Statement of Mark J. Warshawsky

Director of Retirement Research 

Towers Watson

For the Joint Hearing of the Departments of Treasury and Labor 

On Certain Issues Relating to Lifetime Income Options for Participants and Beneficiaries 

in Retirement Plans

September 15, 2010 afternoon, Washington, D.C., Department of Labor Auditorium

“Products and Strategies for Lifelong Retirement Distributions”

As is well-documented, private sector employers have been moving away from 

traditional defined benefit pension plans for more than a decade. These plans generally 

pay benefits to a participant as a life annuity, thereby providing a fixed stream of lifetime 

income at retirement. Employers have moved toward defined contribution and hybrid 

plans, that is, individual account plans, which are almost always designed to pay benefits 

as a lump-sum. There are many reasons for this trend, but the focus of the Departments 

in your request for information and in this hearing is on the consequences for plan 

participants in terms of lifelong security during retirement and whether government 

policy can play a positive role in this particular area. Stated more directly, the operative 

questions are whether something important is being lost by the steady decline in 

mandatory annuitization, and if yes, whether there are products or strategies that can 

replace, in whole or in part, what has been lost. Finally, if such products and strategies 

are reasonably available, a further question is how the government can encourage their

adoption by individual account plan sponsors and participants.

As Towers Watson stated in its April 2010 response to the original RFI, we believe that 

the desire of all plan participants for flexibility, liquidity, and control, as well as the 

particular desire of those with impaired longevity for more immediate access to funds, are 

legitimate considerations for choosing a lump-sum. Indeed, when given the choice, most 

retirement plan participants take a lump-sum distribution. At the same time, insurance 

against outliving retirement assets, the simplicity of investment and distribution 

management for many households, and the peace-of-mind and prudence obtained from a 

steady income flow, make encouragement, but not the mandate, of annuitization a worthy 

public policy goal. 

In this testimony, I will first describe the features of the insurance product most like the 

traditional defined benefit pension in its distribution phase – the immediate fixed life 

annuity—and list some of its advantages and disadvantages. Then I review several other 

products and strategies – the inflation-indexed immediate annuity, immediate variable 

annuity, variable annuity with a guaranteed minimum withdrawal benefit, systematic 

withdrawals from a portfolio of mutual funds, and combinations of immediate fixed life 

annuity(ies) with systematic withdrawals – and compare their advantages and 

disadvantages. I also pay attention to the consequences of risks arising from uninsured 

health and long-term care expenditures for the household. 
2

For the most part, I rely in my statement on past research that co-authors and I have 

conducted – empirical investigations and stochastic simulation studies modeling the 

probability distribution of payment streams from these products and strategies given the 

background risks of uncertain asset returns and interest rates, individual mortality and 

inflation.

1

 We have been careful to get the essential details of product features, including 

average fee levels, incorporated correctly in this research. The studies generally describe

what is available in the retail market, although with the exception of fee levels, many of 

the features and characteristics carry over to the institutional market. The other members 

of this panel will focus more on the institutional market, as well as on some other 

products that are currently available to retirement plan participants. 

Advantages and Disadvantages of Full Use of Immediate Fixed Life Annuities at 

Retirement

Research shows that the uncertainty about the remaining length of life during retirement 

is large and reduces welfare because the household faces a distressing choice – either it 

should reduce consumption in order to maintain assets to finance a possibly long 

retirement, or maintain its standard of living and risk having to reduce spending suddenly 

and significantly if it outlives the average and runs out of money. [1] Things are 

somewhat better for a couple than an individual because there is some pooling of 

mortality risk with two members rather just one, but even here risks remain and hard 

choices must be made. Research shows that full use of an immediate straight life 

annuity, either for an individual or as a joint-and-survivor payment, at the point of 

retirement resolves this uncertainty and gives a substantial lift to the welfare of the 

household. [1]

The full use of fixed annuities also has the virtue of simplicity for investment strategy, 

where that responsibility and risk falls entirely on the insurer who guarantees the 

payment flows (which include investment and mortality returns). Simplicity also applies 

to distribution strategy, where a fixed income flow from an annuity frees the household 

from having to manage the size of withdrawals from its pool of savings and blocks the 

opportunity to entertain rash temptations for large, imprudent, expenditures. It also likely 

that simplicity is more highly desired and becomes more appropriate as the retired 

household ages and its cognitive abilities decline.

