A new analysis from Portfolio Evaluations, Inc. (PEI) suggests that an increasing number of workers in the U.S. retirement system are now planning for retirement under solely a defined contribution (DC) framework—without any of the guarantees provided by defined benefit pension plans (see “Personal Accountability in a DC World”). And while in-plan lifetime income solutions can be a powerful tool for some participants to address lifetime income needs, PEI warns that the current regulatory framework governing such products is ambiguous as to the extent of fiduciary risk involved. This makes it exceedingly difficult for prudent plan officials to implement in-plan income guarantees.
PEI suggests this perceived fiduciary risk and regulatory uncertainty is enough to scare most plan sponsors and advisers off of in-plan income solutions—fearing they will somehow be on the hook for participants’ lifetime income needs should a provider of an in-plan income product fail to deliver “promised” benefits. However unlikely that is, PEI says, it’s still a risk to be taken seriously.
In addition to the perceived risk and added fiduciary burden of in-plan income solutions, PEI says most recordkeeping platforms are as-yet unable to efficiently accommodate in-plan guaranteed income products. For these reasons, as well as lack of portability, high participant cost and increased administrative complexity of in-plan lifetime income, PEI urges plan officials to wait for regularity clarity and better guidance to emerge. Patient plan fiduciaries should also benefit as the investment marketplace creates better products to meet burgeoning demand for income solutions—whether in-plan or out.
The PEI analysis suggests the lack of viable in-plan income solutions is for the most part due to the DC industry’s historical focus on asset accumulation alone. This is proving to be problematic as more and more Baby Boomers approach retirement lacking sufficient lifetime income promises from Social Security and private pension plans from current or former employers (see “Baby Boomers Caught in the Middle”).
Further exacerbating the lifetime income problem, a growing number of near-retirees who have accumulated significant assets in DC plan accounts are unaware of what kind of income stream their savings will provide—or even what level of savings is needed. On top of that, PEI says, it is increasingly the job of participants, who generally lack the investment knowledge and time to conduct proper due diligence, to select and pay for the vehicle with which to convert DC savings into an income stream.
PEI researchers point out that the investment industry has done a decent job of anticipating these needs and already offers a great number of annuity products and other guaranteed income solutions. As PEI observes, many of these solutions could be integrated in a DC plan—but the reasons for slow adoption are many. Again, a primary reason is worries about the fiduciary burden and regulatory ambiguity associated with offering such products in-plan.
So what’s the upshot for sponsors, advisers and other plan fiduciaries? According the PEI, there are several attributes that are key to employees as they evaluate the various retirement income options available to them—attributes plan officials should consider closely when addressing the income question. These include:
- An income stream that is guaranteed to last a lifetime;
- Low costs/expenses;
- Protection of the market value of retirement savings from declines in the years immediately prior to retirement and in retirement;
- Potential for participation in market value increases during retirement, especially to address inflation;
- Participant’s ability to access savings, in case of emergency; and
- Inheritance potential.
Several surveys cited by PEI reveal that generating stable income is the most important attribute of a retirement income solution for most participants. For example, a June 2012 survey from MetLife on retirement income practices showed that 68% of the participants polled would prefer a guarantee of stable income, albeit with lower returns, to the potential for higher returns without a guarantee. Additionally, according to a State Street Global Advisors (SSgA) survey from June 2013, 74% of plan sponsors and 55% of participants prioritize the security of lifetime income over liquidity and level of income, and 80% of participants expressed that a guaranteed monthly payout is a “must have.”
According to these same surveys, the protection of the market value of savings is the secondary priority, and third is allowing participants to readily access their savings, PEI says. Because it is still so difficult to adopt in-plan income solutions that address all these criteria, PEI suggests plan officials should for the time being consider what type of education might prepare participants to shop effectively for income solutions outside the plan.
The PEI analysis goes on to break down the various income solutions that are currently popular among retirees and late-career DC plan participants. Popular investment-based solutions include managed payout and retirement income funds, which are designed to provide a steady stream of income while allowing investors to control and access their accounts. These funds are often delivered in-plan, PEI explains, and so they can be cost-effective based on access to institutional share classes, but their potential as a lifetime income solution is limited because income distribution stops when the account balance reaches zero.
