The Employee Retirement Income Security Act of 1974, or ERISA, hasn’t done much to specifically address retirement income security in defined contribution savings plans. The United States isn’t alone in this regard. Australia’s superannuation DC system hasn’t yet solved the problem of running out of money in old age.
Will giving plan sponsors a safe harbor provision in the Setting Every Community Up for Retirement Enhancement Act of 2019, or Secure Act — which allows them to have some fiduciary flexibility with respect to annuities — herald a new generation of investment solutions that provide true lifetime income security? Or will it open the floodgates to an unwashed horde of complex and expensive products that provide little benefit to workers?
Most plan sponsors, 62%, cite fiduciary risk as a barrier to implementation, and another 69% say that administrative issues such as portability prevent them from adding annuities to a plan, according to a 2019 survey by Willis Towers Watson.
The recently passed Secure Act significantly lowers the fiduciary risk of adding an annuity to a plan via a safe harbor and opens the door to no-cost annuity portability by participants. This should finally provide the 60% of surveyed plan sponsors who said they’d consider adopting lifetime income solutions with a pathway to begin adding annuities to their plans.
Employers want to provide employees with solutions for turning savings into income without leaving the security of the employer-sponsored 401(k) plan.
What impact will including annuities in retirement plans have on workers? Will the trend toward lower costs be reversed when the invisible hand of fiduciary liability is lifted for a class of products that generate the highest number of consumer complaints to FINRA?
Or will the addition of annuities pave the way for the next phase of the defined contribution revolution by finally giving employees an efficient way to turn their savings into a lifestyle?
The non-ERISA 403(b) market is a “living, breathing” example of what happens when annuities make their way into retirement plans without adequate regulation, according to Barbara Roper, director of investor protection for the Consumer Federation of America.
Some 80% of all investments are held in annuities in 403(b) accounts now, and 33% of total assets are held in oft-maligned variable annuities. The 403(b) plan is viewed as a “living hell” and the “most exploitative retirement system on the planet” by Anthony Isola, a financial advisor with Ritholtz Wealth Management.
But 401(k)s may be different. Plan sponsors have developed a far more paternalistic, fiduciary mindset and are wary of adding any potentially uncompetitive options to a plan menu. Not to mention the challenges of getting a recordkeeper on board.
“The difference with the 403(b) market is twofold,” said Fred Reish, a partner at Faegre Drinker Biddle & Reath and an ERISA expert. “A retail agent can sell directly to the individual investor. With 401(k) plans, they have to get on the recordkeeper’s platform. It’s just a different vehicle than an individual sale that marks the schoolteacher 403(b) marketplace.”
The Secure Act provides safe harbors when it comes to the selection of the insurance company to be included in 401(k) plans, but it also has a provision stating that fiduciaries are required to evaluate costs, according to Reish: “This could bring the same kinds of pricing pressures that are applied to mutual funds. If people think there’s going to be traditional kinds of retail annuities in plans — I don’t know if that can happen.”
Fear and speculation about the possible invasion of variable annuities into 401(k)s seems a bit overblown to Kevin Hanney, senior director of Pension Investments at United Technologies Corporation. UTC, one of the largest employers in the United States, already uses a variable annuity with a guaranteed income withdrawal benefit rider. And they don’t just use it as a core menu option for a few participants — a variable annuity is the qualified default investment alternative (QDIA).
UTC implemented the VA over seven and a half years ago, and the plan has over $2 billion invested by some 47,000 employees — all within an ERISA environment.
The UTC Experience
A recent AllianceBernstein survey found that 69% of employees list “a steady stream of income” as a top feature they would like to see in their retirement plans, and almost 90% would keep some or all of their contributions in a guaranteed-income target-date fund if their employer automatically enrolled them in it.
“I would say that United Technologies did not set out to pick an annuity. They set out to pick the key criteria,” explained retirement expert Mark Fortier, who was head of product and partner strategy at AllianceBernstein during the development of UTC’s QDIA.
“They wanted a default, certainty of income and control over the money (liquidity). They wanted to address the fact that a loss of control and risk aversion were real forces that they had to respect, and they wanted a simple enough experience that the only choice for participants was ‘when do I take the income?’ The variable annuity just happened to fit the needs of certainty and control,” said Fortier.
A traditional QDIA is built for accumulation but does not offer a pathway to decumulation. There is plenty of control, which is fine for sophisticated participants who feel comfortable investing and withdrawing from the account for income.
But to an average participant, especially one accustomed to the idea of receiving a pension in retirement, the 401(k) offers little in the way of clarity. Workers don’t know if they have enough to comfortably retire.
“There’s nothing wrong with keeping them in the traditional QDIA. But you can put them in something better. As a fiduciary why wouldn’t you? That’s my attitude,” noted UTC’s Hanney.
