The IRS has cleared the path for 401(k) sponsors who wish to expand clients’ use of longevity insurance within 401(k)s by allowing target date funds (TDFs) to include deferred annuities, even for those plan participants who do not actively manage their investment allocations.
While the Treasury emphasized its commitment to encouraging taxpayers to secure guaranteed lifetime income sources by finalizing the rules governing the inclusion of deferred annuities within retirement plans earlier this year, these products have yet to gain traction with the average client.
This is largely because, while the 401(k) is widely accessible, many plan sponsors have yet to include deferred annuities among their investment options. By removing the existing barriers, the IRS has now paved the way for plan sponsors to incorporate deferred annuities—without violating the previously existing rules—making it very likely that the prevalence of these products is about to explode.
The New IRS Guidance
IRS Notice 2014-66 specifically permits 401(k) plan sponsors to include deferred annuities within TDFs without violating the nondiscrimination rules that otherwise apply to investment options offered within a 401(k). This is the case even if the TDF investment is a qualified default investment alternative (QDIA), which is a 401(k) investment that is selected automatically for a plan participant who fails to make his own investment allocations.
Further, the guidance clarifies that the TDFs offered within the plan can include deferred annuities even if some of the TDFs are only available to older participants—even if those older participants are considered “highly compensated”—without violating the otherwise applicable nondiscrimination rules. Similarly, the nondiscrimination rules will not be violated if the prices of the deferred annuities offered within the TDF vary based on the participant’s age.
The new guidance will allow plan sponsors to include annuities within TDFs even if a wide age variance exists among the plan’s participants. Additionally, the new rules allow plan sponsors to provide a participant with guaranteed lifetime income sources even if the participant is not actively making his own investment decisions with respect to plan contributions—a situation that is increasingly prevalent as employers may now automatically enroll an employee in the 401(k) plan unless the employee actively opts out of participation.
QDIAs and Deferred Annuities
QDIAs are types of funds that are specifically identified by the Department of Labor (DOL) as being secure enough to be used as default 401(k) investment options for plan participants who do not proactively allocate their contributions among the otherwise available plan investment options. QDIAs commonly include TDFs, balanced funds and managed accounts.
QDIAs are important because a plan sponsor’s allocation of a participant’s contributions to a QDIA is treated as though the participant himself made the allocation, removing the fear that the default allocation will cause the sponsor to become liable as a fiduciary if market volatility causes the QDIA to perform poorly.
The DOL’s approval of these types of funds, coupled with the fact that many participants do not actively manage their 401(k) investment allocations, has made QDIAs very popular in recent years. However, the QDIA does little to help the plan participant manage his account balance after retirement, increasing the likelihood that the funds could run dry.
By allowing TDFs to include deferred annuities—even if the plan participant does not actively select the option—the Treasury has cleared the way for plan sponsors to create a secure retirement income stream for each plan participant.
The initial rules governing the use of deferred annuities within retirement plans created uncertainty and the potential for conflict with the existing rules. By removing this uncertainty, the IRS has once again committed to its goal of expanding access to guaranteed lifetime income sources for all clients.
Originally published on National Underwriter Advanced Markets. National Underwriter Advanced Markets is the premier resource for financial planners, wealth managers, and advanced markets professionals who provide clients with expert financial and retirement planning advice.
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