How Secure Act Paves New Road to Retirement Income

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.

Variable Annuities

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.