Once upon a time, before the era of 401(k) plans and takeover capitalists eviscerating many company pension funds, defined-benefit pension plans were America’s primary supplement to Social Security. Back then, the actuarial assumptions were generally reasonable, even for the public pension systems, before some of the latter strayed down the path of unsustainable benefits promises and fishy math. Needless to say, times have changed, and nowadays the vast majority of Americans have very few guarantees of lifetime income other than their modest Social Security benefits.

As an occupational category, most retired public employees and military personnel enjoy lifetime pension incomes they can count on. The problem now is that they have come to be viewed as a privileged caste, and politically that’s not a good situation for public workers: It invites “pension envy” from their cohorts who retire from nongovernmental employment. America needs a better system of “longevity insurance” whereby private-sector 401(k) and IRA savers can convert some of their nest eggs into annuities, providing guaranteed lifetime income with an earnings rate at least a little better than what insurance companies typically offer. There could be an important role for public pension systems in making that happen.

Arguably, 401(k)s and IRAs would be fine if they were properly funded for 30 or more years for most workers and had a built-in back-end annuity feature, but only a minority of Americans enjoy a retirement account balance likely to provide income security for a lifetime. Almost no private-sector plans include a retirement medical cost coverage strategy, so many of those retiree assets will be chewed up with bills that Medicare doesn’t cover. Although life expectancies had a hiccup lately because of COVID-19, the long-term trend worldwide has been for longevity to keep increasing.

So even though American senior citizens’ household wealth has improved over the years, a good number still face the prospect of living longer than their savings will cover, and that’s particularly bad news for the bottom 80 percent of the elderly demographic who face a rather bleak lifestyle adjustment if they outlive their average life expectancies. Some studies show that on average Americans save only 78 percent of what they need for retirement. Even those who take out reverse mortgages can run the risk of outliving their home equity. The numbers get far worse for those who live beyond age 85, when many will have consumed virtually all of their life savings.

Advocates for retirement security, including prominent public pension officials and associations, have promoted efforts in some states to provide a retirement option for private-sector workers. That’s a laudable first step: Anything legislators can do to encourage payroll savings for retirement will be helpful. But for today’s retirees, it’s too late for those programs to be of much help unless they rejoin the workforce, as some will have no choice but to do. And so far, none of those programs have a lifetime-income option because their participants have not accumulated enough savings to make that feasible.

For educators and health-care workers, by contrast, the 403(b) retirement plan market has long included a lifetime-income feature whereby a private or nonprofit insurance company can convert defined-contribution savings into a life annuity for the worker and spouse. Likewise, retired IRA investors can convert their accounts to a life annuity. For savvy IRA savers, there is also a little-known provision for “qualified life annuity contracts” that enables the IRA owner to exchange up to $200,000 of those assets for a deferred annuity that pays out lifetime income, beginning as late as age 85 for those with enough assets to get by until then. For a married couple at age 70 who agree to wait 15 years for such lifetime payouts, that transfer buys them maybe $30,000 of future annual income to supplement their Social Security benefits as long as one of them is still living.

All of these payouts are typically subject to state and federal income taxes. There are other variations, and I have no doubt that the private-sector insurance industry will be inventing and promoting many more such arrangements in coming years as healthier baby boom retirees face up to this inevitable longevity problem and think harder about the risks of outliving their money.

A Competitive Yardstick

If your expectation is that the private sector will figure this all out and that competition will drive the economics for retirees so favorably that they can all get a maximum return on their annuity investments, then you will see no need whatsoever for a public-sector alternative. But if you harbor the average American’s distrust of insurance companies, then you might want to get behind the idea of a competitive yardstick to be provided by public pensions. The idea here is not to replace the insurance and annuity industries, just to keep them honest and price competitive.

Here’s how it might work: Statewide public pension funds could be authorized by state law, subject to securing favorable federal tax code provisions, to make a tax-deferred exchange of 401(k), 457 and IRA account assets for a lifetime pension payable to state residents by that state’s public retirement system. A separate common trust account would be established to hold and invest the assets in accordance with the system’s normal pension fund practices, but with a 50 percent limit on risk-asset allocations to stocks and other volatile assets. The advantage of public pension math is that the assumed — and probable — rate of return on such a diversified portfolio is likely to be a bit higher than the actuarial rate that private insurers use for their annuity calculations, which of course are net of profit margins. And public-plan participants would not need to worry about an insurance company going broke.

The pricing of such public pension exchanges would have to be based on strict actuarial rules and practices to prevent unsustainable “giveaway” and “adverse selection” features. (California’s notorious experience with “air time” pension purchases has clearly shown how not to do this.) To focus the program on the middle class, the exchanges should be limited in size so that nobody can receive an annual annuity payout greater than the national median annual household income (around $70,000 today). That’s enough for a modest retirement when paired with Social Security, but not for cushy benefits underwritten at the risk of state taxpayers. And unlike many public pensions, there should be no cost-of-living adjustments unless prudently funded actuarially by a lower initial benefit and capped at perhaps 3 or 4 percent per year.

Costly Indigent Elder Care

Pension hawks and insurance industry lobbyists will squawk that this arrangement simply invites the same kinds of gamesmanship with actuarial assumptions that have already driven so many public pension systems into their underfunded positions. Clearly there would be an underwriting and investment risk if the annuity programs are not carefully designed. But if you think about it, it’s state governments that will ultimately bear much of the megabillion-dollar costs of indigent elderly who run out of money from outliving their savings, so a case can be made for this arrangement as a prudent social insurance prophylactic. Nobody has anything to gain from getting this wrong: There is no union of annuitizing retirees, and if anything this constituency would be fiscal conservatives.

That said, legislators would need to decide who backstops any actuarial shortfalls. But a fractional underwriting shortfall would be far less painful to state budgets than elder-care welfare costs. I would thus have no moral or policy problem with this being a valid public purpose as long as it’s overseen by an independent and accountable fiduciary board obligated by a fiscally conservative mandate and including both the state controller and insurance commissioner.

From a purely political standpoint, having this lifetime income feature available to private citizens would help overcome some of the pension envy that is often directed toward public employees, viewed as cashing in at taxpayer expense. And it’s unlikely that such programs will ever swamp the pension systems: States could even cap the total number of such exchange annuitants to no more than perhaps 5 or 10 percent of their governmental retiree headcount. With a new feature like this, public pension systems could eventually be viewed as taxpayer-friendly and serving the broader public purpose of promoting retirement security for senior citizens from all walks of life.

Given the obvious political hurdles and vested interests, I don’t expect this idea to see the light of day anytime soon, but the next time public pension reform comes up in state legislatures, it’s a worthy idea to consider. States that already mandate that most businesses provide retirement benefits to their employees should lead the way, as it’s a logical extension of those initiatives and their sponsors already understand the merits of middle-class retirement security.

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