Analyzing Income Replacement Options By: Gabriel PotterMBA, AIFA®

Converting defined contribution assets to a defined benefit-like income stream.

Our retirement system depends heavily on defined contribution savings, but many employees prefer a stable income stream akin to the defined benefit programs of old.

Imagine a typical employee ready to retire at age 65. If he wanted, he could cash out of his 401(k) or IRA account, pay the necessary taxes, and use the lump sum to purchase an annuity to provide a lifetime of income. He will need to do his homework, manage the transfer, be satisfied by the soundness of his insurer and the terms of his contract, but this is a viable way to convert retirement savings into a lifetime of income.

Retirement plan sponsors can provide a similar solution on a larger scale to their plan participants. There has been an explosion of interest in new products - called income replacement products - which exist to generate a lifetime of income within the structure of a defined contribution plan.

In simple terms, think of an income replacement option as standardized annuity program. Some income replacement options are like fixed annuities, with limited upside potential. Some income replacement options are like variable annuities: they invest in underlying investments (like a balanced mutual fund of equity and fixed income) with the potential for appreciation in the markets. The income replacement funds may borrow other features common to variable annuity “rider” provisions. For instance, they may guarantee a minimum market value, and provide a stable income stream based on “high-water marks” of that minimum market value. The provisions depend on the specific income replacement fund.

The advantages to income replacement plans

Arguably, the greatest benefit of these products is the removal of a key liability to retirees: outliving your money. The insurer now bears the risk that an employee will continuously receive predictable benefits during a long retirement.

Second, these products reduce market risk for employees. Employees have suffered through two significant market crashes in the past decade and trading volatile assets for a predictable income is a notable advantage. 

Third, income replacement options impose a spending discipline by making the consequences of overdrawing immediate to participants. The products generate a predictable income stream, typically around 4% to 5%, of the total market value of the underlying investment. Withdrawing beyond that amount deducts from the investment principal and lowers the future income stream. As a related advantage, an investor’s retirement budget is easier to predict since they know what their accumulating savings will generate.

Fourth, when comparing income replacement products to traditional annuities, these products are often able to create an effective economy-of-scale. Income replacement products are more expensive than a direct investment in the underlying investments (i.e. – buying shares of an ordinary balanced mutual fund), but they are often less expensive than a comparable annuity contract that an individual could purchase from an insurer. 
Lastly, these products work within the structure of an existing, tax-deferred 401(k). Research shows that simple, easy-to-access solutions have the greatest impact on participant behavior. Easy access to an annuity-like income stream without the inconvenience of changing accounts (or the immediate tax bill of moving assets into a taxable account) is a clear benefit to employees.

The disadvantages to income replacement plans

The costs of income replacement programs must be acknowledged. First, the product providers are adopting more risk, so they must get compensated. Income replacement products have higher fees than traditional investments. Americans, in general, have not saved enough for retirement, so an additional layer of fees will deplete our resources that were already scarce. 

Second, greater participant education is required since these products are not equally useful to every employee. For instance, a 20 year old employee typically can bear more investment risk than a 55 year old, but they have the same income replacement option available in their 401(k) lineup. The 20 year old employee can afford the market risk of traditional investments because of their longer time horizon; the additional fees have a higher impact because of the loss of compounded returns. Participant education is also required because it is more difficult to efficiently combine annuities, as an asset class, into a portfolio.

Third, these products are essentially insurance placed on top of investments. Thus, the due diligence requirement is necessarily higher than traditional investments because of the additional complexity. Employers have to demonstrate a prudent process for selecting these idiosyncratic products, and their unique features, which are difficult to compare. (The plan sponsor’s IPS should reflect the criteria for the comparison.) In the worst case scenario of an insurer default, the guarantee of stable future income is nullified and employers must clarify how the underlying investments will be assigned to employees. 

Fourth, using income replacement products will reduce a retirement plan’s flexibility. Logistically, these products are usually tied to a specific recordkeeper, so adding these products may limit the portability of the plan. Client retention is an unspoken incentive for recordkeepers and insurers to create and market these products.

Gabriel Potter

Gabriel is a Senior Investment Research Associate at Westminster Consulting, where he is responsible for designing strategic asset allocations and conducts proprietary market research.

An avid writer, Gabriel manages the firm’s blog and has been published in the Journal of Compensation and Benefits,...

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