For several years, PEI has been studying the retirement income landscape. We have been evaluating in-plan retirement income products, actively monitoring the regulatory activity and legislative environment, and keeping a close eye on the implementation of retirement income products within defined contribution plans. Michael Sasso, one of PEI’s three co-founders, was the Issue Chair for the 2012 ERISA Advisory Council’s “Examining Income Replacement During Retirement Years in a Defined Contribution Plan System” report. Mr. Sasso then collaborated on the report that provided recommendations to the Secretary of Labor as the DOL contemplates providing guidance on such solutions for plan sponsors.
While PEI understands the benefits of in-plan retirement income solutions, we do not believe the time is right for plans to implement them. As an increasing number of participants are now planning for retirement in a defined contribution plan framework, without the guaranteed retirement benefit payouts that were provided by defined benefit plans, it can be argued that the solutions that would be most beneficial to defined contribution plan participants are those that offer a lifetime income guarantee. However, many plan fiduciaries perceive that there may be a fiduciary risk to offering guaranteed income products within their plan, believing that the regulatory guidance for selecting and monitoring these products is unclear. In addition to the perceived risk and added fiduciary burden, most recordkeeping platforms are unable to accommodate these guaranteed income products at this time. For these reasons, as well as the low participant utilization, lack of portability, high participant cost and increased administrative complexity of these solutions, PEI suggests that plan sponsors wait for regulatory clarity and guidance to emerge and for the market to evolve before adding an in-plan retirement income solution to their plan lineups.
Just fifteen years ago, most retirees depended on defined benefit plans to provide them with a regular and reliable income stream through retirement. The baby boomers, however, are retiring under a different paradigm, one in which defined benefit plans have been eclipsed by defined contribution plans as the primary source of retirement savings. As the focus of defined contribution plans has always been on asset accumulation alone, a void has been left by the diminished role of defined benefit plans–a means of turning retirement savings into retirement income streams. A growing number of retirees does not know what kind of income stream their savings will provide. On top of that, it is up to participants, who generally lack the investment knowledge and time for proper due diligence, to select (and pay for) the vehicle with which to convert their savings into an income stream. This can be a confusing and overwhelming task, as the products are quite complex. With baby boomers starting to retire, the issue is coming to a head.
The retirement product market, which includes both insurance companies and investment firms, has been anticipating this need and has developed an array of retirement income products (including products that provide a guaranteed lifetime income stream) that could be integrated in a defined contribution plan. Despite the growing number of solutions available, offering such products within the defined contribution plan (“in-plan solutions”) is not getting much traction. The reasons for slow adoption are many, with the primary reason being the plan sponsor’s concerns about the additional fiduciary burden associated with offering such products.
In the following pages, we will discuss the dilemmas participants face as they prepare for retirement, especially in light of the void left by the diminished role of defined benefit plans. We will then provide an overview of the current retirement income product market, discussing the benefits and drawbacks of various solutions. After laying out the benefits, to both participants and plan sponsors, of an in-plan solution, we discuss the significant barriers plan sponsors face in implementing such solutions, including an analysis of the most significant barrier – the lack of clear regulatory guidance.
Risks Facing Participants in Retirement
In the defined contribution paradigm, employees face a new set of investment risks as they plan for their retirements-risks that were previously borne by defined benefit plans. These risks include:
- Longevity risk: the risk of outliving retirement savings. As life expectancies continue to rise and health care costs continue to soar, the risk that retirees will exhaust their retirement savings before they die has increased.
- Shortfall risk: also called sequence of returns risk, the risk of suffering an investment loss with an inadequate time horizon with which to recoup that loss. The frightening and disheartening experience of older employees and retirees losing a significant chunk of their retirement savings in 2008 cannot be minimized.
- Inflation risk: the risk of the erosion of the purchasing power of retirement savings. In periods of high inflation, more of the retiree’s income is required to purchase the same goods, causing retirement savings to dwindle more quickly.
- Expenses: the cost of purchasing or investing in a retirement income product can eat away at retirement savings.
- Cognitive risk: the risk that retirees may make poor investment decisions as they age, or may become more prone to be victimized by fraud.
