Even as defined-benefit pensions continue to advance up the endangered-species list, 401(k) plans, a presumably hardier species, have hit some evolutionary bumps of their own.
Chief among them, of course, is the impact of the economic downturn, which left many plan participants with decimated account balances. The resulting outcry has prompted many employers — and policymakers — to look for ways to make 401(k) plans more effective. And part of their solution can be summed up in a single word: annuities.
The appeal of building annuity options into 401(k) plans is simple. Unlike mutual funds, which dominate discussions of 401(k) investment strategies, annuities promise to deliver guaranteed payments to retirees for their entire lifetime. They also allow employees to see how much income they have accrued for retirement at any given time. And, for employers jettisoning traditional pension plans and emphasizing a switch to 401(k) plans, offering annuities provides at least the appearance of a pensionlike guarantee.
But the biggest driver is employee demand for more certainty. In 2007, for instance, Paychex, a payroll and human-resources outsourcing firm that administers 401(k) plans for other employers, began offering an annuity as an investment option in its own defined-contribution (DC) plan. The reason was that "our employees, who were feeling the downside of 401(k)s becoming, as the joke goes, '201(k)s,' were asking for it," says Will Kuchta, the company's vice president of organizational development.
Many Paychex employees had invested heavily in the company's stock and saw their savings dwindle in the wake of the dot-com bust. Some began to request traditional pensions like the ones police officers, firefighters, and teachers routinely get, according to Kuchta. The firm's answer was to offer a Genworth Financial Services annuity that resembles a pension in that enrollees receive guaranteed periodic payments upon retirement.
As is the case with any other form of 401(k) investment, however, the bulk of retirement income is funded by employee contributions rather than employer contributions.
Nevertheless, employers and benefits policymakers feel the time is ripe for a serious look at annuities as one piece of a broader strategy to fill the gap in retirement income that many employees face. The demise of traditional pensions and increased anxieties about the risk of investing in debt and equity mutual funds have added a certain urgency to the subject. "We're used to living from paycheck to paycheck," says Jody Strakosch, national director of strategic alliances for MetLife's retirement-products group. The use of annuities in DC plans represents "a way of getting that paycheck in retirement."
To date, Paychex is part of a tiny minority of employers actually offering annuities as a 401(k) plan option. "We have not seen an overwhelming demand from plan sponsors" for the use of such products, says Beth McHugh, a vice president with Fidelity Investments. Indeed, of the 19,000 defined-contribution plans that the mutual-fund company administers, only one offers the choice of an annuity — and only 10% of that plan's employees participate in it.
It should be noted that different plan providers differentiate themselves in different areas of expertise, and Fidelity has long stressed its vast selection of stock and bond mutual funds, as opposed to more-stable investments like annuities. But even representatives of annuity providers like MetLife and Prudential — insurance companies seeking business in this area with relatively new products — agree that the offering is still rare among DC plans.
One reason is that annuities have, over the years, earned a reputation for high fees and unscrupulous, sometimes criminal, sales practices. As recently as July, without admitting or denying guilt, Bankers Life and Casualty reached a $1.5 million settlement with the Wisconsin insurance commissioner's office, which had charged the insurer with failing to prevent its agents from "unsuitable annuity sales and replacement, improper annuity marketing and sales practices," and other improper business dealings.
Short of such improprieties, sellers of individual annuities are famous for tagging on sales charges of 7% to 8% of a plan's assets and for adding costs by getting clients to cancel existing policies and buy new ones, according to Kuchta. He says, however, that such fees are a far cry from the group pricing Paychex gets for its variable annuity option: a 1% to 1.5% fee.
Another factor inhibiting the use of such products is the fear that inflation will kill their value. Asserting that the current 401(k) annuity push by insurers is an "opportunistic" use of the recession, John Burns, an independent plan fiduciary and adviser, says that "even if [insurers are] well intentioned, I'm not sure the results are all that good."
For a 62-year-old person looking to retire in a few years, "the interest rates they're locking into [by buying an annuity] today to get that fixed income are pretty low," according to Burns. After all, retirees can get the same results, but with lower costs and more flexibility, from a Treasury bill or a balanced mutual fund. "Ultimately, what will happen with some of those guaranteed annuities is that resources will be diverted from their families to insurance companies, and I don't see that as a good solution for American families," he says.
While they grant that locking all of an employee's assets into an annuity at current interest rates might not be the best idea, insurers contend that the technique of dollar-cost averaging can mitigate some of the risk. For instance, 401(k) participants can start off by buying 25% of the annuity they eventually hope to purchase and then "make laddered purchases to take advantage of any interest-rate movement," says MetLife's Strakosch.
The inflation risks may also vary with the type of annuity being offered. "Someone locking into a fixed annuity that is interest-rate sensitive might want to do an analysis of that, given current interest rates," acknowledges Chris Daley, president of Genworth Financial's institutional retirement income group. But Genworth's product is a variable annuity that has an underlying balanced portfolio providing the guaranteed income. That means that there is some upside potential above the guaranteed income — as well as some downside potential if the value of the portfolio declines.
Perhaps the biggest deterrent to employers, however, is the frightening possibility of being sued for what turns out to be a bad choice of annuity providers. In the shadow of AIG's recent problems, the fear of insurance-company insolvencies adds to the fear of such liability. If employers hire a provider that becomes insolvent, the members of the plan's fiduciary committee could be held personally liable, says Ed Rayner, a benefits attorney with Pryor Cashman. "It means they could lose their house, their car, the personal assets that they hold," he says.
A particular worry is that of being sued for the mismanagement of income distribution once retirement begins. Currently, some employers offer retirees the chance to roll over their 401(k) earnings into an individual retirement account and then buy an annuity through the plan with the funds in the account, rather than taking the funds in a lump sum. That provides retirees with a way of making sure their money lasts over the course of their lifetimes and gives them the cost advantage of group buying.
At a hearing on retirement income held in September by the U.S. Labor and Treasury departments, speaker after speaker decried the vagueness of wording in the DoL's "safe-harbor" provision for plan sponsors in choosing annuity providers. Determining whether an employer has met the standard "require[s] subjective judgments," according to Allison Klausner, assistant general benefits counsel, Honeywell International. Speaking for the ERISA Industry Committee, an employer group, she took special note of the subjectivity of the word appropriately in the rules. The DoL currently requires that an employer "appropriately considers" enough information to assess a provider's ability to make future payments and "appropriately concludes" that the chosen provider is financially able to make them.
Despite those far-from-trivial concerns, interest in the use of annuities to at least partially replace the features once offered by traditional pensions is on the rise. "We're on the cusp of an era in which individuals will have to depend on 401(k) accounts for their total retirement income, and that's the reason annuities are such a topic of discussion," says Bob McAree, a senior vice president with Sibson Consulting, an HR advisory firm. New and improved annuities may be one way that companies can give employees a little more peace of mind, if not an actual pension.
David M. Katz is New York bureau chief of CFO.