For the life insurance industry, it’s a victory that came only after years of battle.
The Treasury and Labor departments last month gave the green light to the inclusion of deferred-income, or longevity, annuities, which guarantee monthly income streams for retirees, in target-date funds seen in 401(k) and other defined contribution plans. Plan sponsors will be able to offer these annuities in qualified default investments to workers aged 55 or older without running afoul of ERISA’s non-discrimination rules.
The move has the potential to unleash huge changes in the retirement industry, and is exactly the type of regulatory support the insurance industry has spent years promoting.
Deferred income annuities are designed to provide guaranteed income for life, but unlike immediate annuities, the benefit payments for DIAs do not begin until some later date.
Back in the mid-2000s, as momentum for passage of the Pension Protection Act picked up steam, financial services industry interest groups besieged legislators, hoping to get their products favorable treatment in the legislation.
The mutual fund industry — the competition to those selling annuities – was pushing to get target date funds qualified as a default investment in DC plans. The insurance industry was hoping for the same favor to be bestowed on annuities.
When the smoke cleared, TDFs won out. To call the PPA a windfall for TDFs would be an understatement. Tower Watson research says 86 percent of defined contribution plans now use TDFs. Assets in them tripled between 2006 and 2012.
But annuities were not so lucky in 2006. That, however, changed in October when Assistant Secretary of Labor Phyllis Borzi wrote Mark Iwry, deputy assistant secretary for Retirement and Health Policy at Treasury and the primary architect of the recent guidance, validating the use annuities in TDFs.
As the news spread, some suggested the new rules could do for annuities what the PPA did for TDFs.
That may be the case but certain things have to happen first. David Blanchett, head of retirement research for Morningstar’s investment management team, builds annuity allocation strategies and has been doing so long before the recent guidance was issued.
A lot has to happen, he says, before annuities become a staple in 401(k) plans, though ultimately, their future hinges on one thing.
“Sponsors — big plan sponsors — are going to have to lead the way. When a couple of major plans become comfortable with the new products industry provides, then yes, that could very well lead to adoption across most plans.”
Once awareness and acceptance grows, Blanchett expects the competition will become intense. That will be good for participants and sponsors, he said, because it will drive costs down, which addresses a core complaint many have with annuities in the retail market.
Annuities, in fact, can be expensive. Fees can range up to 3 percent. A $30,000 annual benefit can cost in the range of $500,000. For the first 16 years of retirement, all the insurance company is doing is paying back principal that could have been grown more aggressively.
And annuities generate great commissions, a temptation that can test advisors’ fiduciary obligation, critics say.
“Those arguments are small-minded,” counters Blanchett. “It makes no sense to compare the costs of an annuity contract with the fees on a mutual fund. They are two completely different products, with completely different functions.”
Blanchett does say sponsors are going to have to fully understand the potential risks of annuities. That means they may not be right for every plan.
“Fiduciary obligations with annuities are potentially more complicated. Sponsors are going to have to refine their level of due diligence. Annuities are long-term contracts. A mutual fund is not a contract. When a sponsor wants to move from one mutual fund to another, they do so. With an annuity contract, it’s much different.”
In other words, moving annuities into 401(k)s will complicate things.
And it may require further regulatory guidance, according to Jim Szostek, vice president for retirement security at the American Council of Life Insurers.
Szostek has been lobbying Capitol Hill on the value of lifetime income products and has worked closely with Treasury and Labor since regulators began signaling their interest in improving access to annuities.
In 2010, Szostek and the ACLI received a request for information from Treasury and Labor, essentially wondering how wider adoption of annuities could be facilitated.
One of the questions is related to sponsors’ fiduciary obligations, specifically with respect to the Annuity Selection Rule, which says sponsors are responsible for picking an insurance company that will remain financially able to make all future payments.
That’s a regulation that spooks a lot of plan sponsors, says Szostek. “It can be an impractical expectation, especially with smaller sponsors. But we’re working closely with Treasury and the DOL on this and they’ve been responsive.”
He said the DOL is expected to take up the issue of the Annuity Selection Rule early next year.
Clearly, the recent guidance on annuities in TDFs, along with guidance issued last summer paving the way for longevity annuities, is a boon for Szostek’s clients and will no doubt go a long way to delivering wider access to annuities in 401(k) plans.
But Rome was not built in a day, he says. “There’s been great movement in getting more people access to lifetime income products. But it’s a process, and we know there are still miles to go.”
As to when pre-retiree participants will see annuities in their TDF line-up, Szostek says it’s anybody’s guess.
Notwithstanding the momentum generated by the recent guidance, big questions remain, like exactly what the products will look like, what they will cost, and how efficiently the insurance industry and mutual industry can come together to innovate.
“The two industries have a history of working together. Annuity contracts have mutual funds built into them. So there is a model,” Szostek said.
Indeed, defined benefit pension plans have used annuities for decades.
Now it’s up to two industries that more often than not have competed against each other to come together and meet the demands of the defined contribution market.