What Participants are Looking for in a Retirement Income Solution
In light of these risks, following are several attributes that are key to employees as they evaluate the various retirement income
solutions available to them:
- 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 – this may be very important in terms of inflation-protection
- Participant’s ability to access savings, in case of emergency
- Inheritance potential
Several recent surveys of 401(k) plan participants reveal that generating stable income is the most important attribute of a retirement income solution to most participants. For example, a survey by MetLife (MetLife Retirement Income Practices Study, June 2012) showed that 68% of the participants would prefer a guarantee of stable income, albeit with lower returns, to the potential for higher returns without a guarantee. Additionally, according to an SSgA survey (SSgA DC Investor Survey, July 2013), 74% of plan sponsors and 55% of participants prioritize security of lifetime income over liquidity and level of income, and 80% 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 ready access to their savings.
Retirement Income Solutions and Products
Investment management firms and insurance companies are quickly responding to the new set of investment risks and income needs for defined contribution participants by introducing a wide array of retirement income products. Most retirement income solutions can be grouped into three categories: investment-based, annuity-based, and blend of investment- and annuity-based products. A description of the most common solutions follows, as well as a brief discussion of the benefits and drawbacks of each type of
Managed Payout and Retirement Income Funds are designed to provide a steady stream of retirement income while allowing investors control and access to their accounts. Offered by investment management companies, these funds make regular distributions out of the participant’s account balance, in an amount (or percentage) designated by the participant. When the participant’s account is depleted, and the account balance is zero, the distributions stop. There is no guarantee that the participant balance will provide income for life. As such, they do not address longevity risk, nor do they resolve shortfall or inflation risk. Investors are subject to the effects of market declines, but do participate in market rallies. If there is a balance left in the account upon the investor’s death, it is distributed to beneficiaries.
Managed (Retirement Income) Accounts are more of a service than a product. Participants hire an advisor to manage their accounts, with objectives of capital appreciation, income and inflation protection. The participant, with counsel from the advisor, determines the amount and timing of distributions. Similar to managed payout and retirement income funds, these accounts are not insurance-based, and thus, cannot offer any type of guaranteed income stream. Investors have some control over the accounts, have access to their assets and participate directly in market value appreciation. However, managed retirement income accounts do not guarantee lifetime income and they are subject to market volatility, and therefore they do not address longevity or shortfall risk.
Annuity-based solutions offer income guarantees and, as such, may only be offered by insurance companies. There are a wide variety of annuities available to investors, which can be offered with a wide variety of features (such as inflation-adjustments and joint survivor benefits). Following are the most common annuity-based retirement income solutions:
Traditional Fixed Annuities (or Immediate Annuities) are the most common and recognized retirement income solution. The investor purchases annuity units from an insurance company (makes a deposit) in exchange for the insurance company’s guarantee for a specified guaranteed income stream for life (or any specified period of time). The insurance company manages the participant deposits in its General Account, pooling the deposits of all its participants. The insurance company profits by earning more in its General Account than it needs to pay out in benefits. The participant relinquishes all control over those deposits and the insurance company takes on the risk of market value declines and enjoys the benefits of market value appreciation. The participant does not participate in those market value gains or losses.
The key benefit of a traditional annuity contract is the lifetime guarantee of the income stream in retirement (and the possibility of extending that guarantee for the lifetime of the participant’s spouse), which addresses longevity risk: the annuity purchaser cannot outlive his income. In turn, cognitive risks are also eliminated. However, participants relinquish control over their investments once the annuity is purchased. They cannot withdraw funds in the case of an emergency and they do not benefit from market rallies.
Additionally, there is no possibility of a residual market value being left to heirs.
Variable Annuities are similar in some respects to fixed annuities, though, as the name implies, the amount of income provided varies. Investor deposits are not invested in a General Account, but are invested in underlying sub-accounts, available in a variety of asset classes. Income payouts vary as they depend on the performance of the underlying sub-account(s). Variable annuities do not protect the participant against downside risk after retirement, but they do allow participants to benefit from market appreciation. They also allow for some participant control over the assets, as investors can choose the asset classes in which their deposits are invested. Variable annuities can provide a lifetime guarantee, which could solve for longevity risk.
Longevity Annuities (also known as deferred annuity contracts or longevity insurance) are a type of annuity in which units of insurance are purchased that provide a specific amount of income, guaranteed for life, with payouts beginning once the contract holder reaches a specified age (typically 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.
