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In this article we address the issue of payout options in a defined contribution plan, from the sponsor’s point of view.
We are going, generally, to limit this article to the question: should a sponsor include one or more annuity options in its DC/401(k) plan? We will begin, however, with a brief discussion of why annuity options are important for participants and the financial advantage inside-the-plan annuities provides them. We do that because most of the benefits inside-the-plan annuities provide to sponsors are indirect – they are ‘good for the sponsor’ because they are good for participants. We’ll follow with our pro vs. con discussion of inside-the-plan annuities from the sponsor’s point of view. Then we will conclude with a brief review of a related issue – educating participants about annuity options.
In our last article, we surveyed participant payout options. In that article we focused primarily on different annuity-based solutions — single premium annuities, inflation-protected annuities, longevity annuities and Guaranteed Lifetime Withdrawal Benefit (aka Guaranteed Minimum Withdrawal Benefit (GMWB)) annuities. We did so because annuities provide a key tool – pooling against longevity risk – that is unavailable in most plans and that can be a real problem for individuals managing retirement assets. Our point in that article was not that every participant should take an annuity but that having an annuity option available allows participants to hedge risk in ways that they cannot where the only option available is a lump sum or draw-down.
Thus, we believe it is clear that it is to the participant’s advantage to have an annuity option available as a retirement risk management tool. For sponsors, however, the question remains: does the annuity option (or do the annuity options) have to be available inside the plan?
In this regard consider three alternatives: (1) The participant could simply roll over a lump sum distribution to an IRA and purchase a retail annuity in the IRA (or purchase a tax-qualified individual retirement annuity). (2) The sponsor could arrange for an annuity bidding service to be available to participants. (There is a continuum of sponsor involvement with respect to such a service, from merely informing the participant of its existence to, e.g., setting up streamlined procedures for use of such a service.) Or (3) the sponsor could include one or more annuity options inside the plan.
In its recently released paper, The Next Evolution In Defined Contribution Retirement Plan Design A Guide For DC Plan Sponsors To Implementing Retirement Income Programs, the Society of Actuaries (SOA) cited estimates that using competitive bidding with respect to immediate annuities would increase a participant’s retirement income by 10%-20% and that the “reduction or elimination of transaction fees and commissions and group pricing has the potential to increase retirement incomes by 4% to 8%.”
Thus, with respect to immediate annuities, the financial advantage to the participant of employer involvement may be significant, although competitive bidding (which is available outside-the-plan) seems to be the most significant determinant.
With respect to Guaranteed Minimum Withdrawal Benefits (GMWB) annuities, employer involvement seems even more significant. Quoting the SOA paper:
Total annual insurance and investment management charges for retail GMWB annuities are approximately 3.5% (350 basis points) vs. about 1.5-2.0% (150-200 basis points) for competitive institutional products.
Initial amounts of guaranteed retirement income are often lower with retail products compared to amounts from institutional products.
Insurance guarantee fees may apply to guaranteed benefits value for a retail product compared to the market value for an institutional product, resulting in higher charges when returns are unfavorable and the guaranteed value is higher than the market value.
Thus, with respect to this more complicated (and harder to understand) product, some sponsor involvement clearly reduces costs, and institutional pricing (and, with respect to larger sponsors, scale and the bargaining leverage that comes with it) probably reduces the cost of inside-the-plan annuities even more.
This is all to say that including annuities in a plan, and, to a lesser extent, providing for an “outside-the-plan” bidding service, can be to the financial advantage of the participant. Is that a sufficient reason for the sponsor to act?
Here are the reasons the SOA (in its paper) identifies for why a “a retirement plan sponsor may want to implement a retirement income program in its defined contribution retirement plan:”
Improve the likelihood that retirement plan assets will do what they were intended to do, i.e., improve retirement security
Retain assets in the plan, which can help drive down per-capita administrative costs
Implement a low-cost yet valuable benefit improvement
Enable workforce succession by helping older workers retire ‘gracefully,’ thus improving productivity and morale
Enhance the employer brand as a desirable place to work
Be a good corporate citizen – it’s the right thing to do for employees
It’s pretty obvious from this list that, as we said at the outset (and as is characteristic of DC plans), the sponsor generally has no direct stake in the plan’s and participants’ financial outcomes. And the sponsor’s indirect interests often sound abstract. When you’re down to ‘be a good corporate citizen,’ you begin to wonder, is there a strong business case for undertaking this?
Let’s consider some of these indirect benefits in detail.
Improving the value of the plan. Adding annuity options will increase the value of the plan to many participants. It will give them an important retirement risk management tool at a lower (perhaps a significantly lower) than retail cost. The big question is: will the sponsor get (meaningful) credit for this? How important is the plan’s ‘brand’ in ‘selling the company’ to employees? What is company culture on this issue?
Retain assets and thereby reduce per capita cost. This argument has been around for a long time and is routinely made by those advocating that sponsors make efforts to retain retiree assets. Our sense is that there are significant tradeoffs to retaining assets – additional administrative expenses – that may not be very well quantified but that make some sponsors reluctant to do so. Whether retaining assets will actually decrease costs will depend on plan and plan menu design and recordkeeping arrangements (roughly, the plan’s ‘administrative structure’). The possibility that retaining assets will reduce costs is certainly worth considering, especially in the current litigation climate, but it is not obviously true.