In developing the lifetime income solution for UTC, he faced the common resistance of plan consultants: “I’ve been in meetings where we have been talking to a plan sponsor who believes in the importance of including some sort of a guaranteed income option, and the consultants have been saying, ‘No, no, no, that’s too risky.’ There’s no upside for the employer and there’s a lot of potential downside,” he explained.
The idea that employers don’t benefit from offering a default retirement plan with guaranteed income is dismissed by Hanney. “Any consultant that says there’s no upside for the employer is wrong,” he said. “You’ve now created the feature that gives your workforce the option to retire according to their own schedule.”
An employee who looks at their 401(k) statement and sees a lump sum number that can’t be translated into income may feel uncomfortable moving into retirement. And there is a price to pay for keeping workers at their job when they’d rather be retired.
“When you start to add up the hard and soft costs of someone who’s effectively retired at their desk, that’s very expensive to the employer,” according to Hanney.
The UTC pension chief also had the advantage of working with experts to design a retirement income product that fit the needs of UTC’s workers as they transitioned from a traditional defined benefit pension. UTC created a consortium of three insurers to reduce price and capacity risk, and it worked hard to keep pricing in line with other lean QDIA options.
Although sponsors of small firms may not have the same research muscle, insurers can work collaboratively with plan sponsors, consultants and recordkeepers to develop creative DC solutions designed for the unique needs of an employer’s workforce.
The Rollover Problem
In the United Kingdom, the Financial Conduct Authority recently admonished nearly 2,000 financial firms for recommending the transfer of assets at retirement out of defined benefit income and into managed portfolios from which the firms derived compensation. According to the U.K. regulator, “We expect you to start from the assumption that a pension transfer is not likely to be suitable for your client.”
Billboard ads have been put up outside UTC facilities by “IRA poachers,” Hanney says, trying to get employees to pull savings out of their guaranteed income QDIA and to “put your money back where it belongs.”
Economists consider a TIAA variable annuity to be among the most efficient products for creating a protected lifetime income that can rise with equity performance. Yet a recent study found that annuitization among TIAA participants fell from 50% to 19% over the last 20 years.
One possible explanation for this decline is the often self-serving discreditation of annuitization by those who get paid to manage assets that would otherwise be turned into lifetime income. Should an annuity be the default choice for all retirees?
In the United States, most defined contribution plans do not contain any automatic annuitization into a defined benefit-type lifetime income plan. The vast majority of assets rolled over from a 401(k) to an IRA are either self-managed or managed by advisors who are compensated by either the sale of investment products or through ongoing asset management fees.
An investment-only approach is not necessarily the most efficient way to provide a steady income in retirement when lifespan and investment returns are unknown, according to William F. Sharpe, professor emeritus of finance at Stanford University’s Graduate School of Business and a 1990 Nobel Prize winner in economics.
The 1% asset management fee represents more than 10% of retirement assets in present value terms. Plus, the investment-only approach exposes retirees to the risk of either outliving assets or the often-ignored risk of spending too little in order to avoid running out.
Overall, the 401(k) is a new system, and few have experienced the downside of decumulation without annuitization. “The problem is that we are dealing with the first generation of 401(k) retirees, and they don’t have the experience of seeing their grandparents run out of money in their rollover IRAs,” according to Reish.
“It’s almost like we’re indigenous people sharing experience of what life was like with chants and songs,” he said. “We don’t have any chants and songs about running out of money when you’re 95.”
The primary benefit of discouraging rollovers out of a 401(k) is that the incentives of a plan fiduciary may be more aligned with a worker than with an investment advisor.
“Participants go from being bubble wrapped by plan fiduciaries to a world where they’re on their own,” said Reish. Keeping a worker in an employer plan after they retire could help ERISA defined contribution plans better live up to their name by giving employees true “retirement income security.”
“The key is how do you garner the strength of the employer-based system — their trust of employees, willingness to do the right thing and to communicate a complex problem in a simple way,” Fortier explained.
In-plan solutions that transition into lifetime income can allow employees to benefit from a pension-like lifetime income from institutions with reserve requirements that make them safer than many public pensions.
For instance, I wouldn’t want to stake my income 30 years from now on the financial soundness of, say, the taxing power of the state of Illinois. Plan sponsors can more effectively negotiate lower-cost lifetime income products and create defaults that are more likely to be in the best interest of workers who might not otherwise be able to choose a competitive income product on their own.
A 1965 study by Menahem Yaari, now a professor emeritus of economics at Hebrew University of Jerusalem, proved mathematically that a retiree with an unknown lifespan should optimally annuitize 100% of her wealth if lifestyle is her primary goal. A retiree willing to accept some variation in lifestyle to potentially spend more should buy a variable income annuity that rises and falls with market performance.
Annuitization is both optimal and potentially impractical in DC plans, according to David Blanchett, head of retirement research for Morningstar. Academic studies “assume the individual is willing to effectively trade accumulated savings for lifetime income,” he said. “While this approach might seem rational using most economic models, people have been relatively averse to this more pure form of annuitization.”
