With the passage of the SECURE Act into law in December 2019, plan sponsors should not shy away from offering in-plan retirement income options in their defined contribution plans, as growing numbers of participants are moving to retirement and need to shift focus from asset accumulation to decumulation.
To be sure, two-thirds of plan sponsors have taken on some form of retirement income option. But that still leaves a sizable number of plans that do not offer them, and, of those offered, most have no guarantee attached. Without such options, participants in those plans are forced to shoulder the burden of determining how to sustainably invest their assets going forward at retirement—a risky possibility, to say the least, since most don’t have the financial knowledge needed to make such decisions.
But plan sponsors should know that, as more workers see defined contribution plans as their only source of retirement income outside of Social Security, the industry trend is to make DC plans work in many ways like defined benefit plans, particularly in the decumulation phase at—and beyond—retirement. And in-plan retirement income products are the best way to allow DC plans to deliver retirement benefits as DB plans do.
Debunking the deterrents
What’s keeping so many plan sponsors from adding such in-plan options? The two chief deterrents are concerns over fiduciary responsibility and the inertia of plan providers and participants.
Plan sponsors’ concerns over fiduciary responsibility are not unreasonable, and the retirement income-focused elements of the SECURE Act address them. Now sponsors can turn to the critical questions for retirement security: Are participants ready and able to retire on time and receive a lifetime stream of income? Are they appropriately allocated as they move through their lifecycle? In-plan guaranteed lifetime income options provide that security, both for participants and employers. By pooling risk with a regulated guarantor, a predictable annual income amount can be offered for the remainder of the participant’s life, and spouse if desired, giving peace of mind and allowing the participant to plan without worrying about the income running out.
And then there’s the inertia among plan providers and advisers, like record-keepers, to focus on investment products beyond what they see as the most commonly used qualified default investment option approved by the Department of Labor, the target-date fund. Inertia, after all, is the dominant force among plan participants, and if target-date funds are the only choice offered, that’s what they’ll choose.
However, a close look at the Labor Department’s pronouncement of safe harbor rules for DC plans, first in 2008 and then in a 2015 update, shows that income products are already included under safe harbor guidelines. Both the DOL and Treasury have been consistent in advocating for regulations designed to encourage the development and use of lifetime income solutions precisely because of the shift away from traditional DB pension plans. So, under DOL rules, given prudent consideration, selection and review, lifetime income options are part and parcel of the safe harbor. And unless plan sponsors are paying close attention to these safe harbor rules—or have an advisor partner keeping a pulse on legislation updates—they may not realize that prudently selected in-plan income options are protected.
In-plan income as a QDIA
Not only are guaranteed retirement income options under safe harbor guidelines, they’re also considered a qualified default investment alternative (QDIA). In the original guidance on QDIAs issued by the Labor Department in 2007, investments that include elements such as guarantees, death benefits and annuity payouts do not remove QDIA status from otherwise eligible options, like target-date funds or managed accounts. That means income products have been included as a part of QDIAs since the beginning—again, showing consistency in the regulators’ approach to expanding the use of such options.
Also, there’s a variety of ways that income products can be used as QDIAs, not exclusively as stand-alone investment options. They can be incorporated into a target-date fund and can be part of a model portfolio, among others. And again, when delivered as part of an otherwise eligible option, all of them qualify as a QDIA under DOL rules.
Instituting qualified default options was the DOL’s way of changing the behavior of plan sponsors. As an example, the DOL put into place QDIAs to encourage plan sponsors to default participant assets into options other than stable value and money market investments, which deliver limited upside over long time horizons. The regulation is a de facto recognition that reward does not come without some level of risk, and in a prudently designed retirement plan, delivering the right risk at the right time can do a power of good for the underlying investor.
Benefit of remaining invested
Investment industry professionals prefer that participants stay the course with their investments and not jump around trying to time the market. Here is where participant behavior matters so much. Take the hypothetical example below, where two investors planning to retire in 2018 at age 65 invest in the same target-date fund. Investor A (the dotted line) decides after the debacle of 2008 that given the decline in market value, staying in the target-date fund is no longer acceptable, and moves to a money market fund to wait out the turmoil. Investor B, who has an income guarantee on top of the target-date assets, stays put. (To be sure, the guarantee is not without a cost: Investor B’s fund has an additional fee of 1% starting in 2008 to pay for that guarantee.) After two years, Investor A decides it’s now time to return to the target-date fund, or perhaps gets reenrolled into it, and of course does not pay the guarantee fee. By the time they are both ready to retire, Investor B, despite the extra fee, has a balance 27% greater than Investor A, and a lifelong income to go with it!
This is a hypothetical example for illustrative purposes only. It does not reflect a specific [annuity/ of guaranteed lifetime income options], an actual account value, or the performance of any investment. Actual client results will vary.
Staying the course also applies to contribution and savings rates among participants. In the fallout from the Great Recession of 2008-2009, there was a significant and sharp drop-off in DC account values. Experience from our own book of business showed two powerful differences between those with and without guarantees: Investors in guaranteed options were 2.5 times more likely to stay the course and maintained 38% higher contribution rates than those without guarantees. This shows that guarantees are able to exert a powerful positive force on investor behavior in two of the most critical aspects of investing. In our collective excitement over ever-declining fees, we cannot lose sight of the fact that failing to save enough will always lead to a suboptimal outcome for the participant, regardless of how low fees go.
Decumulation and income products
As the number of participants moving into retirement continues to grow, some of them may choose to go to a private investment adviser with a lump-sum payout and let the adviser figure out how best to distribute the assets in retirement. But there are also in-plan guaranteed income products that can do the same without the cost involved in moving a pool of assets from a DC plan to an individual portfolio.
The crux of the issue relates to what Nobel Laureate Bill Sharpe calls the toughest problem in finance: How do I know the amount of money I can spend every year for the rest of my life? The answer is, we don’t. That leads participants to either underconsume—spending too little, believing a life span will be greater than it ends up being—or overconsume—spending too much and outliving one’s savings.
But when you place that longevity risk onto a pool of assets, you can then neither underconsume nor overconsume. That’s the principle behind defined benefit plans that are properly funded, and also what insurers do with guaranteed income products—pooling risk in large volumes to align with expected mortality. Guarantors go a step further, assigning reserves against the guarantees as well. On average, in both cases, the actuarial assumption of a pension plan and an underwriter of an insurance company will be right enough times on life expectancy that there will be enough assets to cover those who live longer than expected. Of course, all product guarantees are backed by the claims-paying ability of the issuing insurance company.
This allows for what many are calling the “DB-ification” of DC plans: where guaranteed lifetime income options in a DC plan can provide a steady, predictable and guaranteed stream of income to DC plan participants using products that tap a pool of assets to ensure that expected payouts will be made. With the SECURE Act now law, the industry is in a position to meaningfully move forward towards this goal.
The continued shift to defined contribution plans as the chief means of employment retirement savings has created more challenges to create a steady, predictable stream of assets for participants at and into retirement. But the addition of guaranteed lifetime income options into DC plans can provide that income stream while also protecting plan sponsors from fiduciary risk and offering sponsors a way to improve the chances that participants can retire when they expect.
Doug McIntosh is vice president of investments at Prudential Retirement.
© 2019 The Prudential Insurance Company of America, Newark, NJ.