In February, the Department of Labor and the Department of the Treasury issued proposed new rules aimed at giving 401(k) plan participants more options to invest in annuities that guarantee a lifetime income stream. But the proposals don’t go nearly far enough to persuade plan sponsors to offer such “longevity annuities,” experts contend.
These products offer participants the chance to defer up to 25% of their account balances into an annuity that starts paying out further into retirement, such as at age 80 or 85. Only 16% of plan sponsors offer such an option, according to a recent Aon Hewitt survey. And only about 1% of participants at those companies take advantage of the opportunity, says Martha Tejera, a retirement-plan consultant, even though for most a longevity annuity would be “a better deal” than taking distributions directly from the plan balance upon retirement, she says.
The government’s plan has four components, two of which are key. The first is a change in the rules for calculating annuity payouts that could make plan sponsors more willing to offer participants the option of putting part of their retirement savings into an annuity while taking the rest in cash. That should appeal both to new retirees reluctant to give up control of all their retirement savings and to those who simply find annuities hard to understand.
Under the second key proposal, the value of the longevity annuity would no longer count in determining the required minimum distributions that plan participants must begin taking at age 70. Thus, participants may be more likely to want such an option — hence plans would be more likely to offer it.
But pension experts view the proposals as baby steps that do not address the most important factors keeping plan sponsors from offering guaranteed retirement income products.
First, there are potential liability issues. For example, while many insurance companies offer such products (including several launched within the past year), each insurer offers only its own solution. That undermines a plan sponsor’s fiduciary duty to prudently select investment options.
“You’re supposed to compare several different options for things like performance, appropriateness, and cost,” says Gregory Marsh, vice president and corporate retirement plan consultant at Bridgehaven Financial Advisors. “But if your provider offers only one solution, how can you make a prudent decision? Providers are going after clients, saying theirs is the greatest thing since sliced bread. But they have no fiduciary liability whatsoever.”
The plan sponsor also has a duty to pick an insurer that will be able to make annuity payments long into the future. “You’ve got to pick a provider that’s going to be around for 50 or more years,” says Robyn Credico, director of defined-contribution consulting at Towers Watson. “But many insurance companies have financial challenges and took bailout money,” she points out, making employers “pretty reluctant” to offer an annuity option.
Also, what happens if a plan sponsor tells a participant that, based on what the employee has saved, he will get $500 a month from an annuity — but he ultimately receives only $300 a month? Could the sponsor be liable? The answer is not yet clear, says Tejera.
Until these issues are resolved, longevity annuities will be unlikely to catch on, experts say — even though plan sponsors have more reason than ever to see that employees are adequately prepared for retirement. Since the economic downturn began, many workers have put off plans to retire despite being past their most productive years, fearing they will not have enough money in retirement. The downturn “has shone a spotlight on how limited defined-contribution plans are in helping companies manage” age-related attrition, says Tejera.
A Four-Step Plan for 401(k) Plans
Timely actions that plan sponsors should consider.
Many 401(k) strategies — whether for maximizing performance, spurring greater participation, or achieving regulatory compliance — are practically boilerplate for plan sponsors. But sponsors might consider taking other, specific measures in response to recent events and trends in the 401(k) space:
1. Review fee-allocation methodologies. The newly required disclosures of fees and compensation that service providers and sponsors must make starting August 30, 2012, will no doubt generate much greater scrutiny of fees (see “Lifting the Lid on 401[k] Fees,” December 2011). Plan committees should review and document the methodology for allocating fees to participant accounts, whether it’s through revenue sharing or other methods, advises consulting firm Mercer.
Revenue sharing refers to any portion of the expense ratio (the total fees charged to an investment option, expressed as a percentage of assets invested in that option) that is used to pay administrative fees other than investment costs. As for “other methods,” more plans are now charging administrative expenses directly to participants’ accounts, says Bill McClain, Mercer’s defined-contribution intellectual-capital leader. Whereas revenue sharing doesn’t show up on account statements but rather is embedded in the fund’s returns, charging costs directly to accounts makes them more visible.
“It makes sense to charge investment costs pro rata based on account assets,” says McClain. “But administrative costs don’t depend on how much money you have; a $400,000 account costs the same to administer as a $4,000 account.” Making the expense ratio available to pay for administrative costs, which until now has been the prevailing practice, not only is somewhat illogical but also “has not led to a great deal of openness and scrutiny,” he says.
2. Monitor stable-value options. Most 401(k)s offer at least one capital-preservation option, usually money-market accounts or stable-value funds. Both are designed to always trade at $1 so that participants don’t lose capital; they are paid in the form of income on the investments. The income can be held until retirement or withdrawn at any time. The difference between the two is that money markets trade in short-term fixed-income securities, while stable-value funds invest in long-term instruments.
Stable-value funds have historically generated far higher long-term returns than money-market funds, but now the stable-value market is under stress. The insurance companies that guarantee that the investments will always trade at $1 (by valuing them at book value rather than market value) have grown increasingly risk-conscious since the last time a fund “broke the buck,” three years ago. In response, they are increasing the pricing for stable-value funds and adding new investment restrictions.
3. Reconsider custom target-date funds. Custom target-date funds are tailored to a plan’s specific participant demographics rather than having a standard target retirement date that a plan provider applies to all of its clients. These funds and other “default investments” are now cost-effective at much lower asset levels, owing largely to efficiencies gained from the growing number of plans employing automatic enrollment and automatic escalation of participant contribution levels, says Toni Brown, director of U.S. client consulting for Mercer’s investments business.
4. Consider adding a diversified inflation option. Such options are intended to continue performing well when inflation rises. They offer access to asset classes not normally available in defined-contribution plans, like Treasury inflation-protected securities, commodities, real estate, and inflation-sensitive equities and bonds. — D.M.