One of the more visible trends coming out of the recession is a shift by 401(k) providers to more guaranteed retirement income solutions. Retirement plan experts gravitate toward these products as an avenue by which participants can be free of worry about outliving their retirement nest egg.
To meet the shifting market demands, retirement providers have been rolling out a variety of retirement income solutions to offer within, or as an extension to their retirement plan products. There is no consensus among providers as to what constitutes the ideal option that will be widely accepted and used by participants. Plan sponsors and their advisors will reward providers who can correctly identify the right fit.
The Value of Guaranteed Retirement Income
As an advisor, it is important to have an understanding of the various methods being used to provide guaranteed retirement income for life and to provide a decision framework for examining the various options. But first, it's worthwhile to understand why this issue remains so important.
Traditionally, employer-sponsored retirement plans were primarily defined benefit plans; a form of pension that provided a guaranteed monthly income for life - much like Social Security. Defined benefit plans lost favor with employers. There has been a seismic shift away from defined benefit plans to defined contribution plans, such as the 401(k) plan.
The 401(k) plans provide participants with a menu of investment options and an account balance that can be easily tracked. However, while many plan participants are well aware of their 401(k) account balances, very few understand how much retirement income that balance will provide.
Plan participants also have a hard time understanding how much they'd be able to draw down on their account balances, while not outliving their savings. Thus, the 401(k) plans have quickly become viewed solely as investments. Participants have lost sight of the ultimate purpose of the plan - to provide retirement income for life.
As an industry, our focus has been on the accumulation phase and we've failed to adequately prepare participants for decumulation. Fortunately, that is now changing. Providers have been developing a variety of retirement income solutions that can be offered within a retirement plan or as an extension of it.
Among the solutions offered:
- Immediate annuities: an in-plan or external option where the participants purchase income for life at the time of retirement
- Deferred fixed annuities: an in-plan option where each contribution buys incremental units of guaranteed retirement income. In this option, the money is invested in an account that guarantees principal and pays a fixed rate of interest
- Deferred variable annuities: an in-plan option where each contribution buys incremental units of guaranteed retirement income. The money is typically invested in asset allocation funds with equity exposure and upside potential
- Guaranteed minimum withdrawal benefit: an in-plan option that guarantees a minimum lifetime withdrawal rate (typically 5 percent at age 65) of a "benefit base." The benefit base varies by product but usually involves cumulative contributions adjusted by either a set percentage annually or market appreciation. The money typically is invested in asset allocation or balanced funds.
While these examples are the primary solutions being presented today, there are as many variations on these themes as there are product providers. With so many variations in the marketplace, how do you select the option that is best for your client? The income for life option, for example, is only one feature to consider when selecting a provider. It's important to look at the whole package before deciding what's right for your client and their participants.
Ask the right questions
When specifically evaluating income for life options, you'll want to ask several questions to determine what is most important to your client. Some of these questions include:
1) How paternalistic is the client's culture?
Let's face it, some employers are more paternalistic than others. For some, guaranteeing that their employees won't run out of money in retirement will be very important. For others, it won't be worth the additional risk to the company. Make sure you know your client and where they stand on this issue.
2) How risk averse is the employer?
Most of the guarantees provided today are single-insurer commitments. The income promises may not come due for 40 or more years and a lot can happen in that time. Does the insurer's financial strength and management philosophy provide you with a comfort level that they will be around to meet the promised commitments?
3) What are the fiduciary considerations?
Plan-level fiduciary considerations and account portability are important when selecting income for life options. In addition to the insurer's ability to meet its commitments, portability of the lifetime income feature is key. If the guarantee disappears when the participant leaves the company or when the plan moves to another provider, its value is significantly diminished. Participants might be upset if they've paid their fees but receive nothing in return.
4) What is most important to participants?
Do they want to maximize retirement income or retain access to their retirement assets?
Annuities tend to maximize retirement income, whereas GMWB's typically provide a lesser income while allowing participants access to their account value during the payout period. Annuity proponents would argue that the ultimate goal is to maximize retirement income for the life of the participant (and generally the spouse). In their favor, a typical payout on a GMWB is 5 percent at age 65. An annuity, at the same age, may provide a payout in the 7 percent to 8 percent range. That translates to 40 percent to 60 percent more income through the annuity option.
GMWB proponents maintain that people want continued access to their account balance. They'd also like to leave something to their heirs should they die shortly after retirement. With a GMWB, participants have the flexibility to access their remaining balance at any time and, should they die shortly after payments start, the balance would be available to their heirs. While participants view increased access favorably, it can be a double-edged sword. Tapping into the remaining account balance will likely decrease future retirement income.
5) What are the underlying investments?
Are they consistent with the participant's risk tolerance? With any lifetime income feature, the underlying investment options are typically restricted. Are the restricted investment options appropriate for the participants in the plan? Will participants find the equity investments required by some providers acceptable? Are participants comfortable being limited to the non-equity options required by other providers?
6) What is the cost?
Lifetime income features come with a price tag. Know what your client's employees will be paying and what they'll get in return for that payment.
While there is no consensus as to the best means of providing guaranteed income for life, there are certainly a variety of options to consider. No matter how you look at it, it'll be beneficial to participants in the long run because it shifts their mind-set from investment aspects to a more income-focused retirement plan. In the end, it is about retirement income not asset accumulation.
