America gets retirement wrong. Can Vanguard fix that?

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I've been a retirement economist for my entire adult life, and yet I am continually amazed at how America continues to get retirement saving so wrong. Now, finally, the world's largest issuer of mutual funds is showing signs that it recognizes a major flaw in the system.

Vanguard announced last week that next year it plans to offer target-date mutual funds that allow customers to buy annuities. This may address one of the failings of the US retirement system, which is that it does not offer any good answers for what people should do with their money once they retire.

Spending in retirement is not an afterthought: Knowing how much to spend each year - when you don't know what will happen in markets, how long you'll live or what your medical expenses will be - has been called the nastiest problem in finance. The question is whether people will like a solution that involves annuities.

To be clear, I think the old system of defined-benefit plans was overrated, and the switch to defined-contribution plans has been a net positive. More people have retirement savings, and more wealth in retirement, than ever before. But it is remarkable that the transition occurred without any plan to address the spending question.

The easy answer, at least to retirement economists (and now Vanguard), is to turn defined-contribution pensions into defined-benefit plans by having savers buy an annuity when they retire. An annuity is like reverse life insurance - in exchange for giving an insurance company your wealth, it pays you every year for the rest of your life.

It's a great idea - in theory. People were happy with their defined-benefit pensions, and an annuity can offer the same kind of security in retirement.

But the annuity market never took off. Annuities are expensive. Many annuity products are overly complicated. The low-interest-rate environment offered meager income. And Americans were just reluctant to turn over their lifetime savings to an insurance company.

Part of the problem is that people have been conditioned to view the assets in their defined-contribution plans as wealth. They open their accounts and watch their balances grow. Handing over their hard-earned savings to an insurance company is not nearly as gratifying.(1)

Yet annuities have the potential to increase income because they pool together purchasers to reduce the risk of outliving your money. People who die early subsidize those who live a long life. This means more income than if you bore the risk yourself - but it's a bad deal for you and your heirs if you die young. It also means giving up flexibility; once people put in their money, it's hard to get it out.

But the shortcomings of the alternative - relying on market returns - are starting to be realized. Baby Boomers are the first generation to retire with significant assets in defined-contribution plans. The most common strategies people use now, spending a fixed percentage of their savings or spending their "required minimum drawdown" (the amount the government requires people to withdraw from, and pay tax on, their tax-deferred accounts), expose retirees to huge swings in what they can spend each year.

Big asset managers have developed retirement income strategies over the years that attempt to offer flexibility and stability, but they have never caught on. This is partly because offering the predictability of an annuity and the benefits of a non-annuity usually means extremely complex and expensive products.

Vanguard's solution is to offer a new target-date fund that, starting at age 55, allocates some money to a secure income fund. This fund offers a guaranteed return, about the same as a bank CD, but with the option for people to convert about 25% of their portfolio into an annuity when they retire. Depending on the rate at conversion, this could be a good deal for retirees.

People may feel more comfortable annuitizing their savings if it is only 25% of their portfolio, but it won't meaningfully reduce the risk of running out of money in retirement or add much to their retirement income. The median retirement account balance among Americans aged 65 to 69 is about $165,000; annuitizing 25% of it will produce only about $300 more of income a month. A better alternative would be longevity insurance - an annuity that kicks in once people reach their 80s.

Still, offering annuities could help change how people see their retirement assets. Retirement plans are supposed to show how much income a client's assets could finance. But that estimate is sometimes hard to find, and even when it isn't, it is often unclear how the calculation is made. This new fund, which Vanguard is calling "Target Retirement Lifetime Income Trusts" and is offering in partnership with TIAA, will be able to show participants how much income they can count on in retirement if they consider an annuity.

People hate annuities for some good reasons. But they could help usher in a fundamental and necessary shift in how Americans perceive their retirement accounts. Your account is not merely a nest egg to be admired as it is being built. It is a practical way to provide you and your family with income in your old age.

--- (1) One of the few countries that has had a good experience with annuities is Chile, where savers are conditioned early to plan on buying one.

(COMMENT, BELOW)

Allison Schrager, a Bloomberg columnist, is a senior fellow at the Manhattan Institute and a contributing editor of City Journal.