But this product and simple strategy has several disadvantages as well. A steady fixed 

flow of income can easily turn into an impediment if a large legitimate need for a 

significant amount of assets arises suddenly, such as a family emergency, a big uninsured 

medical or long-term care bill, an uninsured home or auto repair, and so on. A fixed 

annuity also does not hedge other extant economic risks, in particular inflation and 

insurer insolvency. If there is inflation, a fixed annuity will produce less and less income 

in real terms with time, and, more significantly, if inflation picks up suddenly what was 

originally adequate will unexpectedly shrink in terms of purchasing power. In our 

research, this inflation risk is found to be significant and can produce real income 

shortfalls, even though a fixed life annuity gives the highest income flow of all the 

 

1

 References will be made throughout the text to the published articles listed at the end of the statement. 
3

products and strategies at the point of retirement. [3] In addition, insurer insolvency, 

although a rare event, could be catastrophic if the relevant state guarantee funds do not 

cover the losses. An immediate annuity has a shorter horizon (20 or 30 years) than a 

deferred annuity (which might need to exist for 50 or 60 years through the last payment) 

and so reduces insolvency risk, but not to zero, even for highly rated issuers. 

Two other disadvantages arise from the nature of fixed annuity pricing, which depends 

mainly on three factors – marketing and administrative expenses, interest rates at the time 

of issuance, and mortality expectations. Because interest rates are volatile, the prices 

charged for fixed annuities are also volatile. This can be called timing risk. Two 

otherwise identical people retiring with the same account balance could receive

significantly higher or lower incomes simply because one retired just one year (or even 

quarter) earlier. For example, my research found that retiring in March 1986 instead of 

March 1985 would have caused a loss of 27.4 percent of income if the full annuitization 

strategy were pursued. [2]

With regard to mortality, insurers must price their life annuities based on the expected 

mortality rates of those who purchase the product. In a voluntary market (as opposed to, 

say, Social Security and some traditional defined benefit plans, where annuitization is 

mandatory), those with impaired health and shorter expected longevity are likely to avoid 

the purchase of annuities. The insurer must therefore consider the resulting downward 

bias to mortality rates in pricing the annuity. Also annuity purchasers are likely to come

from higher socioeconomic groups than non-purchasers, and the wealthy generally have 

lower mortality. Our research found that the impact of these “adverse selections” add 

about 10 percent of the annuity price, compared to what would have been charged if the 

mortality of the general population were to apply. [1] This may be the cause of the 

complaint sometimes heard that annuities are “expensive.” 

Some Alternative Product and Strategy Solutions

An inflation-indexed immediate annuity reduces the exposure to inflation risk. This 

product is the same as the fixed annuity except that payments increase with consumer 

price inflation (although insurers do impose annual caps of 5 or 10%, somewhat limiting 

the extent of protection). It has the same advantages of hedging longevity risk and 

simplicity, but suffers from the same disadvantages of illiquidity, the risk of insurer 

insolvency, timing risk and adverse selection. My research, admittedly based on a small 

sample, found that the expense load, which includes the cost of adverse selection, on an 

inflation-indexed annuity was about 5 percentage points higher than on the fixed annuity, 

perhaps owing to a more limited investment portfolio available to insurers to back 

inflation-indexed products. [2] To pay for the cost of indexing, the initial and some 

subsequent payments from an inflation-indexed annuity will pay less than the nominal 

fixed annuity; if the rate of inflation is lower than expected, a nominal annuity will, after 

the fact, be a better deal.

An immediate variable annuity delivers variable income for life, with no residual at 

death. At the time of purchase, the investor selects an assumed interest rate (AIR). This 
4

AIR together with the insurer’s mortality guarantee determines how many annuity units 

the investor gets for his premium. The annual payment to the insured, conditional on 

surviving, is equal to the number of annuity units multiplied by the value of each unit. 