Enable workforce succession. There are likely to be some companies where workforce succession is a meaningful enough issue to make it worth changing the DC plan’s payout options. This may have been a more compelling argument in the 1980s, when the baby boom was coming into the workforce, than in the 2010s, when it is thinking about retiring. Again, company culture is important here.
If there were no downside to adding annuities to a plan, we think for many sponsors the decision to do so would be easy.
Let’s consider some of the barriers to the adoption of a retirement income program identified in a recent AonHewitt survey cited in the SOA paper:
Administrative complexity. If an annuity is simply bought from a carrier and then distributed to the participant, the administrative issues may not be significant. But if the annuity is held by the plan for any period of time, e.g., if there is ‘accumulation phase’ annuitization, the recordkeeping and disclosure challenges can be daunting. There are some efforts to solve some of these problems; and legislation has been introduced in Congress to allow sponsors to, in effect, outsource some of this administration. The challenges of recordkeeping for inside-the-plan annuities may also make them ‘un-portable’ – tied to the issuing carrier/recordkeeper – making it hard to change recordkeepers or transfer the annuity to another plan. Adding to these complexities, while the qualified joint and survivor rules usually don’t apply to a 401(k) plan, if the participant elects an annuity they do.
Fiduciary liability. The biggest concern here is possible sponsor liability, perhaps decades in the future, for carrier insolvency. Our most recent article on this topic discusses a proposal by the American Council of Life Insurers that would address this concern by providing a safe harbor where the insurance carrier meets certain state insurance commissioner review standards. We also note, as some have argued, that depending on the facts and the extent of sponsor involvement, arranging for access to an annuity bidding service outside-the-plan may also raise fiduciary issues.
Want to see market evolve. Many of the annuity products we discussed in our last article (including longevity and GLWB annuities) are relatively new and third-party administrative support systems are still in the early stages of development.
Lack of utilization. Some sponsors who have implemented annuity options have been discouraged by lack of participant interest. The point here is obvious: if very few participants are going to use annuities, why take on the burdens of including them? Advocates of the increased use of annuities see lack of utilization as a ‘framing’ problem. They have made a number of suggestions about how to encourage annuity use, including some combination of better communication/education, using default (‘nudge’) strategies, allowing annuitization during the accumulation phase, allowing partial annuitization and using ‘hybrid’ annuity products like longevity and GLWB annuities. Many (sponsors and participants) remain skeptical.
Communications difficulty. Annuities are complicated, and the newer, more sophisticated products are more complicated. Explaining how they work, what are their benefits and what are their risks, is a challenge. And a mistake in communication may make the sponsor vulnerable to a lawsuit.
This is a pretty big list. The industry is trying to address many of these problems. So are both Congress and the Department of Labor and IRS. But progress seems to be slow.
Are the benefits of providing an inside-the-plan annuity option (directly to participants and indirectly to the sponsor) worth the costs? It depends. Sponsors for whom the 401(k) plan is an important part of their employee relations/culture ‘brand’ have a greater incentive to include annuities, in effect as a best practice. Sponsors with strong administrative resources and the leverage to get good service and a reasonable price will find it easier. Maybe being a ‘good corporate citizen’ is a high priority. Each company will have to assess the tradeoffs between cost and benefit for itself.
This article is primarily about the inside-the-plan vs. outside-the-plan issue. But we did want to say a couple of things about communications. First, the implementation of an annuity option will inevitably have to be accompanied with a lot of explaining to participants how the annuity works, why it is a useful tool, what are the risks it presents and (especially in the current environment) how much it costs/what are the fees. The latter issue is particularly problematic because an annuity doesn’t strictly have a ‘fee,’ it has a ‘purchase rate’ – e.g., how much monthly income $1,000 buys. Sponsors will want to provide some notion to participants of the relative value of buying an annuity vs. a draw-down strategy or, for that matter, buying one sort of annuity (e.g., a longevity annuity) vs. another (e.g., a GLWB).
Second, even if the sponsor does not include an annuity distribution option in its 401(k) plan, there will be increasing pressure to explain the relative utility to participants of using an annuity as part of a distribution strategy. In this regard, consider DOL’s current retirement income disclosure project. Clearly many policymakers (very much including the current Administration) are committed to encouraging more use of annuities by DC plan participants. And in that regard, many policymakers seem to view requiring sponsors to increase disclosure with respect to annuities as a ‘low cost’ way of doing this.
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It’s clearly not the case that every DC/401(k) plan participant should use her account balance to buy an annuity. But it is also clear that for many participants, the longevity protection that an annuity provides is a useful tool. Making such a tool – an annuity – available inside a plan would generally be helpful to participants if it would (versus the outside-the-plan alternative) lower costs to the participant. It would also make participant decision-making simpler – a participant wanting an annuity would not have to go through a rollover procedure. But there are clearly burdens – legal and administrative – that adding an inside-the-plan annuity imposes of sponsors. Different companies will assess the benefits and costs of including annuities differently. In our view, most sponsors will want to make that assessment of the inside-the-plan vs. outside-the-plan issue, and revisit any prior assessment from time to time as the annuity industry and regulatory structure change.
We will be publishing at least one more article in this series, assessing the role Social Security can play in DC plan participant retirement planning.