Spring 2023 Fiduciary Commentary
Retirement is often depicted as a carefree, well-deserved time to relax, travel, and enjoy family and friends. It should be a well-deserved stress-free period after a lifetime of work.
In generations past, an employer’s defined benefit plan provided the bulk of a worker’s retirement income by granting a specified sum in retirement. Today, 401(k)s and other defined contribution plans dominate the retirement landscape, and the responsibility of retirement funding has shifted from plan sponsors to individual savers. While defined contribution plans have been critical in assisting participants in accumulating assets for retirement, they have not yet proven successful in providing a lifetime of income.
Most investors find calculating the necessary savings rate over their working years that will produce sufficient assets needed in retirement to be a daunting process. At retirement, when wage-based income ends, the need to structure retirement savings to produce the cash flow from investments begins. To do so, savers must diversify their funds, factoring various interrelated risks, and determine an adequate withdrawal rate to ensure that their savings will last their lifetime—this is no small feat!
This challenge includes factoring concerns such as rising inflation and the subsequent erosion of purchasing power, equity market volatility, and the fear of outliving one’s savings. While there is typically a broad array of plan-level investment choices to structure a portfolio suitable for retirement for all manner of individual circumstances, no option is risk free. Savers and other plan entities have voiced support for retirement income products as an effective plan tool to address these anxieties and ensure plan participants don’t outlive their retirement savings.
A 2022 EBRI Retirement Confidence Survey found that one-third of all savers and retirees see guaranteed income products as an important part of retirement income planning. Additionally, a Pew Research Center study identified that an estimated 60% of employees would be willing to contribute additional amounts from their paychecks to ensure a definite income stream after their working years.
There are mounting structural issues that highlight the importance of retirement income products, including the following:
- Defined benefit plans are increasingly rare. According to the EBRI Databook, less than 20% of private sector workers still have access to a defined benefit plan.
- Longevity continues to increase. The Social Security Administration states that life expectancy has increased by five years since 1940.
- Interest in maintaining retiree assets in plans is increasing. According to a Cerulli survey, 54% of 401(k) plan sponsors prefer to keep their retirees’ assets in their plan.
- Retirees may be underutilizing their retirement assets. According to BlackRock, 20 years after retirement, most retirees still have 80% of their pre-retirement assets left.
- Lifetime income products help employees retire when they are ready. A Prudential study revealed that the annual incremental cost to an employer for a delay in retirement of one-year is $50,000 per employee.
Retirement Income Products
Guaranteed income products come in various flavors. The investments can be a stand-alone guaranteed income fund or a guaranteed income sleeve in another investment offering such as a target date fund. Guaranteed products are usually insurance products (annuities), but an alternative offering can be stable value funds or money market funds.
The common characteristics of all these offerings are that they are conservative investments that provide consistent investment returns with relatively modest risk and a guarantee of principal. They often maintain an insurance element to guarantee the principal and a predetermined interest rate.
There is a growing interest in making plans more retiree friendly by addressing the largely unmet need for more effective, comprehensive plan decumulation solutions. Some sponsors are addressing this need by creating a “retirement tier” for their plans to highlight and differentiate these investment products from the plan’s other investments. Plan sponsors offering retirement tiers will likely offer a suite investment option to address the needs of this diverse investor group. However, it is important to carefully weigh participant choice against understandable investment options to avoid unnecessary complexity when addressing the various needs of participants. Various studies have identified investment simplicity, along with guarantees, as the most desired product attributes for retirement income choices. Products such as immediate or longevity annuities are easy to understand and would have a higher likelihood of wide acceptance. Additionally, studies have identified a preference for annuities purchased in-plan at the point of retirement versus an accumulation annuity where the payout is deferred to a later date.
SECURE Act and Retirement Income
Regulatory changes under the Setting Every Community Up for Retirement Enhancement Act (SECURE Act) of 2019 significantly reduced the liability of offering annuity-type products in qualified retirement plans. The 2019 law provided a new fiduciary safe harbor for selecting an insurance provider as a plan distribution option. Combined with greater product availability, the original SECURE Act has become something of a catalyst, with more sponsors expressing interest in evaluating retirement income options for their defined contribution plans.
Unease surrounding the selection and monitoring of the guaranteed products and insurance companies impeded plan sponsors from adding retirement income investments in the past. The SECURE Act addressed these concerns and promoted the use of guaranteed investment alternatives in qualified retirement plans by providing:
- Fiduciary Safe Harbor for Selection of Lifetime Income Provider: The SECURE Act created a fiduciary safe harbor for employers when selecting an insurance company to offer an annuity as a plan investment.
- Lifetime Income Portability: The Act required the portability of these annuity investments. If an annuity offering is removed from a plan, participants will be permitted to take a distribution of the investment to an IRA or another defined contribution plan.
- Lifetime Income Disclosures: The law mandates that the DOL standardizes the way participants’ lifetime income is reported.
Potential Obstacles to Adoption
As many of the fiduciary obstacles have been reduced, and the products are top-of-mind to many savers, why haven’t guaranteed income products gained more traction in defined contribution plans? To date, only 11% of companies have added some type of guaranteed retirement income product to their defined contribution plans since the passage of 2019’s SECURE Act. The low adoption rate of these investments has traditionally been attributed to the negative attitudes towards annuities, their complexity, and a general lack of interest. Other factors cited are the products’ high cost, lack of flexibility, and troublesome recordkeeping. While many of these negative impressions are easily understood, the technology and recordkeeping aspect is one that continues to evolve. Currently, not all recordkeepers are in sync with the ability to maintain guaranteed retirement income products on their platforms, while others can only support their own firm’s proprietary products.
The concept of lifetime income has been a topic of conversation for the better part of a decade, yet there has been little placement in defined contribution plans. The products clearly have unique qualities and have garnered plan sponsor and saver interest, yet industry observers are split as to whether an effective retirement income solution needs a guaranteed income component at all when competing investment types, such as fixed-income funds and various target date solutions, can be designed to meet the income needs of retirees. That said, it may make sense for a plan sponsor to conduct an evaluation of these investments, including the various expected outcomes from the different product types.