For most American workers, defined benefit plans with their guarantee of a lifetime income have gone the way of the dinosaurs.
For workers whose employers sponsor a retirement plan, 63% have only a defined contribution plan, such as a 401(k). Unfortunately, DC plans typically function solely as savings plans, with only a small portion (fewer than 25%) offering an annuity to provide lifelong retirement income. Moreover, even when an annuity option is available, only a very small percentage of retirees (around 6%) choose an annuity option.
At the same time, there is widespread agreement among policymakers that retirees could substantially benefit if they received some portion of their 401(k) plan balance in the form of a life annuity.
One of the key challenges to increasing use of life annuities is how to make this option available to more employees. In this regard, a rulemaking proceeding is quietly advancing in Washington, which has the potential to heavily influence the availability of annuities to section 401(k) participants.
Last year, in the Pension Protection Act, Congress directed the Department of Labor to issue regulations clarifying that the selection of an annuity contract as the optional form of distribution from a DC plan “is not subject to the safest available annuity standard under DOL Interpretive Bulletin 95-1.”
By way of background, selecting an annuity provider in connection with distributions from a section 401(k) plan is a fiduciary act, subject to the fiduciary standards of ERISA section 404(a). In Interpretative Bulletin 95-1, dealing with the selection of annuity providers for defined benefit plan distributions, DOL adopted guidance that generally requires DB plans to choose the “safest available annuity.” This guidance also required DB plans to consider numerous aspects of the issuer’s financial condition, including, among others, the issuer’s investment portfolio, the level of the issuer’s surplus and capital, and indications of the issuer’s exposure to liability.
In 2002, DOL extended the “safest available annuity” standard to DC plans, but the adoption of that standard has been widely perceived as creating a significant impediment to employers making annuities available in DC plans. This has been recognized not only by Congress, but also by DOL itself.
As a result, in September 2007, DOL issued a very significant proposed regulation. It provides a safe harbor under which a plan fiduciary is considered to act prudently in selecting an annuity as a distribution option under a DC plan, if the fiduciary takes certain steps. The steps–proposed in the form of a safe harbor–are quite involved (see chart).
If you are thinking that this standard is not likely to increase meaningfully the use of annuities in section 401(k) plans, you are not alone.
Although the proposed regulations are undoubtedly intended to encourage the use of annuities in 401(k) plans, widespread concern exists that the proposals may have the opposite effect. The primary concern has to do with the portion of the proposed regulations (see chart) that deems a fiduciary to have acted prudently in selecting an annuity if the “safe harbor” conditions in the proposed regulation are satisfied.
The preamble to the proposed regulations does not expressly state why the DOL included a “safe harbor.” Presumably, the reasoning is that a safe harbor will give plan fiduciaries a level of comfort with the relevant fiduciary considerations in selecting an annuity, which will encourage fiduciaries to offer annuity options.
Many in the insurance industry believe, however, that the safe harbor in the proposed regulations will not provide plan fiduciaries with comfort. Rather, they believe it will be viewed as setting forth the process that fiduciaries must utilize in order to satisfy their fiduciary obligations.
Viewed as a minimum standard of conduct, the fiduciary process outlined in the “safe harbor” could wind up being perceived as imposing a heightened fiduciary process.
As a result, the industry is urging DOL to delete the so-called safe harbor and to simply clarify that the general fiduciary standards applicable to plan investments are applicable to the selection of an annuity for plan participants. Hopefully, this will occur. Otherwise, another unfortunate barrier to guaranteed lifetime income for retirees may continue to exist for years to come.
Joseph F. McKeever III, a partner with the Washington, D.C. law firm of Davis & Harman, represents the Committee of Annuity Insurers, a coalition of 33 life insurance companies.