Pensions are an essential part of America’s retirement system, starting with Social Security. So why do so few Americans understand it?
Most of us seem to have no idea about pension insurance. In a recent study, the American College of Financial Services gave older Americans a score of 12 out of 100% for their retirement knowledge based on their performance on a short quiz.
Among a dozen knowledge areas measured in the school’s Retirement Income Literacy Study, retirement ranked last. Respondents knew more about Medicare, life insurance and long-term care than they did about pensions. The college surveyed 3,765 Americans ages 50 to 75 in August 2023.
In another recent survey, researchers at the TIAA Institute and Stanford University tested Americans on retirement literacy with a multiple-choice question that couldn’t have been much simpler:
“Susan worries about living a long life and running out of money, the survey says. How can she best approach this possibility?“
The quiz offered the following options: She could buy an annuity. She was able to get life insurance. She can’t do anything. I don’t know.
About half of the adults surveyed chose correctly. 3,876 adults took part in the January survey.
“The question arises as to why people don’t buy pension insurance. Part of it is because they don’t understand them,” said Gal Wettstein, senior economist at the Center for Retirement Research at Boston College.
What is a pension anyway?
Broadly speaking, an annuity is a series of fixed, predictable payments made at regular intervals over several years. You can purchase a pension yourself or earn it through work. A pension is a pension paid by an employer to a retired employee. Social Security is a pension paid to you by the government.
“I think it’s important for people to understand that they already have a pension and it’s called Social Security,” said Chester Spatt, a professor of finance at Carnegie Mellon University.
However, when financial advisors talk about annuities, they are generally talking about commercial annuities, a product sold by insurance companies that provides a guaranteed source of income in retirement, generally until death. They are available in different versions. A fixed annuity, for example, offers a guaranteed return. A variable annuity provides variable returns based on the returns of an investment portfolio.
Only about 10% of Americans own commercial pension plans, Wettstein said, citing research from Boston College. Buyers are usually upper middle class, meaning neither very rich nor poor. They probably live longer than the rest of us: good genes are probably one reason they bought the annuity.
It would be great, say many retirement researchers, if many more of us bought annuities.
Why? Because most Americans rely on Social Security to cover the majority of their retirement costs. And that pension alone doesn’t provide enough monthly income to fund a comfortable retirement, at least not for many of us.
The average monthly Social Security benefit was $1,907 in January. Still, the average household headed by someone 65 or older spends $4,345 a month, according to an analysis of federal statistics by investment firm BlackRock.
Americans don’t understand Social Security particularly well either
Speaking of retirement literacy, only about two-fifths of Americans understand the nuances of Social Security, according to the TIAA Institute, a research arm of the nonprofit financial services organization.
This is how many adults correctly identified three false statements about Social Security in a multiple-choice question:
“An employee receives Social Security benefits if he/she becomes disabled before retirement.”: True.
“Social Security benefits are paid as long as a person lives, regardless of how long they live”: True.
“The amount someone receives in Social Security benefits depends on his/her income during the last two years of full-time employment.”: False.
The amount of your Social Security check depends on your average earnings for up to 35 years of work.
That only two-fifths of Americans answered the question correctly “was a surprising result to us,” said David Richardson, research director at the TIAA Institute, because Social Security “is so fundamental to retirement planning.”
He added: “We don’t ask deep, difficult questions.”
Half a century ago, much of the private workforce supplemented Social Security with private pensions, annuities that offered a guaranteed monthly benefit in retirement.
Do 401(k)s and IRAs do the job of securing American retirement?
Over the decades, pensions have given way to 401(k)s and IRA savings accounts, tax-advantaged savings accounts that allow Americans to build their own retirement funds.
The problem with 401(k)s and IRAs, according to retirement scholars, is that they don’t do the job of protecting Americans in retirement.
Wealthy people accumulate huge amounts of money in their retirement accounts. But middle-income workers tend not to save nearly enough, economists say. According to census data, less than half of Americans have a retirement account.
Millions of Americans are at risk of outliving their savings, retirement researchers say. Because they live on Social Security alone, their standard of living could decline in their final years.
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Pensions could theoretically eliminate this risk.
“If you’re retiring within 10 years, you’re better off looking into annuities to build your own retirement if you don’t already have one,” said Dan Casey, an investment advisor in Bloomfield Hills, Michigan. “I have yet to meet anyone who can retire on Social Security alone.”
Researchers suspect that most Americans don’t seriously consider commercial pensions for several reasons. Pensions are complex. Purchasing is not as easy as enrolling in a 401(k) plan through an employer.
“It’s not easy,” Richardson said. “There’s a lot of discussion about making it easier.”
Annuities are expensive and counterintuitive: in fact, they insure us against the risk of living too long, which many of us don’t recognize as a risk.
“There is a risk that your assets will outlive because you lived longer than expected,” Wettstein said. “And that doesn’t sound bad, because everyone wants to live longer.”
Many Americans distrust pension insurance
Many Americans distrust pensions, sometimes with good reason.
“If you Google ‘annuities,’ you get these messages from people who just say, ‘I hate annuities, annuities are bad,'” said Michael Finke, a professor of wealth management at the American College of Financial Services, a private, nonprofit institution in King of Prussia, Pennsylvania.
“Annuities are a frequently misused financial product,” Finke said.
Regulators warn that the industry is attracting fraudsters who try to deceive customers with misleading sales practices, aggressive sales pitches and inflated prices. The annuity industry is vulnerable to fraud, in part because the product itself is so complex and set out in contracts that few people read.
Federal law in recent years has made it easier for employers to offer a quality commercial pension as part of a 401(k) plan. And that could be a game-changer, pension experts say.
On Wednesday, BlackRock, the world’s largest asset manager, announced the availability of LifePath Paycheck, a retirement savings vehicle that allows older workers to convert a portion of their 401(k) contributions into an annuity targeted toward a projected retirement year.
“As a society, we focus an enormous amount of energy on helping people live longer,” BlackRock CEO Larry Fink said in his 2024 letter to investors. “But not even a fraction of that effort will be dedicated to helping people afford those extra years.”
Daniel de Visé covers personal finance for USA Today and writes Our free Daily Money newsletter, offering financial tips and business news Monday to Friday.
This article originally appeared on USA TODAY: What is an annuity? Many Americans don’t know. Here’s why you should do it