Economically pure annuities maximize the so-called mortality credits from savings by pooling assets into the account of an insurance company. This loss of liquidity may be difficult to implement in a defined contribution plan.
Most annuities in DC plans have a guaranteed minimum withdrawal benefit “as a contract they wrap around the target date funds,” said Reish. “There’s an investment component with a guarantee. When a participant gets to be 65, they guarantee, say, a 5% withdrawal rate from the high-water mark.”
“If my high-water mark is $500,000 and I retired in 2021, after a market crash drops my balance to $400,000 I can withdraw $25,000 each year. If the account runs dry, the insurance company steps in. Those benefits cost between 60 and 100 basis points. There are transparent costs,” he said. “The fee variation generally is justified by contract features. For example, a 100 basis point fee may allow the high-water mark to reset after retirement.”
A savings vehicle that trades growth for downside protection may have value, particularly for participants who are nearing retirement. Imagine holding $1 million in an average target date fund with an equity allocation of 45%.
If the stock market pulls a 2008 and falls 50%, a worker might see their expected retirement lifestyle fall by nearly 25%. It often takes months or even years of planning to make a comfortable transition out of the workforce. This uncertainty is a risk that workers who could plan on a defined benefit pension in retirement would not have to face.
Insurance companies can use financial options to cut off the downside tail of the distribution for workers who value greater certainty. A modern variable annuity with a guaranteed minimum income provides both downside lifestyle protection and protection against outliving income.
The value of protections offered through income insurance is highlighted by Moshe Milevsky, a professor of finance at York University’s Schulich School of Business.
Variable annuities with lifetime income benefits “provide insurance against two expensive events (bad markets and extreme longevity) vs. any one of them alone … [A]nd if the only way for consumers to buy (and understand them) is fused into a variable annuity chassis — then so be it,” Milevsky explained.
Of course, income protection guarantees are costly. Products that contain lifetime income guarantees and also provide account liquidity often require the use of financial options to hedge equity risk. Fees withdrawn from a worker’s investment account to pay for these options will reduce a retiree’s savings over time.
It is possible to replicate the benefits of a variable annuity by combining a traditional investment portfolio with the purchase of a simple single premium immediate annuity at retirement or through the purchase of a deferred income annuity that begins making lifetime payments in the future.
“Variable annuities with guaranteed lifetime withdrawal benefits can be best suited to those who are not comfortable with a SPIA and would otherwise be all fixed income no matter what, or who otherwise can accept the argument that it is OK to be more aggressive with their asset allocation when the rider is in place,” said Wade Pfau, professor of Retirement Income at the American College of Financial Services. “That additional equity exposure can offset the rider charges if markets end up doing fine,” he added.
Both Pfau and Milevsky defend the common variable annuity product structure as a better alternative than not annuitizing at all. But it is not necessarily the solution that will provide the highest and safest income possible.
Ins & Outs of GLWBs
“Guaranteed lifetime withdrawal benefits represent an evolution in the annuity space, since they provide retirees with the ability to ensure guaranteed income for life while also having access to the purchase (i.e., they are revocable),” Blanchett explained.
“The fact the annuitant can change their mind is going to reduce the amount of expected income, but that actually might make them better off if they would have been otherwise unwilling to purchase an annuity,” he said. “One would expect lower payouts from GLWBs compared to annuities, but I don’t know if that’s a fair comparison. It’s probably better to compare the GLWB to a regular portfolio.”
Differences among products with the variable annuities label can serve as a large barrier to the adoption of annuities by wary plan sponsors. In the accumulation phase, many variable annuity products provide features that resemble structured products and aim to change the distribution of future investment returns. These features may appeal to behavioral, loss-averse investors, but the costs are high and likely not in the best interests of long-run savers.
“One concern with GLWBs in general is that they are relatively hard to understand. There is no consistent terminology used to describe the benefit features and payout approaches, so it’s different for advisors, and especially consumers, to truly do a cost/benefit analysis,” Blanchett said. “Offering these types of annuities in 401(k) plans is a way for savers to have access to a high quality product, one that is generally going to be a lot better than they might purchase in the retail space.”
This, of course, assumes that plan sponsors know how to evaluate the competitiveness of annuity products. Most do not, but there are consultants and other experts who can provide the insight needed to select products that give participants income security as they transition into retirement.
Plan sponsors should take the leap, and not just by adding an annuitization option to the plan menu, Hanney says. Selecting a default QDIA with a lifetime income feature means that the average employee will receive a pension-like income from their 401(k).
“I’d say to the plan sponsor out there who has the traditional QDIA today, ‘There’s nothing wrong with that, but you can make it better. And it’s not that hard,’” he explained.
Michael Finke is professor and Frank M. Engle Chair of Economic Security at the American College of Financial Services and leads the Wealth Management Certified Professional designation program.