One of the greatest fears and risks in retirement is outliving one's income and savings so that at the age of 93 you are reduced to either depending on charity, giving up and dying, eating cat food or a combination of options. Social Security and other defined benefit pension/retirement plans are one of the guarantees against these outcomes as these plans are there at least until you die, and can often be bought up to include a spouse. Defined contribution retirement plans such as a 401(K) provide no such security, as sometimes the money will be there, and sometimes it may not be if the market tanks.
During the Social Security privatization debate one of the answers to this concern about people outliving their retirement savings was the pushing of private annuities. The basic plan would be that in the SUPER 401(K) money would grow until an individual neared retirement age. At that point, the individual would transfer their money into a private annuity contract that based on the interest rates of that day, the size of the transfer on that day and the age/health of the individual would give a guaranteed yearly lump sum payment to that individual. And here we come to the big issue of systemic risk or privatized accounts. Two virtually identical individuals who did everything they were supposed to do but chose to retire six months apart could face massively different retirement outcomes.
Let's break this down a little more on annuities. The simplest annuity is a perpetual annuity where the annual payment is equal to the principal times a fixed interest rate. There is no inflation protection over time, and the interest rate is usually fixed for a very long period as the annuity may have bought a 30 year US Treasury bill to fund the pay-out. Most annuities are single life annuities where the payout is equal to the principal times a variable interest rate times a factor based on the individual's remaining life expectancy at the time of the purchase. The goal of the annuity company is to have over a large enough risk pool a little bit left over in most accounts at the time that those account owners die. In both cases the individual is buying an end of life defined benefit pension plan with their defined benefit contributions.
So what impacts the annual payout of an annuity besides the age of the individual? The amount of principal put into the annuity and the interest rate of safe investments will impact the annual value of the annuity. And here is a major individual risk factor. If an individual was planning to retire in October, 2007 and pulled their money in September to roll it over into an annuity, they would be double-lucky as they would have pretty much top-ticked the market for the largest potential principal amount AND the interest rate they would have received on their principal would be decent. Now if someone is planning to retire in the next couple of months due to health concerns they are down 15% to 20% and the interest rate that they can receive for safe investments has dropped through the floor. Assuming that these individuals had the same privatized account balance on the day that the first individual rolled-over and out, the second individual is looking at an annual income stream that is 25% to 35% less over the course of his lifetime.
Why did this happen? The second individual bore the entire cost of the timing risk himself. The rational response for this individual is to stay in the labor market for as long as possible until they are made nearly whole again through increased capital contributions brings the account value up, the economy returns to trend growth in an indeterminate number of years and fewer expected years of life expectancy increases the annuity payout. This is a counter-cyclical incentive as a recession or downturn should encourage people to retire to clear out the market. And it is blatantly unfair.
Social Security and other defined benefit plans work on the premise that over the long term the US economy generally increases at a trend rate. However there are times when it decreases and there are times when it increases below trend. In these situations since only a small proportion of people covered by these plans are going to retire at any one time, the risk pool consisting of thousands or hundreds of millions of individuals can bear the timing risk much cheaper and easier than any single individual and borrow against future growth or draw down on past reserves to smooth things out. In this way two identical individuals who did everything right but retired six months apart won't face outcomes with massive differences.