The unit value evolves with the net investment performance of underlying funds chosen 

by the insured, relative to the AIR. The net performance is the gross investment returns 

net of fund management and insurance fees – these average more than 200 basis points. 

The payment stream will rise if the net investment return is higher than the AIR. The 

investor can choose a higher AIR to receive larger payments in the early years of 

retirement, but then she risks more income volatility later in life and smaller payments if 

investment performance is poor. 

The main advantage of an immediate variable annuity is that it eliminates timing risk –

for the same AIR, every investor starts out with the same initial payment. Because it is a 

life annuity, it also covers mortality risk– payments will continue for life. Depending on 

the funds chosen, their investment performance and the AIR used, payments might

increase, even substantially, over the life of the insured. The disadvantages include lack 

of liquidity, insurer insolvency risk, and adverse selection; fees can also be significant. 

There is also some added complexity in the product, which arises from the need to make 

investment and AIR selections. Finally, by definition, the income flow is uncertain and 

makes financial planning during retirement more difficult. Our research shows that the 

volatility of inflation-adjusted income for a variable annuity invested 50/50 in stocks and 

bonds is among the highest of the products and combinations that we have modeled and 

the risk of real income shortfalls is higher than for a fixed annuity. [3]

A relatively new product has been developed which adds a guaranteed minimum 

withdrawal benefit rider to a conventional deferred variable annuity. The deferred 

variable annuity acts as an investment account while the rider guarantees that, regardless 

of investment performance and length of life, (nominal) income will not fall below a 

certain percentage (generally 5%) of the “income base” and could increase if investment 

performance is good. The income base does not decrease and could increase with the 

account value. The account value is the actual market value of the invested portfolio that 

fluctuates with investment performance and may be reduced to zero after subtraction of 

income payments and fees. With the addition of the fee for the rider to the usual variable 

annuity fees, total fees come to about 300 basis points, on average. 

We have modeled several portfolio choices for this product in our research and here 

report on the results with a 70/30 stock/bond mix, which may be a sensible choice to 

maximize the value of the rider without adding too much risk. The advantage of this 

product is that the account provides liquidity, at least until it (is likely to) runs out if the

retiree lives too long. There is no timing risk, and lifelong payments can increase (but 

will not decrease in nominal terms) with investment performance. The disadvantages 

include complexity, insurer insolvency risk and fees. Our research shows that the 

variable annuity with guaranteed minimum withdrawal benefit has a reasonable 

expectation of a significant account balance, and low volatility around the income flows, 

but the initial income is relatively modest and is highly likely to fall short of minimum 

real income targets over the lifetime of the retired person. [3]
5

A completely non-insured strategy is to take systematic withdrawals from a portfolio of 

mutual funds. There are many ways in which this can be done; we model in our research 

the withdrawal of a constant percentage of the mutual fund balance in each period and 

use the same percentage as is guaranteed by the variable annuity with a guaranteed 

minimum withdrawal benefit – 5 percent. We assume a 50/50 equity/bond asset 

allocation – a common balanced fund or target-date fund allocation around retirement –

and that investment fees are 120 basis points. 

This distribution strategy produces the highest account balances throughout retirement, 

with a good possibility of a significant residual upon death, according to our research. [3] 

Hence, liquidity is excellent and there is also no insurer insolvency risk and little timing 

risk. Although there is some complexity here, some products in the marketplace 

“automate” the investment and withdrawal functions. The disadvantage of this strategy 

comes on the income side – it produces the highest probability of not meeting minimum 

real income targets, and averages the lowest real income flow. [3]

Finally, we have considered some combination strategies using a fixed annuity and 

systematic withdrawals. The motivation is that the sharp edges of the trade-offs 

presented above might be smoothed and something more desirable will result. We 

modeled two combinations – (a) a one-time partial fixed annuity purchase using 30 

percent of the value of the retirement accounts while the remainder of the account is 

distributed through systematic withdrawals from a mix of mutual funds, and (b) a gradual 

annuitization until age 75 combined with systematic withdrawals from mutual funds, and 

at age 76 and beyond – full annuitization. For both combinations, we increase the equity 

share in the mutual fund portfolio because the annuity basically has bond-like investment 

properties. 