There is also the managed account option, which PEI says is “more of a service than a product.” Under this arrangement, participants hire an adviser to manage their accounts, with objectives of capital appreciation, income and inflation protection. The participant works with the adviser to create a sensible withdrawal strategy—but similar to managed payout and retirement income funds, these accounts are not insurance-based, and thus, cannot offer a guaranteed income stream.
PEI says insurance-based options may be a better approach, though it can be difficult for participants to effectively shop for annuities outside of the plan without substantial guidance. There are a wide variety of annuities available to investors, PEI says, which can be offered with a wide variety of features, such as inflation adjustments and joint survivor benefits. PEI says the following are the most common annuity-based retirement income solutions:
- Traditional fixed annuities – Also called immediate annuities. The investor purchases annuity units from an insurance company in exchange for the insurance company’s guarantee for a specified income stream for life—or a shorter period of time if designated. These annuities help the participant offload longevity and investment risk, but the individual cannot withdraw funds in the case of an emergency and they do not benefit from market rallies. Additionally, there is usually no possibility of a residual market value being left to heirs.
- Variable annuities – These are similar to fixed annuities, though, as the name implies, the amount of income provided varies over time. Investor deposits are typically not invested in an insurance company’s general account, but are instead invested in underlying sub-accounts, available in a variety of asset classes. Annuity payouts then fluctuate with the markets, often with a floor. They allow for some participant control over the assets, as investors can choose the asset class for their deposit, but some investment risk remains.
- Longevity annuities – Also known as deferred annuity contracts or longevity insurance, this type of annuity is built around units of insurance which are purchased to provide a specific amount of income, guaranteed for life, with payouts beginning once the contract holder reaches a specified age—usually 85. Contributions to the longevity insurance account are typically invested in the insurance company’s general account and are not accessible to the account holder. These annuities can act as a lifetime income safety net, PEI says, but it’s entirely possible that the retiree will die before taking advantage of the income guarantee that was purchased.
- Balanced solutions – PEI says there is also a class of blended solutions often called guaranteed lifetime withdrawal benefits (GLWBs). These are retirement income products that combine features of investment products and annuities. Usually a comingled fund or mutual fund is combined with a guaranteed income stream “wrapper” that is similar to an annuity. The main drawback of GLWBs is that they are expense, PEI says. Not only do participants pay the expense ratio of the underlying fund, they also pay a fee for the insurance company component.
Despite the appeal of these products, a strong majority (79%) of plan sponsors in the MetLife survey suggest that fiduciary liability concerns are discouraging them from offering annuity-based solutions within their DC retirement plans.
PEI suggest plan officials should look to a final rule issued by the Department of Labor in 2008 (“Selection of Annuity Providers – Safe Harbor for Individual Account Plans”) for guidance on how to fold annuity products into a DC plan. It is important to note, PEI warns, that the rule applies to plan fiduciaries as they evaluate annuities to serve in a benefits distribution capacity only. While there is currently no specific guidance that pertains to the evaluation and selection of products with an annuity feature that serve as vehicles of asset accumulation and benefits distribution—such as GLWBs—some contend that the rule can prudently be extrapolated to blended products.
As explained by PEI, part of this rule is that plan fiduciaries must conclude, at the time of selection, that the provider of an annuity is “financially able to make all future payments and the cost of the contract is reasonable in relation to the benefits and services provided.” While the rule also allows plan fiduciaries to consult with an expert, if necessary, to confirm safe harbor compliance, for most plan sponsors considering adding an in-plan annuity as a lifetime income option, this level due diligence is simply too high a hurdle.
In closing the paper, PEI urges plan fiduciaries to closely follow the implementation of a DOL final rule that took effect July 1 and impacts in-plan longevity annuity access (see “Final Rules Seek to Expand In-Plan Longevity Annuity Access”). The regulation takes a key step towards making it easier for retirees to utilize longevity annuities as part of a retirement income strategy, PEI says, but fiduciary due diligence concerns are still an issue.
The full PEI analysis is available for download here.