401(k) plan participants worry that they will outlive their retirement income. Studies show that a large percentage of 401(k) participants (a recent survey by Nuveen and TIAA put that percentage at 93%) think it is important for their plans to provide lifetime income options such as annuities.
Yet too many 401(k) plans still provide only lump sum options. Even installment options that allow participants to spread their payouts over a period of years are rare. Plan sponsors seem afraid of annuities that can guarantee lifetime income or just unaware that they are an option. Is fear of annuities valid and, if so, what can be done about it?
Why is the Uptake Low?
· Complexity and Fees. One of the reasons plans don’t provide annuities is that there are so many different types of products on the market. Annuities can be complicated and hard to understand and compare. Some can also have high fees. This leads some plan advisers to argue that plans should not provide annuities at all.
While there is some basis for these general criticisms of annuities, annuities are not fungible and a blanket refusal to even consider annuity options doesn’t serve participants well. Many are not equipped to manage their own funds to provide adequate income in retirement or to select personal annuities or annuities through rollover IRAs, which will probably have higher fees.
What to Do The solution is for plan sponsors to engage qualified professionals to assist in their search for an annuity provider because there are products worth considering out there. And not all annuities are excessively complicated. A fixed income annuity can provide guaranteed annual income over the payout period. Annuities offered by plans can be limited to the most easily understandable types.
· Not Enough Recordkeeper Support. Recordkeepers setting up plans don’t spend time explaining annuity options to plan sponsors. If the plan had only a lump sum option before and is changing recordkeepers, the new onboarding team will usually just copy the old distribution choice without much or any discussion. Contrast this with the emphasis recordkeepers put on other plan features that are optional, such as the new autoportability options for small accounts, new SECURE 2.0 withdrawal options, or in-plan Roth rollovers.
What to Do Plan sponsors can initiate discussions about available lifetime income options. Many providers offer them now but don’t publicize them much.
· Liability Concerns. Plan sponsors are afraid of fiduciary liability and potential secondary liability if the insurer becomes insolvent.
The Department of Labor has issued guidance (Interpretive Bulletin 95-1) in the defined benefit plan context generally requiring selection of the safest available provider after considering a detailed list of factors. Insurer insolvency is a rare occurrence, but fiduciaries might also be challenged for imprudently selecting a risky insurer or for selecting a product with unreasonably high fees. While they involved defined benefit risk transfers and not defined contribution plan annuities, recent lawsuits filed by participants challenging risk transfers to insurer Athene as imprudent have also sparked general concerns about litigation risks associated with annuitizing benefits.
What to Do. There are two solutions to limit liability risk. Plan sponsors can get professional assistance from third parties familiar with the annuity market to help select the annuity provider and they can now rely on a new fiduciary safe harbor enacted as part of SECURE 1.0 spelling out how fiduciaries can fulfill their responsibilities when selecting an annuity provider. The safe harbor allows the plan fiduciary to rely on certain information provided by the insurer and was intended to encourage the inclusion of annuities in defined contribution plans.
· Not Enough Focus on Other Helpful Law Changes. Participants have been reluctant to select annuities when they are available and plan sponsors could not easily find commercial annuities that satisfied pre-SECURE Act required minimum distribution (RMD) payment rules under Code Section 401(a)(9). With a few exceptions, the pre-SECURE Act rules required that the annuities have non-increasing payments and generally prohibited features such as cash refunds or accelerating payments. For example, single participants worried about dying shortly after an annuity was purchased and few payments had been received. Participants could also incur penalties if in-plan annuities had to be closed out in connection with changes in recordkeepers or the plan sponsor’s phaseout of a group annuity contract.
What’s New. In addition to providing a safe harbor for fiduciaries selecting an annuity provider, the SECURE Acts made other changes to address and fix these concerns. The RMD rules were amended to permit defined contribution annuities purchased from commercial insurance companies to provide more flexible payment options, including cash refund features and cost-of-living adjustments of up to 5% each year to help protect the annuitants against inflation. To avoid penalties on annuity closeout, participants may also roll over their contract to IRAs or even another employer’s plan if their plan provides for distribution of individual annuity contracts when the plan sponsor terminates its contract with the insurer. The rules governing partial annuitization of benefits were also changed to more fairly treat participants in RMD calculations. These have not been well publicized or understood by plan sponsors.
What to Do. Consult plan service providers and your ERISA counsel to get more information.
· Failure to Consider QLACs. These annuities were specifically designed to help lifetime income planning, and deserve special mention. The law permits a plan to provide that a portion of a participant’s account (up to $200,000 adjusted for inflation) may be applied to purchase qualified longevity annuity contracts, or QLACs, which begin later than the participant’s general date for commencing RMDs. The participant can select the payment commencement date at any age up to 85. QLACs directly protect against the risk of outliving retirement income, and the participant can select a QLAC along with other payment options. QLACs are even less publicized than other forms of annuities, and the uptake so far has been disappointing.
What to Do: Find out if your provider offers a QLAC option and, if so, get more information about it.
Little Knowledge of New Products. The 401(k) market is developing new products that can facilitate annuity adoption. Target date funds are now available that will automatically allocate part of a participant’s account that would otherwise be allocated to fixed income towards an annuity purchase as the participant nears retirement age. There are guaranteed income and savings type annuities, and the allocation may be made over a period of years. For those worried about whether these features affect an investment’s status as a qualified default investment alternative (QDIA), it should be noted that in the Preamble to the 2007 final QDIA regulations, the Department of Labor set out its opinion that: “[c]onsistent with providing flexibility and encouraging innovation in the development and offering of retirement products, model portfolios or services, the Department intends that the definition of ‘qualified default investment alternative’ be construed to include products and portfolios offered through variable annuity and similar contracts…”
· What to Do: Find out if your plan’s target date fund or managed account option includes or is considering adding this feature. Let your adviser know that you want to follow new developments in lifetime income investment products.
How to Get More Sponsors to Consider Annuities As Congress moves to consider a SECURE 3.0, it will have an opportunity to add additional flexibility to the annuity process and perhaps greater fiduciary protections. Eventually the law might even be changed to mandate that some or all 401(k) plans include lifetime income options. Since we can’t know if further changes in the law will be considered, here are some suggestions for increasing the availability of lifetime income options that don’t require Congressional action:
· Insurers can develop simplified annuity products to market to 401(k) plans
· Recordkeepers can prominently feature annuity options on their websites
· The IRS and the DOL can provide information sessions online to educate plan sponsors about lifetime income options
· The DOL can confirm its opinion in the Preamble to the QDIA regulations by issuing binding guidance that target date funds and managed accounts that include annuities can still qualify as qualified default investment alternatives (QDIAs)
· Insurers and the IRS and DOL can develop sample information sheets to describe the benefits of lifetime income options to plan sponsors and participants in nontechnical terms
· Pooled Employer Plans (PEPs) can facilitate the provision of annuities by selecting from among available providers and making annuity options available. Professionally managed plans such as PEPs, which are managed by a named fiduciary, can take much of the burden of setting up annuities off the shoulders of plan sponsors.
· Managers of target date funds and plan managed account options can proactively seek to include lifetime income options. The managers of these funds can also take over much of the burden of selection and monitoring annuity options.