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Guaranteed Income Riders In DC Plans: A Bridge To Retirement

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There is a new movement among insurance company record keepers for defined contribution plans. This is the move to provide guaranteed income riders as a new investment choice on 401(k) platforms.

These products seem like they should be an immediate hit for participants who are approaching retirement and who are concerned that they might outlive the income stream their assets could provide.

But some advisors question the necessity of having a guaranteed income rider in a 401(k) plan. They maintain that 401(k)s are accumulation vehicles–”if participants want a guaranteed income stream, they can buy an immediate annuity when they retire.” These advisors are trying to rationalize the extra cost of the guarantee during accumulation, particularly for younger participants with a long horizon until retirement.

Accumulation versus decumulation: Part of the problem is that many advisors evaluate the guaranteed income rider for the value it provides during retirement, when participants are decumulating assets. It is hard to blame the advisors, as insurance company marketing, including the names marketers give these products (e.g., “guaranteed income”), point in that direction.

What is overlooked is the value these riders provide to participants during the accumulation phase of retirement planning, especially in the later working years. This is when participants tend to grow more concerned about their 401(k) balance value.

Building a bridge: It has been well chronicled that investors, when left to their own devices–as they are in self-directed 401(k) plans–make predictably poor decisions. They become more aggressive at market tops, and sell at market bottoms. Herein lays the unappreciated value of the guaranteed income rider.

Such riders let participants stay invested through market cycles, even in the later years of their working careers when they are more prone to panic.

The graphic shows how such a rider could help participants build a bridge to retirement, even if a volatile stock market occurs in the later working years.

It shows 2 imaginary participants, Rhonda River and Bobby Bridge, who experienced the same imaginary market scenario–many years of solid growth giving way to a prolonged correction and subsequent recovery.

For simplicity’s sake, let’s assume that Rhonda River and Bobby Bridge are the same age, had the same starting account value and subsequent contributions, and were invested in the same lifestyle growth fund. The only difference is Rhonda had no guaranteed income rider while Bobby did.

At age 58 (Point A), Rhonda never felt better about her prospects for retirement. After many years of steady growth in the stock market, she had accumulated a bigger balance than she ever thought possible.

However, a sustained 3-year correction cut her 401(k) value by 30% (Point B). What do you suppose Rhonda does at this point? More than likely, she either reallocates her 401(k) to a much more conservative posture, or she moves entirely into cash. One can hardly blame her; she is 61-years-old and has very few years left to recover before her retirement date.

Consequently, when the market does start to recover (Point C), she does not fully participate. At retirement, her only choice is to walk away with (rollover) her account balance, similar to any mutual fund.

What about Bobby? He had purchased a guaranteed income rider when he turned age 55. This rider provided him downside protection with an annual step-up of his account value while he was in the accumulation phase.

When the market went into its 30% contraction, Bobby was concerned, too. However, he had his “bridge to retirement” provided by the guaranteed income rider. The guaranteed income rider gives him a choice at retirement; he can either take his account value, adjusted for additional rider fees, or he can elect to take a 5% income stream off of the final step-up value for the rest of his life. The guaranteed income stream is backed by the financial strength and claims-paying ability of the insurance company and will be adjusted if Bobby were to take out over 5% in any given year.

Given this choice, Bobby is less likely to engage in destructive investor behavior by reallocating to a money market or similar conservative investment at market bottoms. At age 61 and approaching retirement, he is also likely to be less anxious, and sleep better, than Rhonda.

Simplicity and cost are key: The example described above works best if the guaranteed income rider is both simple to understand and relatively low in cost. Guaranteed income riders in their simplest form offer a choice of the same lifestyle funds already on the platform, but with the option of having them guaranteed by the rider.

It is important to note that the cost of the guaranteed income rider is relatively low, ranging anywhere from 35 basis points to 95 basis points in today’s current array of competitive products. In the example above, where Bobby purchased his guaranteed income rider at age 55 and held it for 10 years to retirement, the importance of a lower cost guaranteed income rider is self-evident.

David Longfritz is senior vice president at John Hancock Financial, Boston. His e-mail address is