Income Options
Although defined benefit plans must offer annuity payment options under federal tax law, 401(k) plans and most other types of defined contribution (DC) plans are not subject to this requirement. However, the Obama Administration believes that promoting the availability of lifetime income options in DC plans is an important policy objective.
Under current practices, there are three basic approaches to annuitizing DC plan benefits: annuitization outside the plan, adding an individual annuity distribution option to the plan, and adding a group annuity investment option to the plan’s menu. The level of employer involvement, as well as the duties imposed on the plan sponsor and other plan fiduciaries under the Employee Retirement Income Security Act (ERISA), as amended, vary by approach.
Annuitization Outside the Plan. Just as retired participants can roll over their DC plan accounts to individual retirement accounts, they can also roll them over to individual retirement annuities (IRA annuities). In the past, participants had to shop for annuities by contacting annuity providers individually. Rollover processing platforms now offer Internet portals, giving participants access to wholesale-priced immediate annuities. However, these portals must be offered through the plan sponsor.
Employers can implement these IRA annuity portals without triggering any additional fiduciary responsibility. Under DoL Reg. Section 2510.3-21, an IRA annuity will not be viewed as an employer-sponsored plan if employee participation is completely voluntary, and the sole involvement of the employer is to permit the annuity provider to publicize the program to employees without any endorsement. If these requirements are met, the employer has no fiduciary duty to evaluate the quality or cost of the IRA annuities offered through the portal, and the selection of the rollover IRA annuity is the participant’s responsibility.
Addition of Individual Annuity Distribution Option to the Plan. A 401(k) plan can provide annuity distribution options to participants in the same manner that money purchase plans typically provide them. Typically, if a participant elects to receive a distribution in the form of an annuity, the money purchase plan will purchase and distribute an individual annuity contract to the participant. Similarly, a 401(k) plan could be amended to offer annuity payment options, and to provide for the purchase and distribution of individual annuity contracts to electing participants.
The Pension Protection Act of 2006 created a new fiduciary standard for the selection of annuity providers for DC plans. To implement this new standard, the U.S. Department of Labor created a safe harbor under DoL Reg. Section 2550.404a-4, which requires a fiduciary to engage in an objective and thorough search of annuity providers, and to conclude that the annuity provider is able to make all future payments and that the cost of the annuity is reasonable. If necessary, the fiduciary must consult with experts.
Addition of Group Annuity Investment Option to Plan’s Menu. A DC plan could use a variable group deferred annuity contract to make an annuity option available to participants for both investment and payment purposes. Unlike an individual annuity contract issued in the name of the participant, a group contract is issued in the name of the plan’s trustee or sponsor and, instead of being purchased with a one-time premium, participants gradually purchase the variable annuity over time. During this accumulation phase, participants direct the investment of their premium contributions into the variable annuity’s underlying funds and accounts. After the participant retires, the value of the participant’s underlying investments is converted into an annuity and the payout phase begins.
When adding an annuity investment option, the DC plan’s fiduciary must select an annuity provider in accordance with the applicable fiduciary standards of ERISA. In addition, the plan fiduciary must ensure that the annuity investment option itself is a prudent investment alternative for the plan’s menu. In making this determination, plan fiduciaries should consider the fees and expense of variable annuity options, which generally have higher costs than traditional mutual fund options because of their insurance features.
We can expect any new rulemaking to expand on the three basic approaches to DC plan annuitization discussed above. Given the increasing interest in lifetime income options, financial advisers and consultants should familiarize themselves with the three basic approaches to DC plan annuitization, and advise their plan clients on their advantages and fiduciary requirements.
Marcia S. Wagner is an expert in a variety of employee benefits issues and executive compensation matters, including qualified and nonqualified retirement plans, and welfare benefit arrangements. A summa cum laude graduate of Cornell University and Harvard Law School, she has practiced for 23 years. Wagner is a frequent lecturer and has authored several books and numerous articles.