The benefit of longevity annuities is that they act as an effective safety net if the income stream from other retirement investments becomes exhausted. Longevity annuities protect investors against the risk of cognitive decline. The primary drawback is that the retiree pays for it, but may die before using it. Additionally, the participant relinquishes control over the assets, cannot make emergency withdrawals and is not able to use unused assets for inheritance purposes.
Guaranteed Lifetime Withdrawal Benefits (GLWBs), sometimes called Guaranteed Minimum Withdrawal Benefits (GMWBs), are retirement income products that combine features of investment products and annuities. GLWBs typically combine a commingled or mutual fund (such as a balanced fund or target date fund) with a guaranteed income stream feature (“wrapper”) that is similar to an annuity. Because of the guaranteed income feature, GLWBs are issued only by insurance companies. In contrast to a traditional annuity, in a GLWB participants pay an explicit fee in exchange for the insurance company’s promise to pay a guaranteed lifetime income stream.
As the market is continually evolving, there are variations in the specific features of these products. In general, however, there are two stages associated with GLWBs: accumulation and decumulation. During the accumulation phase, participants make contributions into the GLWB, usually in the years preceding retirement. These assets are invested in some kind of balanced investment fund designated by the GLWB provider. The participant’s account value, on a specified annual date, is called the “benefit base” or “income base.” The initial determination of the benefit base is typically ten years prior to retirement. Any increase in the account value on the anniversary date resets the benefit base to the new, higher amount. The benefit base cannot be lowered due to poor investment performance or due to the effect of fees and expenses. The amount of income that the GLWB will pay out during retirement (the decumulation stage) is equal to a certain percentage (typically between 4 -5%) of the benefit base. If the account balance is depleted before the participant dies (assuming expected withdrawal behavior), the insurance company must continue to pay payments. If the participant dies leaving an account balance, that balance gets passed on to named beneficiaries.
With GLWBs, insurance companies are striving to provide a product that offers more of the features desired by participants. GLWBs, for example, provide a guaranteed lifetime income stream and, as such, give downside protection, as would an annuity; however, unlike an annuity, they also provide the participant with more flexibility and control over the account balance. Participants can take emergency withdrawals and they have the opportunity to participate in market rallies.
However, all these features come at a price. The main drawback to GLWBs is that they are expensive. Not only do participants pay the expense ratio of the underlying investment fund, but the products that are currently available in the marketplace also charge a fee (typically between 1% and 1.5%) for the insurance guarantee component. The total expenses of GMWBs, which are borne by the participant, are typically between 1.75% and 2.50%. Moreover, these expenses get charged during the accumulation phase, which typically begins ten years prior to retirement, as well as in the decumulation phase. As expenses reduce the account value, the negative effects of the expenses are compounded annually and are reflected in a reduced account balance, thus limiting the potential increase in the benefit base. Because the amount of retirement income is calculated as a percent of the benefit base (the participant’s account balance on a specified anniversary date), the compounded effects of high fees during the accumulation period, in particular, can have a significant impact on the amount of income the participant will receive in retirement. It is also important to note that while the idea of participating in market rallies is attractive, the reality is that once income payouts begin, the chances of a net increase in the participant’s account (the market appreciation less the distributions made from the account) on the anniversary date becomes increasingly unlikely as time goes on.
Following is a table depicting the benefits and drawbacks, in terms of participant preferences, for each of the retirement income products discussed. Looking at the table, it appears that GLWBs offer participants most of the attributes they feel are most important, although those attributes come at a cost.
|Managed Payout Funds and
Retirement Income Services
|Immediate Fixed Annuity||Immediate
|Lifetime Income Guarantee/ Longevity Risk||No||Yes||Yes||Yes||Yes|
|Post Retirement Downside
|Access to Savings/Hardship Withdrawals||Yes||No||No||No||Yes|
|0.50 – 1.5%||N/A (expenses not explicit)||N/A (expenses not explicit)||N/A (expenses not explicit)||
1.75 – 2.5%
Considerations of Offering Retirement Income Solutions in the Plan
There are significant benefits to participants having a retirement income solution offered within their workplace retirement plan. Together, these benefits are expected to improve all around retirement readiness, as they help fill the void left by disappearing defined benefit plans. Fostering retirement readiness is not only a heavily discussed topic for plan sponsors, but for policy makers as well. Benefits to participants include:
- Informed evaluation of products and prudent selection: selecting a suitable retirement income vehicle can be a confusing and overwhelming proposition to most individual investors. There are a multitude of products available, each with its own set of complex tradeoffs. Having a professional help to evaluate products and identify the tradeoffs is a significant benefit to
- Reduced costs: the costs for the products are generally significantly lower when offered at the institutional level than they are when purchased in the retail market.
