Funding a Carefree Retirement
In his lecture to accept the 1985 Nobel Prize in Economic Sciences, Franco Modigliani noted that, even though retirees can guarantee a lifetime income with annuities, voluntary purchases are extremely rare. Economists since have studied this “annuity puzzle” from every angle. Current thinking holds that, while every retiree needs income for a lifetime, people are justified in being more concerned with paying unexpected medical and other inevitable living expenses in old age, so that their reluctance to turn over their savings irrevocably to a monolithic insurance company is a rational view.
Financial providers have introduced plenty of solutions for a secure income: insurance products (see “Getting a Guarantee”), as well nonguaranteed retirement income options built from mutual funds. The challenge to advisers is to sort out the costs and benefits of this complicated array, and show sponsor clients which will best add value to their defined contribution plans and participants, while also addressing plan sponsor concerns that they might be extending, rather than mitigating, their fiduciary liabilities. Moreover, these new solutions continue to emerge, presenting advisers with an ongoing challenge in keeping current with the industry.
No one product type is likely to provide all the attributes that a successful retirement income and wealth management program requires, says Stephen Deschenes, Senior Vice President and Chief Marketing Officer with MassMutual’s Income Management Strategies Division. “When you’re decumulating, you’ve got to address several goals, and often the best way to achieve that is with a combination of products.”
Mutual funds can generate higher income than bank deposits but are not guaranteed, while annuities are guaranteed but typically provide limited income. MassMutual’s Retirement Management Account strategy brings those two approaches together by including immediate annuities for an income guarantee, and conventional mutual funds within a rollover individual retirement account (IRA) for growth and flexibility.
“Retirement income products” have been rolled out by about 25 fund complexes. Some are designed to make systematic payouts over time, and invest in mutual funds, typically as the epilogue to a target-date fund series, occupying the most conservative point on the glide path, (see “Funds Move to the Next Level” PLANADVISER, January-February 2009). “Self-liquidating” products, such as Fidelity’s Freedom Income Replacement group, aim to liquidate their holdings at a date certain. Russell’s Retirement Distribution products will make fixed distributions each year, and pay out any excess in their final years.
“An investor can do this on his own, working through an adviser, but we’ve packaged it up, saying “Tell us how long you want this sleeve of your assets to last, and we’ll manage that for you,”” says Dan Beckman, Vice President, Fidelity Investments Institutional Services. “We’re trying to help shareholders balance their spending over the 10, 20, or 30 years that they specify. It’s dynamically adjusted, and more precise than relying on the rule of thumb of spending 4% of assets per year.”
Other funds take an endowment approach, aiming to balance withdrawals for current income with growth in principal, lasting the retiree’s lifetime, with something left over for bequests. Investors in Vanguard’s Target Retirement Income fund can choose low, medium, or high current income distributions: “The key thing about payout funds is that they will go up or down with the market. In exchange for the liquidity of a mutual fund, you have risk to income and capital,” says Steve Utkus, Director of Vanguard’s Center for Retirement Research.
Because retirement income funds are purchased at the time or after a worker retires, and retirees cannot replace any market losses with future earnings, portfolio allocations have to balance the goals of investing in equities against longevity risk with preserving capital, A few funds, such as those from Vanguard and JPMorgan, diversify with alternatives such as real estate and market-neutral equity, but most are constructed from equity and bond offerings in the existing product line.
Fund providers have flirted with linking the worlds of insurance products with conventional mutual funds (both in and out of retirement plans)—so far without gathering much in assets. In one case, DWS Investment Group devised LifeCompass Income, an “endowment”-style retirement income fund that combined limited downside protection with some of the upside of equities. Its returns were driven by a complex quantitative investment process, and the cushions provided by a financial warranty through Merrill Lynch Bank for an incremental annual fee of about 60 basis points.
Launched in January 2008, LifeCompass Income outperformed its peers but, after the extreme moves in stock prices and Treasury yields in the year’s third quarter, Merrill Lynch Bank invoked terms in the warranty agreement that forced the fund to move all its assets, irreversibly, into zero-coupon Treasurys. With the fund no longer able to invest in equities, DWS liquidated it in February 2009. Although the offerings from other providers have not met the same fate, retirees are not flocking to the funds.
Distinguishing Characteristics
Other manufacturers take care to distinguish their mutual funds from annuities. “We have been careful not to describe our retirement income funds as self-annuitizing, or as pensions, because they really represent simplified systematic withdrawal plans,” says Vanguard’s Utkus.
Sales of both endowment-style and self-liquidating retirement income funds are off to a slow start, and the early returns on retirement income funds have not helped the cause. Through mid-February 2009, Morningstar reported that the group was down 20% for one year, and down 4% annually for those with three years on the ground—an immediate realization of the risk of investing in marketable, liquid assets, and a big setback to the funds’ income-earning potential. Wells Fargo’s seven Target Today funds took first place with returns ranging from -5.8% to -7.1% in 2009, owing to their equity allocation of just 15% of assets.
“The equity holdings of the retirement funds were one reason for the rough sledding, but some were stung even worse by their bond investments,” reports Michael Herbst, a mutual fund analyst with Morningstar. Poor performance led some funds to dip into principal unexpectedly, he notes: “If they’ve committed to make payments to investors, and the income isn’t there, they have to take it from investors’ capital.”
