Attorney Explains TDF Annuity Rule

What does the new guidance about annuity investments in target-date funds (TDFs) mean for retirement plan sponsors and participants?

While at the 2014 America Society of Pension Professionals and Actuaries (ASPPA) Annual Conference, S. Derrin Watson, an attorney with SunGard, spoke with PLANADVISER about what exactly the guidance allows and how annuities in TDFs will work for participants. Watson notes the IRS is trying to find ways to provide for at least part of participants’ retirement savings to be invested in annuities that will provide them with lifetime income.

In a TDF series, funds start at a certain participant age—say 55—to move underlying investments from equities to fixed income. The guidance allows the funds that are making this shift to invest in an annuity as part of the underlying investments, Watson explains. The annuity can either be an annuity that starts payments to participants shortly after retirement age or at some age in the future, say 85, to protect a participant against outliving his assets. Watson says at a participant’s retirement date, the fund manager will issue the annuity or a certificate for a group annuity to the participant, and the other assets of the TDF will be retained in the fund and reallocated.

According to Watson, insurance companies will not issue annuities without knowing the age of the annuity recipient, so the TDF series that uses annuities will have to restrict how participants invest in the series. For example, if a 30-year-old participant wanted to invest in a more conservative TDF than the one corresponding to her age, she could not invest in the 2020 fund in the series because if offers annuities. However, if the series did not include annuity investments, the 30-year-old participant could invest in the 2020 fund.

Watson says the IRS provided in its guidance that the age restriction on TDFs in a series that offers annuities will not violate antidiscrimination rules as long as younger participants will have the same investment opportunities at the same as age as older participants do.

The IRS then asked the Department of Labor (DOL) if such funds could be used as a plan’s qualified default investment alternative (QDIA), Watson notes. The DOL said yes, as long as the TDF series that offers annuities meets all other QDIA requirements. “The DOL also said the TDFs would qualify for the safe harbor from liability against a participant claim provided by the QDIA requirements as long as there is nothing inherent in the annuity chosen that would disqualify it,” he adds.

The DOL also said plan sponsors could limit their fiduciary liability for offering annuities to participants by offering them through TDFs. The plan sponsor has a fiduciary liability to prudently select the TDF manager; the TDF manager selects the underlying investments in the TDF. According to Watson, the DOL mentioned that TDF managers could use the Employee Retirement Income Security Act’s (ERISA) safe harbor rules when selecting the annuity in which to invest participants’ money.