The research results do show some nice characteristics for these combinations. The first 

combination produces quite a bit of liquidity, with account balances nearly as high as 

those produced by the variable annuity with guaranteed minimum withdrawal benefit,

and less volatility. It also gives a higher average real income flow, with some upside 

potential, than some of the other products and strategies. [3] The second combination, by 

definition, only provides liquidity for the first 10 years of retirement. Its income 

characteristics, however, are the best of all the products and strategies that we have 

modeled. In particular, mean real income flows are the highest, and the risk of shortfalls 

is the lowest. There is substantial upside potential and the downside is protected. [3] The 

timing risk of annuitization is hedged by the gradual “laddering” of annuities. 

Postponing annuitization increases income flows because of the positive impact of the 

“mortality premium,” that is, the extra return gathered from the pooling of mortality risk 

becomes greater at older ages. Both combinations have some insurer insolvency risk and 

higher fees (and the cost of adverse selection), but, by definition, less than the pure 

annuitization solutions. Because, to my knowledge, these combination strategies have 

not yet been “automated” in the marketplace, they unfortunately appear to be complex for 

a household to pursue. 
6

Particular Consideration of Uninsured Health and Long-term Care Spending Risks

Thus far, I have not paid particular attention to uninsured health and long-term care 

spending risks beyond a generalized desire for liquidity. In one research article, we did 

so, explicitly modeling those risks in an analysis of the optimal annuitization and 

investment strategy for a retiree. We incorporated the results of other empirical research 

that the mean and variance of uninsured health and long-term care spending increase with 

age, especially for households with higher wealth and income. The results of our research 

are that annuitization should begin around the mid 70s for an individual and continue 

until about the mid 80s for significant annuitization, but still keeping aside about a fifth to 

a quarter of the original account balance for other liquidity needs. [4] At the initial point 

of retirement, the investment portfolio should be quite conservative, with only about a 

third invested in equities; as annuitization starts, however, the optimal equity share 

rapidly increases, to around 70 percent in the late 70s, whereupon it starts to gradually 

decline throughout the rest of retirement. [4] The central insight here is that the life 

annuity, purchased in stages later in life, can serve as a hedge against investment risks 

and against health and long-term care spending risks, which increase in probability and 

size with age, in the absence of specific or complete insurance coverage.2

Conclusion

I hope my testimony has depicted part of the rich menu of products and strategies which 

can be used to provide lifelong income to retirees. They all have advantages and 

disadvantages, which plan sponsors and retiring participants have to consider and weigh. 

Some use of life annuities is likely to play a role if income production is a central 

concern, but it will not be the complete solution. Indeed, much more technical research 

and market experimentation is needed, and I hope that any guidance coming from the 

government in this area will be encouraging rather than constraining. 

 

Research References

[1] Olivia S. Mitchell, James M. Poterba, Mark J. Warshawsky and Jeffrey R. Brown, 

“New Evidence on the Money’s Worth of Individual Annuities,” American Economic 

Review, December 1999, 89(5), pp. 1299 – 1318. 

[2] Mark J. Warshawsky, “Recent Developments in Life Annuity Markets and Products,” 

Benefits Quarterly, Second Quarter 2007, 23(2), pp. 46 – 57. 

[3] Gaobo Pang and Mark J. Warshawsky, “Comparing Strategies for Retirement Wealth 

Management: Mutual Funds and Annuities,” Journal of Financial Planning, August 

2009, 22(8), pp. 36 – 47. 

 

2

 As we described in our response to the original RFI, a combination of an immediate life annuity and 

comprehensive long-term care insurance seems like a promising potential development. See [5].
7

[4] Gaobo Pang and Mark J. Warshawsky, “Optimizing the equity-bond-annuity portfolio 

in retirement: The impact of uncertain health expenses,” Insurance: Mathematics and 

Economics, 2010, 46, pp. 198 – 209. 

[5] Christoper Murtaugh, Brenda Spillman, and Mark Warshawsky, “In sickness and in 

health: An annuity approach to financing long-term care and retirement income,” Journal 

of Risk and Insurance, 2001, 68(2), pp. 225-254.