The defined contribution (DC) community has been buzzing about lifetime-income products lately. It’s a topic that’s been dormant for several years, but there are good reasons for renewed interest.
A few years back, lifetime income in DC plans looked poised to gain traction as an option for participants’ retirement portfolios. But several surveys point to a less-than-impressive response—one placed the percentage of plan participants using a lifetime-income option in the low single digits.
Of course, US interest rates were still stuck at rock bottom then, so annuities faced broad headwinds. And DC plan sponsors were more focused on adding automatic enrollment and default investment options—and boosting target-date usage. These competing priorities left lifetime income out of focus.
For DC plans and participants, that lack of focus can have big implications. People are living longer, and their retirement assets need more staying power to fund both expected and unexpected costs in retirement. With the future of Social Security still uncertain, and with more companies freezing or eliminating their defined benefit plans, DC plan savings will be the primary source of retirement income for many Americans.
A Ray of Hope from Lawmakers
That leaves DC plans with a lot of heavy lifting, but federal legislators offer one ray of hope. Last year, the US Senate Committee on Finance approved the Retirement Enhancement and Savings Act of 2016 (RESA). This law includes several provisions that would help alleviate some of the issues plan sponsors face when considering an in-plan lifetime-income solution.
RESA would require that participants see a projection (at least quarterly) of how much monthly income their savings could generate in retirement. As a safeguard for plan sponsors, the Act would protect sponsors from legal liability if actual retirement income didn’t match projections. RESA would also address portability issues that would otherwise hobble wider use of lifetime-income solutions. And the Act would provide a safe harbor for evaluating insurance carriers’ long-term solvency, addressing a risk that has been holding back the wider use of lifetime-income solutions.
New DOL Opinion Paves the Way
RESA is encouraging, but it’s only a template for policymakers to forge actual legislation. An advisory opinion published by the US Department of Labor (DOL) in late December 2016 is a more tangible step in the right direction.
The DOL’s letter responded to an inquiry from Teachers Insurance and Annuity Association of America (TIAA). TIAA asked about the potential qualified default status of a custom target-date fund investment model that gradually allocates a percentage of investment funds to a fixed guaranteed annuity. The advisory opinion stated that it could be prudent to include a lifetime-income product in a target-date fund that served as the plan’s default investment option.
That’s a big step forward by the government: it embraces a more holistic outlook on retirement-savings issues. The DOL’s letter noted that the department’s primary focus when originally developing its qualified default investment alternative (QDIA) regulations was on retirement-savings accumulation, not spending needs in retirement.
But that was in 2006, before the global financial crisis and the slow climb back toward economic health. This recent advisory opinion indicates that longevity risk (the risk of participants outliving their savings) is becoming more important in the DOL’s thinking and guidance.
Prudent Default vs. QDIA
But the letter clearly distinguishes between the possibility of prudence and qualifying as a QDIA. The guaranteed annuity product in the TIAA letter fell short of the DOL’s requirements as a QDIA, because the fixed deferred annuity sleeve of that target-date offering doesn’t provide enough liquidity. The Final QDIA Rule (October 31, 2007) states that “participants and beneficiaries must have the opportunity to direct investments out of a QDIA as frequently as from other plan investments, but at least every three months.”
Fixed annuities typically require participants to trade their account balances in exchange for a guaranteed payment in the future. Once the annuity is purchased, there’s no turning back. Due to that liquidity limitation, the particular TIAA default investment wouldn’t provide full safe harbor protections for plan sponsors—and wouldn’t be considered a QDIA.
Other Routes to QDIA Status for Lifetime Income?
But fixed annuities aren’t the only vehicle for securing lifetime income. Another possibility is to use a variable annuity with a guaranteed lifetime withdrawal benefit (GLWB), which provides liquidity while still guaranteeing lifetime income.
A GLWB is a type of annuity. It’s different than the fixed guaranteed annuity discussed in the TIAA DOL advisory opinion, because the participant doesn’t lose control of the account. The GLWB sets an annual withdrawal amount based on the assets in the account that will last throughout a participant’s retirement. If the market declines or the account assets run out, the participant will never receive less than the set annual withdrawal amount. If the market performs well, the annual withdrawal amount may increase. If the participant doesn’t use up all the assets in the account during his or her lifetime, the rest is passed along to his or her beneficiaries.
The GLWB meets both participants’ need for long-term security and the requirements of QDIA rules, because it provides liquidity. Plan sponsors like it because they get fiduciary safe harbor protection. Participants like it because they keep their account balances—and if they don’t use up the entire balance, they can pass the rest on to their beneficiaries.
Putting a lifetime income solution in a plan’s QDIA is a good step toward helping participants secure income throughout their retirement years. A properly designed GLWB may give plan sponsors QDIA protection, while giving participants the retirement income they need—and letting them keep control over their retirement assets.
"Target date" in a fund's name refers to the approximate year when a plan participant expects to retire and begin withdrawing from his or her account. Target-date funds gradually adjust their asset allocation, lowering risk as a participant nears retirement. Investments in target-date funds are not guaranteed against loss of principal at any time, and account values can be more or less than the original amount invested—including at the time of the fund's target date. Also, investing in target-date funds does not guarantee sufficient income in retirement.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.