On Retirement Income, Part 7: How Guaranteed is Guaranteed Income?

“On Retirement Income” series:

Our prior article looked at several guaranteed income sources, which can serve as a bedrock to a financially sustainable retirement. Income sources such as Social Security, pensions, and annuities are the “Layer 1” cornerstone in Round Table’s Layer Cake retirement solution.

A side note in the last article raised an important caveat: The value of guaranteed income is contingent upon the credibility and creditworthiness of the entity making the guarantee. To the extent the promises might not be kept, both the present value of income guarantees[1] and the planning value of the assumption that income will be ongoing may be compromised.

Consequently, it behooves us to consider the credibility of the guarantees in any form of “guaranteed” income. And hey, we were due for another Q&A installment anyway.

Okay, let’s start with the big one: Is Social Security even going to be there when I retire?

Short answer: Yes. Long answer: Yes, but.[2]

It is well known that Social Security is on an unsustainable trajectory. While this is presently little more than a talking point for politicians bashing the evil fools on the opposite side of the aisle, before too much longer genuine legislative action will be required to protect Social Security from insolvency, currently projected to occur in 2033.

Considering our last article’s observation that Social Security is both the largest source of income and the largest single asset for many retirees, the prior paragraph is, shall we say, not ideal. However, two observations mitigate the expected damage:

1. Even if nothing is done, Social Security payments won’t go bye-bye, they’ll just get smaller.

It has been popular for my generation[3] (maybe others, but certainly mine) to use phrases like, “No way Social Security is going to be there when I retire.” The binary outcome (“there” or “not there”) implied by this phraseology is nonsense. If no reforms are enacted, current projections suggest that yearly Social Security tax receipts will be sufficient to pay out approximately 76% of scheduled benefits.[4]

This is a lot better than 0%! If you’re counting on Social Security to pay your bills, a worst-case scenario where 76% of your bills get paid is better than one where none get paid.

Also, though, this is a lot worse than 100%! (For example, the Social Security Administration calculates that this would double the poverty rate among beneficiaries.) Sufficiently worse, in fact, that the political fallout would be severe for elected officials who allow the system to go off the rails in this way. Which brings me to observation number…

2. If there’s one thing politicians enjoy even more than fighting each other, it’s being reelected.

There’s a bad habit in the United States government of waiting until the last minute to solve impending problems (see: the debt ceiling). However, the increasing political pressure of an impending crisis has a pronounced tendency to force even the most dysfunctional governments to find a solution (see: the debt ceiling). Nobody wants to be a member of the government that allowed Social Security to fail.

Of course, the question is, what might the solution look like? Fundamentally, there are only two ways to make the program solvent: (1) Decrease payouts and (2) increase funding through higher taxation. However, with a complex program like Social Security, there are many available levers to pull to effect either or both of those modifications, in various proportions.

So, the bad news is that the solution will be painful, but the good news is that there are numerous viable paths for achieving a solution. It’s actually a much easier problem to solve than, say, the budget deficit of the rest of the US government! Educational resources on the topic abound. The “Social Security Challenge” from the American Academy of Actuaries is a fun example, though it makes no attempt to provide an exhaustive list of options.

Notably, there seems to be very little stomach for reform proposals that would include benefit reductions for folks already at Social Security claiming age. If you’ve already arrived, congratulations! You are much less likely to face the consequences of dragging Social Security back to solvency.[5]

What about other government pension systems (state pensions, teachers’ pensions, etc.)?

The combined total of state-sponsored pension obligations is much smaller than Social Security payments, and consequently the aggregate magnitude of potential shortfalls is much smaller as well.[6] But because state pension systems are numerous and the problems diverse, finding solutions will likely be much more complex.

No meaningful analysis of this gordian knot will be attempted here. But anyone expecting to rely on a state-sponsored pension fund would likely do well to study the details of their specific situation and at least develop a plan for what to do in the event their promised payments fail to materialize in full.

Hmm…And corporate pensions?

Again, the viability of your corporate pension is a bit like a game of roulette. While events like an economic downturn increase the odds of insolvency for virtually all corporate (and government!) pensions, failure is still an idiosyncratic phenomenon—i.e., they don’t all fail at once, and it can be hard to say whether your company’s plan will be one of the unlucky ones.

On the plus side, there is a government backstop, known as the Pension Benefit Guaranty Corporation (PBGC). Companies with pension plans pay insurance premiums to the PBGC; in exchange, pension payments for defaulted plans are guaranteed up to certain regulatory limits. This is conceptually similar to FDIC guarantees for bank deposits. In a severe economic decline, the PBGC itself could theoretically default on its obligations (presumably kicking the can up to the federal government), but when a retiree’s corporate pension fails for its own unique reasons, the PBGC is an extremely valuable fallback.

Okay, finally: What about annuities?

Annuity providers don’t fail often, but failures can occur. A company that ceases to exist can no longer pay the incomes it has promised. Recommendation #1 is to buy annuities only from highly rated insurers. While it may technically be true that a higher return can be obtained in exchange for accepting the risk of a less creditworthy provider, this is bedrock income we’re talking about; there are far more efficient ways to take measured risk to reach for superior return (stock market, hello?!).

Also, there are backstops here too. But whereas the PBGC is a federal entity, annuities are backed by state-level guaranty organizations, and thus the exact nature of the backstop varies by state. The most common arrangement is to guarantee the benefit amount up to a limit of $250,000 in present value. For a “standard” annuity like a Single Premium Immediate Annuity (SPIA) or Deferred Income Annuity (DIA), this is relatively straightforward: In the event your insurer defaults, your benefits will be assumed by the state agency and you will continue to receive your income[7]—or at least the portion of income that represents a present value of less than $250,000, or whatever figure applies in your state.[8]

More complicated annuity types, such as variable annuities or fixed index annuities, likely have more complicated coverage rules. Assessing the nature of the backstop might be a worthwhile exercise for folks considering the purchase of such a vehicle.

Wait a second, you also had continued employment on the list; no guarantees there, right?

Well, typically not, no. But the tradeoff can be flexibility in the nature, quantity, and timing of cash flow generated by “employment income” (broadly defined) in “retirement” (also broadly defined). Such flexibility over time typically will not exist with the contractually guaranteed products reviewed above. One could argue that the best, most flexible retirement plan is to not retire!

However, in our biased opinion, contacting us here at Round Table to work out a high-quality, flexible retirement plan is not a shabby option either!

[1] E.g., as measured by multiplying all possible outcomes, including default, by the probability of those outcomes, and then calculating a present value via some risk-sensitive discount formula.

[2] Well, it is twice as long as the short answer!

[3] Admittedly it’s not entirely clear which generation is mine.

[4] The linked Social Security Administration article’s summary paragraph says 75 percent, but the body text says 76 percent. Your government at work! The 76% figure seems to be quoted more often, but it’s just an estimate either way.

[5] Note that this also applies to increased taxation, at least for anyone no longer drawing employment income.

[6] Social Security’s “unfunded liability” is estimated at about $23 trillion at present, vs. about $1 trillion for all state pension systems.

[7] Or 80% of your income if you are in California.

[8] This potentially suggests a strategy of splitting up annuity purchases to obtain higher aggregate coverage, similar to splitting bank deposits across multiple accounts to increase FDIC coverage. Notably, because the deferred income annuity (DIA) products that Round Table may recommend as part of a Layer Cake retirement plan don’t start paying income until down the road, a DIA with more than $250,000 of present value (or upfront cost!) is uncommon anyway.

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Annuities, Income, Social Security