A new research paper by experts at Wharton and elsewhere solves that challenge with a comprehensive evaluation of the moving pieces of retirement planning. The best route is to include deferred income annuities in defined contribution retirement accounts, according to the paper titled “Fixed and Variable Longevity Annuities in Defined Contribution Plans: Optimal Retirement Portfolios Taking Social Security into Account.”

In the U.S., the longer one waits to start claiming Social Security payments, the bigger will be the monthly check. Someone who starts tapping into Social Security at age 62 (the minimum qualifying age) will receive much less in monthly payments than if they were to wait until age 67 or 70.

But the reality is that many people do not delay taking Social Security benefits until they are 70, and so they need a Plan B. “For most Americans, it is financially sensible to delay claiming Social Security until age 70, as this maximizes the retirement payments that they receive for the rest of their lives,” said Wharton professor of business economics and public policy Olivia S. Mitchell, who co-authored the paper with Goethe University finance professors Vanya Horneff and Raimond Maurer. “Nonetheless, most people do not do this, when they cannot or do not want to continue working until age 70.” Mitchell is also executive director of Wharton’s Pension Research Council.

In their research, the authors explore what happens when workers leave their jobs before age 70 while using their retirement savings as a “bridge” to the delayed claiming of Social Security benefits. “We show that most people would be better off if they had access to deferred income annuities in their 401(k) accounts that allowed them to finance consumption while deferring claiming benefits,” Mitchell said regarding their key research finding.

“We show that most people would be better off if they had access to deferred income annuities in their 401(k) accounts that allowed them to finance consumption while deferring claiming benefits.”— Olivia S. Mitchell

That finding is important in view of recent legislation (the SECURE 2.0 Act passed in December 2022), which encourages employers to include lifetime income payments in their 401(k) plans, Mitchell noted. The SECURE Act specifically recommended the inclusion of annuities in defined contribution (DC) plans and Individual Retirement Plans, also known as IRAs.

A Case for Variable Annuities

Specifically, the paper made a case favoring “well-designed deferred income annuities” in 401(k) accounts, but with an important additional feature. “If plan sponsors could also provide access to variable deferred income annuities with some equity exposure, this would further enhance retiree well-being, compared to having access only to fixed annuities,” Mitchell said. The investment options for a variable annuity are typically mutual funds that invest in stocks, bonds, money market instruments, or some combination of the three.

Equity investments inherently carry risk, but they can deliver significant gains if they are within limits and people make well-informed decisions about those. “Our research shows that including 20%–50% equities in a variable annuity could improve retiree well-being by 15%–20%, for both college-educated and high school graduates, compared to the currently permitted fixed income annuities,” Mitchell said.

In any event, legal barriers currently prevent retirees from going in that direction, since at present, U.S. law does not permit variable annuities in 401(k) accounts. Mitchell noted that “policymakers seeking to improve retiree well-being should consider allowing variable deferred income annuities in retirement plan portfolios.” The paper concluded that “well-designed variable deferred income annuities in retirement plan portfolios can markedly enhance retiree financial well-being.”

Striking a Balance Across Retirement Realities

The study also estimated how much money retirees would need under various scenarios differs according to their gender, education level, and benefit deferral ages (85, 80, and 67) when they begin receiving Social Security benefits. For instance, a college-educated woman who could delay claiming Social Security benefits but lacks access to a fixed deferred income annuity (DIA) requires an additional $17,367 in her DC plan to be as well off, the paper reported. The opposite is true for a female high school dropout: On average, she would be $4,056 worse off if she could not delay claiming but did have a DIA.

For the least-educated people, the preferred option is to delay claiming Social Security, the paper concluded. By contrast, higher-paid better-educated people benefit more from using accumulated DC plan assets to purchase deferred annuities. The authors also considered two other aspects: The least educated also have higher mortality rates, and the Social Security annuity is relatively higher for lower earners.

The most important factor in making those choices is the quantum of Social Security payments one could receive. The Social Security retirement system pays a lifetime annuity with fixed real benefits that depend (progressively) on retirees’ earning histories and claiming ages, the paper noted, setting the backdrop for this research.

“Policymakers seeking to improve retiree well-being should consider allowing variable deferred income annuities in retirement plan portfolios.”— Olivia S. Mitchell

“For this reason, if a retiree receives a substantial portion of her income through a Social Security annuity, it stands to reason that her remaining financial portfolio should include substantial exposure to risky equities, through a target date fund or with annuities whose payments are linked at least in part to the performance of an equity portfolio,” the paper found. (Target date funds are designed to maximize revenue and minimize risk until the target date when a retiree initiates her 401(k) payouts.)

Social Security payments are designed around “replacement rates,” or the extent to which they replace workers’ pre-retirement earnings. About 70% of pre-retirement income is considered sufficient by many advisors to maintain one’s pre-retirement lifestyle, and Social Security benefits replace about 40% of the average retiree, according to a bulletin from the Social Security Administration.

Social Security replacement rates are higher for lifetime low-earners, and lower for lifetime high-earners, Mitchell and colleagues noted. “Low lifetime earners receiving a higher replacement rate could decide to devote a greater proportion of their remaining financial wealth to risky equities,” as a result. Retirees with higher lifetime earnings whose Social Security replacement rate is lower could buy larger private annuities from their tax-qualified retirement accounts to secure “a predictable income stream sufficient to cover necessities,” they added.

A Snapshot of the Findings

Below are the main findings of the research:

• Using retirement account assets to purchase at least some fixed deferred income annuities is welfare-enhancing for all sex/education groups examined.
• The better-educated and thus higher-paid men and women benefit far more — 7 to 11 times more — compared to the least educated.
• The better-educated will do better using retirement plan assets to purchase deferred income annuities, versus delaying claiming Social Security benefits by a year and financing consumption from retirement plan withdrawals.
• By contrast, lower-paid and less-educated retirees will do better with the opposite strategy: They will delay claiming and use retirement assets to bridge their consumption needs, versus buying DIAs. This is because lower-paid retirees receive a higher Social Security replacement rate and also face a higher mortality risk, whereas the better-educated receive relatively lower Social Security benefits and can anticipate longer lifetimes.
• Providing access to variable deferred annuities with some equity exposure would further enhance retiree well-being in most cases, compared to having access only to fixed annuities.