Today’s financial product marketplace has the annuity and investment components needed for a reliable and inexpensive retirement income product, but has yet to find the right combinations. As Utkus concludes: “What is undeveloped is not the product set, it’s the advice that we give the clients. Should a retiree who has taken a lump-sum distribution go to a systematic withdrawal plan? Where do managed payout funds fit in? Or do I need an annuity, and should I combine these in some way? Which products are a good deal, which are too expensive, which are too risky?”
As with most financial decisions, the answer is “It depends”—in this case, on two known variables, the retirees’ level of assets relative to the income they want to draw and how well they can manage their own finances; plus two unknowns, how long they will live, and how predictable their cash needs will be. Retirees with excess assets might be better off in endowment-type funds, as they are better able to contend with market risk. Self-liquidating funds would be appropriate for funding a specific need, such as a home mortgage or college tuition. For those who expect to live a long time and will not need to draw on capital, annuities are a solid choice, as long as care is taken to buy at institutional prices. In all cases, the risks in the market, and to the long-term health of insurance companies, call for a diversified solution that includes several assets.
Getting a Guarantee
Over the last two decades, 401(k) plans replaced traditional pension plans as the primary retirement vehicle for the majority of workers. The 401(k), however, was not designed to provide guaranteed lifetime income, and the recent financial crisis exposed a major flaw—if the market drops precipitously, 401(k) plans can leave participants at or near retirement vulnerable.
As a result, sponsors now are showing interest in providing investment options that can preserve capital and provide guaranteed income to participants, says Joseph Maczuga, the Executive Director of Fee Advisers Network in Troy, Michigan. For those interested in implementing an annuity feature as some aspect of their retirement programs, advisers can point them in various directions: Annuities can be used as an investment option within the plan, as an option for a rollover distribution out of the plan, or in an investment that combines mutual funds and insurance.
Investment Options
Variable annuities can be included directly in the investment lineup but sponsors, for good reason—mostly high costs—are wary of including annuity products in their 401(k) plans.
Variable annuities for 401(k) plans have been around for some time. MetLife, AXA-Equitable, and Prudential all offer classic variable annuity products for use within 401(k) plans as investment options, says Richard De Salvo of Richard De Salvo Consulting, LLC, in Madison, New Jersey. However, right now, few sponsors offer variable annuities as investment options in 401(k) plans, says Hugh Castro, an adviser with AXA-Equitable. When annuities are offered, he says, it is usually only at the small-employer level and never at very large plans. However, that may change sometime in the future as new, cheaper, annuity or annuity-like products come to market, or as plan sponsors adopt the new mutual funds that integrate an insurance guarantee for their plan lineups.
Providing participants with guaranteed lifetime income is the biggest advantage of any annuity. The advantage of having a variable annuity option in the 401(k) lineup, whether as a stand-alone investment or part of a mutual fund product, is that it can be cheaper for participants to buy annuities through their 401(k) plan where they can get the benefits of institutional pricing, particularly if they can be purchased at younger ages, says Maczuga.
Variable annuities also can provide larger death benefits if a participant dies in a down-market situation. For example, says Maczuga, if a variable annuity is purchased for $10,000 and a year later is worth $11,000, and then the next year the market tanks and the annuity is worth $9,000, if that person dies, the death benefit is generally the highest amount during the previous period, or $11,000. A mutual fund does not provide similar protection. Of course, there is a price to be paid for that protection, and that also may serve to limit the upside potential.
The biggest disadvantage of variable annuities in 401(k) plans is their expense, comments De Salvo. Variable annuities’ fees—including front-end fees, back-end fees, administrative fees, and fees paid to the adviser—can add up to a 2% to 3% expense ratio, typically double that of a mutual fund. Surrender charges also would apply to those participant investments if the sponsor wants to end the relationship because of service problems or underperformance of investments, notes Castro. Surrender fees also may have to be paid if the plan is terminated.
The annuity product that participants really want—one with principal protection, annual increases, and low fees—has not been built yet, says DeSalvo, although Genworth, Prudential, and Putnam are starting to introduce newer principal protection products. Once built at a decent price, they will be popular, he says, and the business will go to these principal protection products because that is what Baby Boomers want.
One newer product is an equity-indexed annuity, also known as an index annuity, says Maczuga. The index annuity, he explains, allows upside participation in the market, but does not have downside risk. The problem is, he says, that it is a complex product that is difficult for sponsors and participants to understand. It also has a much higher commission than either a variable annuity or mutual funds. The Securities and Exchange Commission (SEC) also has indicated that it may seek to regulate the product, he says.
Investments such as Genworth ClearCourse, Hartford Lifetime Income, MetLife Personal Pension Builder, and Prudential IncomeFlex products link mutual funds and income protection. Prudential Retirement’s IncomeFlex fund, introduced in January 2007, allows participants to select investment funds based on their risk tolerance and provides income protection from market downturns. Each fund has an income base that increases with employee contributions and provides guaranteed lifetime income.
While it may be a decade or more before annuity products are offered regularly during the accumulation phase, one area likely to see gains is fixed annuity rollover options. In the next three to five years, there will be more use of annuities in 401(k)s, says Maczuga, as a rollover product when the participant is at or near retirement. Castro agrees that the use of annuities will grow as a distribution option. Sponsors, he says, could negotiate better prices for their participants as a group and offer annuities as a rollover option. —Elayne Robertson Demby
Illustration by Charles Immer