By Charles E.F. Millard
This article was originally published by National Association of Plan Advisors
When the SECURE Act was signed into law in December of 2019, it seemed that plan sponsors would be focused on lifetime income solutions in 2020. Instead, the COVID-19 crisis struck.
Since then, asset managers, recordkeepers, insurance companies, and consultants have been hard at work gearing up to offer the kinds of in-plan lifetime income solutions that were envisioned in that legislation.
The SECURE Act makes it easier for plan sponsors to include various forms of annuities inside their 401(k). So now, rather than just offering the participant the chance to buy an annuity at retirement, plan sponsors are able to offer annuities as part of the 401(k) investment plan itself.
The easy part is understanding that lifetime income is encouraged and is now a little easier to provide. The hard part is analyzing the competing products and solutions. Variable annuities, contingent deferred annuities, deferred income annuities, managed payouts, and guaranteed lifetime withdrawal benefits. It’s enough to make your head spin.
So how should a plan sponsor even begin thinking about how to offer a guaranteed lifetime income solution in the 401(k)?
Before deciding to offer a guaranteed lifetime income solution, plan sponsors should evaluate these five key factors.
One of the reasons people don’t buy annuities is the fear they will not be able to get out of them. 2020 has taught us that a lot can change in one year – making an irrevocable investment decision difficult to rationalize. And no plan sponsor wants to “nudge,” let alone default, their employees into a lifetime income solution that they might later regret and be unable to exit.
But liquidity itself can have many meanings, so sponsors need to inquire. Sometimes “liquidity” comes at a cost (e.g., lower income or withdrawal penalties for participants getting their own funds back). Sometimes the investment is “fully liquid” until the moment when it is “annuitized,” when it can become “fully illiquid” (meaning when the funds go irrevocably to the insurer). Understanding these tradeoffs and implications is critical to helping participants make informed decisions.
Employees may retire early or change employers frequently. Plan sponsors change recordkeepers sometimes every five or six years. If you adopt a lifetime income solution, how can you make sure it is portable? That does not mean “portable so long as the employee’s next firm uses the same recordkeeper.” It does not mean “portable so long as my new recordkeeper also offers this solution.” Truly portable is a serious challenge when incorporating annuities into a 401(k) plan.
Plan sponsors should dig deeply into these questions. What happens if the employee leaves? What happens if the employer changes record keepers? Is the solution really portable? Does “portable” mean the income guarantee follows the employee — or just the assets?
When all those questions are asked, the claim that “Our solution is fully portable,” may look a little more challenging than it seemed at first.
3. Long-term Growth Potential
Participants also fear that they are giving away the long-term growth potential in their investments. Many annuities promise a fixed income amount starting on a certain date with no possibility of change. This can be comforting because of the predictable income provided, but it means the participants may reduce the long-term growth potential of their assets.
On the other hand, some annuity solutions promise participation in the market upside by annually capturing a high-water mark, but this can also be less exciting than it sounds. To provide this type of guarantee the insurer may need to restrict the investment selection to conservative portfolios which further reduces the long-term growth potential.
Understanding these tradeoffs and implications is critical to helping participants make informed decisions.
4. Efficiency for the Insurer
The long-term health of the insurer is another factor to consider. A process for the selection of the insurer, despite the safe harbor provided by the SECURE Act, is in everyone’s best interest. But beyond balance sheets and rating agencies, let’s think about the health of the insurer as it relates to the specific product they are offering.
In 2008 we saw many insurers offering variable annuities get caught offering unsupportable guarantees. These guarantees were unsupportable because the insurers couldn’t hedge the risks. The long-term solvency of an insurance carrier may come down to their ability to hedge the major risks they underwrite. Some commitments are easier to hedge than others. Plan sponsors should investigate whether the products offered are easy to hedge and thereby efficient for the insurer. An efficient solution will be the healthiest long-term offering for everyone involved.
5. Ease of use / QDIA eligible
Each of the foregoing traits is complex and varies widely from offering to offering. But once all those requirements are met, the plan sponsor must ask, “How will I be able to explain this to the participant? This is complicated enough that my head is spinning. How will participants understand it?”
Every plan sponsor seriously considering enhancing their retirement plan with a lifetime income solution must consider whether and how this solution can be explained to participants. If the solution isn’t seamless and easily digestible, it will not work.
This especially applies regarding the potential Qualified Default Income Annuity (QDIA) option (also known as “default”). Defaulting employees into lifetime income solutions may well be the most responsible option a plan sponsor can select for them. But if the solution is too hard for the plan sponsor to adopt or explain, it will also be too difficult for plan sponsors to use, regardless of the economics.
End Goal: More Income. Higher Guarantees.
If you are counting, this is number six. Only after the previous five requirements have been met should the sponsor ask about the level of income that is supportable, the amount of income that is guaranteed, and the percentage of outcomes that are favorable to the participant versus competing solutions. The cone of analysis needs to throw out the solutions that are not really liquid, not really portable, don’t really participate in upside, are not really efficient for the insurer and are too complicated to explain to participants.
Next, consider outcomes. Is it acceptable if our lifetime income solution “loses” in the best possible stock market outcomes? Presumably, the reason we are adopting this solution is to guard against the risk of bad investment outcomes. It is not just the percentage of outcomes in which the proposed solution “wins,” but the makeup and composition of those outcomes themselves.
This analysis can seem like a daunting task, but the kind of funnel or analytical waterfall outlined here can be a good guide.
The lifetime income that defined benefit plans pay may soon be relegated to history, but the SECURE Act makes guaranteed lifetime income in defined contribution plans more available and more important than ever. And by evaluating the factors discussed in this article, plan sponsors and their advisors can take an important step forward.
Charles E.F. Millard is the former Director of the U.S. Pension Benefit Guaranty Corporation; he is a senior advisor for Annexus Retirement Solutions.