity Retiree Did Not Choose Annuity All Retirees with Payout Choice Economic variables Annuity price mo. S&P 500 return* 13.6% 11.6% 12.5% 24-mo. S&P 500 return* 30.8% 26.4% 28.3% Out-of-pocket medical expenses, past year $1,732 $1,781 $1,759 Household Social Security income (disability and OAS) $5,802 $5,999 $5,912 SS income as a % of total income* 13.6% 17.7% 15.9% Total household annual income, net of pensions $66,200 $65,751 $65,949 Total household wealth ($,000) $414 $477 $450 Years of education* Tenure at longest held job* Retiree characteristics Age at retirement* Age of spouse at respondent s retirement Self-reported health status (1=Excellent, 5=Poor) Mother s age (current or at death) Father s age (current or at death) Self-reported probability of reaching age % 69.7% 70.5% Self-reported probability of reaching age % 51.8% 51.8% N *Difference in mean for that characteristic significant at the 5% level in a Wald test. 19

20 Table 7: Probabilities of Observing Retiree and Plan Characteristics, Conditional on Annuitization of Pension Benefits Retiree Chose Annuity Variable Retiree Did Not Choose Annuity had DB plan only* 57.8% 24.9% 39.2% had DC plan only* 8.1% 64.7% 40.1% had both DB and DC plans 26.2% 10.4% 20.7% Male 59.5% 55.4% 57.2% White 82.4% 85.5% 84.2% Married 79.0% 78.0% 78.5% Covered by health insurance in retirement* 70.4% 64.2% 66.9% Spouse covered by health insurance in retirement 37.5% 42.6% 40.4% Worried about retirement income 46.0% 46.8% 46.5% Most risk averse (top category) % 69.2% 69.4% Financial horizon of 5 years or greater 44.2% 43.5% 43.8% At least 90% chance of leaving $10K+ bequest 66.9% 66.0% 66.4% All Retirees with Payout Choice N *Difference in mean for that characteristic significant at the 5% level in a Wald test. + In the highest of four risk aversion categories. Level of risk aversion imputed by RAND from HRS based on respondents stated preferences for scenarios involving different levels of income and uncertainty. In comparing the means across the disposition categories, it is apparent that the subgroups are more similar than they are different. From looking at these measures, it might be difficult to determine which describe the group that annuitized and which describe those that took lump sums exclusively. Even the annuity price variable, which reflects the foregone lump-sum amount required to receive a certain annuity payment, did not differ significantly across the annuitizers and those taking lump sums. We construct this measure based on the retiree s reported age at retirement, IRS mortality tables used in annuity calculations, and interest rates at the time of retirement. Still, some potentially key differences stand out. Most prominent is the type of pension plan in which the retiree participated. As the disposition results illustrated, those choosing an annuity were much more likely to participate in a DB plan than a DC plan, and those that were covered by both types of plans were also more likely to take an annuity. Conversely, and not surprisingly, those choosing not to annuitize were much more likely to have only a DC plan. Beyond this, we also notice that annuitizers Social Security income represented a smaller share of total income than it did for those taking lump sums. Annuitizers were also more likely to be covered by health insurance (although their spouses were not). Those taking annuities also did so following a stronger one and two-year performance in the S&P 500 than those taking lump sums, a 20