- Higher utilization: when offered in the plan, utilization is believed to be higher.
- Increased participant savings: many believe that in-plan solutions lead to better savings behavior during the accumulation phase
In addition to the paternalistic motives of fostering the retirement readiness of participants, there are several other reasons why plan sponsors would want to offer an in-plan retirement income solution. Such reasons include:
- To retain assets in the plan, which lowers administrative costs
- To foster graceful workforce succession, by helping older employees retire, which in turn may reduce the cost of providing health care benefits to employees
- To enhance the brand of the employer; by offering attractive retirement benefits, the company may be better able to attract and retain talent
However, while there are benefits, the barriers to plan sponsors’ adoption of an in-plan solution are many and formidable, particularly for products with income guarantees. Such barriers include:
- Additional fiduciary burden of selecting and monitoring insurance-based products
- While there is regulatory guidance pertaining to the selection of annuities as distribution vehicles in defined contribution plans (which will be discussed in the next section), plan fiduciaries are still apprehensive about the perceived uncertainties associated with prudently evaluating these insurance-based products.
- Fear of litigation risk, especially if product guarantees are breached
- Administrative complexities
- Constraints on portability: a plan’s current recordkeeper may not be able to accommodate a preferred annuity-based or blended solution, necessitating an unwanted change in recordkeeper; additionally, if the plan sponsor no longer believes a current provider of annuity solutions is suitable, it may not be possible to replace providers for those already utilizing the product.
- Additional cost to plan
- Burden of additional communications and participant education
- Lack of utilization and demand of annuity products: while participants may prioritize the idea of a guaranteed income solution, they actually remain reluctant to use them.
Plan Sponsor Fiduciary Obligations with Guaranteed Retirement Income Solutions and Current Regulatory Environment
The increased fiduciary burden and perceived risks associated with adding guaranteed retirement income solutions to a retirement plan are the most significant barrier for plan sponsors. According to the MetLife Retirement Practices Study (2012), 79% of plan sponsors indicated that the fiduciary liability concerns are discouraging them from offering annuity-based solutions within their defined contribution plan.
In 2008, the Department of Labor (DOL) finalized a rule (73FR58447; Selection of Annuity Providers – Safe Harbor for Individual Account Plans) that addresses a defined contribution plan’s fiduciary obligations in selecting annuity providers. It is important to note 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 like GLWBs.
The rule describes the following five-step process by which defined contribution plan fiduciaries can satisfy ERISA fiduciary
standards when selecting an annuity provider for benefits distribution:
- Engage in an objective, thorough and analytical search for the purpose of identifying and selecting providers.
- Consider information sufficient to assess the ability of the provider to make all future payments under the contract
- Consider the cost of the contract in relation to the benefits and administrative services to be provided under the contract
- Conclude, at the time of selection, that the provider is financially able to make all future payments and that the cost of the contract is reasonable in relation to the benefits and services provided
- Consult with an expert, if necessary, to confirm safe harbor compliance
For most plan sponsors who are considering adding an insurance-based product to their plan, the fourth step presents too high a hurdle. Because of the long-term nature of the guaranteed payout, fiduciaries may be expected to prudently evaluate the claims-paying ability of the insurance company for decades into the future. This is daunting, particularly because the legislation does not provide clear and exact guidance on how to assess an insurer’s financial strength, stability and ability to make all future payments. Plan sponsors fear that the requirement to assess the future strength of an insurance company, and the lack of exact guidance on how the assessment should be made, may heighten litigation risk should an insurance company become unable to fulfill its obligations in the future. One of the biggest lessons learned from the 2008-2009 financial crisis was that big insurance companies can fail. While the US taxpayers bailed out failing insurance companies in the crisis, it is far from clear that this established a reliable precedent going forward.
On July 1, 2014, the US Department of Treasury and the IRS issued a final regulation pertaining to the purchase of longevity annuities by participants in qualified retirement plans (including IRAs). The regulation makes it easier for retirees to utilize longevity annuities as part of a retirement income strategy. The new rules also may make it easier for insurance companies to
construct in-plan solutions that utilize longevity annuities. Under the stipulations of the new regulation, the required minimum distribution (RMD) rules were altered so that the value of a qualifying longevity annuity contract is excluded from the participant’s account balance when determining the participant’s annual RMD.
In a press release from the Department of Treasury on July 1, 2014, the following interpretation was offered:
“These final rules make longevity annuities accessible to qualified plans by amending RMD so that longevity annuity payments will not need to begin prematurely in order to comply with those regulations. This change will make it easier for retirees to consider lifetime income options: instead of having to devote all of their account balance to annuities, retirees who wish to follow a combination strategy that uses a portion of their savings to purchase guaranteed income for life while retaining other savings in a more liquid or flexible investment will be able to do so.”
While the fiduciary issues associated with selecting an annuity-based or blended in-plan solution would also apply to longevity annuities (or blended products that incorporate longevity annuities), and the small number of recordkeeping platforms that can accommodate these products still remains problematic, there are several key benefits to an in-plan solution that incorporates
longevity annuity contracts. Not only are longevity annuity contracts cheaper to purchase than immediate annuities, as the payouts begin later in life, but if utilized in a blended solution instead of an immediate annuity, the deleterious effect of compounding fees during an accumulation period would be diminished. The accumulation period may be shorter (as the longevity annuity contract is shorter and cheaper). Another benefit to longevity annuity solutions is the tax impact. With revised RMD rules, there is an element of tax deferral. By excluding the value of the longevity annuity contract from RMD calculations, the participants can defer taxes on that money until they are 85 years old. The lower costs of longevity annuity contracts, combined by a tax benefit, may make them more attractive to participants.
As discussed earlier, utilization of annuity-based solutions is currently very low. As such, it is not surprising that non-insurance company recordkeepers have not been particularly motivated to accommodate products that incorporate annuities. However, should there be products that are more attractive to participants, resulting in an increase in the demand and utilization of products that incorporate annuities, recordkeepers would be incentivized to take steps to accommodate them, not wanting to cede a potentially large market to insurance companies. Increased utilization may also hasten the evolution of industry-accepted guidance for plan fiduciaries in evaluating the claims paying ability of insurance companies, even without explicit and specific guidance from the DOL, thus increasing the comfort level of plan fiduciaries to offer such products as an in-plan solution.
There is little doubt that the diminished role that defined benefit plans now play in the retirement planning of the American workforce has left a void in the retirement income equation. As defined contribution plans are primarily a vehicle for accumulation of retirement savings, employees have lost the ability to translate their retirement savings into an income stream for retirement. Without an in-plan retirement income product, these employees are, at best, compelled to purchase income solutions on their own, at costly retail prices. At worst, these employees make uninformed, expensive and poor investment choices. With the retirement of the baby boomer generation upon us, the problem is magnified. Though there are many retirement income solutions available in the marketplace, the ones that offer employees a guaranteed, lifetime income stream impose the greatest fiduciary hurdles to plan
While PEI understands the need for retirement income solutions and the tremendous benefits to participants of in-plan solutions, we believe that the obstacles for plan fiduciaries relating to their implementation are too high at this time. At this time, the solutions that would be most beneficial to employees, most of whom do not have a defined benefit plan guiding their financial planning in retirement, are those that offer a lifetime income guarantee. However, the uncertainty surrounding the current regulatory guidance for evaluating and selecting insurance-based products has created what most plan fiduciaries consider to be a fiduciary burden and risk. These fiduciary issues, as well as the low participant demand and utilization, lack of portability, high participant cost, and increased administrative complexity of these solutions, and the lack of recordkeeping platforms able to accommodate such solutions, lead PEI to suggest that plan sponsors wait for regulatory clarity and guidance to emerge and for the market to evolve before adding an in-plan retirement income solution to their line-up.