The aging of the baby boomers in a defined contribution plan world has revealed a weakness in many 401(k) and 403(b) plans: the plans offer no systematic process for providing lifetime income. (For 403(b) plans funded with annuities, the issue may be less acute, but it still exists.) By “lifetime income,” we mean a source of money that won’t run out during the retiree’s life.
Until now, plan sponsors have done a reasonably good job of focusing on participant needs in saving for retirement but haven’t been as aware of the importance of addressing their needs after retirement. There is no fiduciary requirement to provide post-retirement help in a 401(k) or 403(b) plan; but when plan sponsors decide to do so, they face a perceived impediment -- fiduciary responsibility. In doing work for TIAA-CREF and Lincoln Financial Group, we have been able to study the issues and develop an answer to the concern.
We don’t provide citations in this bulletin, but you can find citations and an in-depth discussion of the issues and fiduciary analysis in three white papers we have written:
“Lifetime Income in Defined Contribution Plans: A Fiduciary Approach,” May 2012 (available here.) Commissioned by TIAA-CREF.
“Lincoln Secured Retirement Income? Solution: Addressing Participant Retirement Income Risks,” March 2013 (available here.)
“Lincoln Secured Retirement Income? Solution: Fiduciary Process in Evaluating In-Plan Guarantees,” March 2014, and the accompanying Sample Checklist for Evaluating an Insurance Company (available here.)
The most important risks that retirees face are:
They are living longer, which means their retirement savings needs to last longer. A draft report of the Society of Actuaries says that life expectancies for 65 year olds increased by about three years between 2000 and 2014. For a 65-year-old couple, there’s a significant probability that at least one spouse will live to 95.
They face market risks on their retirement money. This is known as “sequence of returns” risk. It refers to the risk of a serious market downturn shortly before or after retirement. Because the retiree is forced to liquidate investments to pay his expenses while the market is down, he has little chance of recouping the loss and a significant possibility of running out of money.
They aren’t sure how much to withdraw -- studies show that many retirees believe they can withdraw 10% of their retirement savings each year, while others are restricting themselves to required minimum distributions (starting at age 70-1/2) — in other words, too much or too little. However, most experts believe that 65-year-old retirees should withdraw no more than 4% per year (inflation adjusted) to have a 90% chance of the money lasting for 30 years.
They aren’t prepared for the erosion of their cognitive abilities as they age. A study done by a Harvard professor in the mid-2000s indicates that, by the time a person reaches age 85, his ability to make prudent financial decisions is seriously diminished.
There are products and investments that can address these risks. Traditional annuities offer a fixed monthly payment guaranteed for the retiree’s life (or in the joint and survivor context, for the life of the spouse as well). Under an annuity, a retiree pays some or all of his account balance to an insurance company in exchange for a promise to pay him a fixed amount for life. He doesn’t have to worry about market fluctuations, how much his monthly “take home” will be or whether the money will last. (Annuities also offer an option to obtain payments for the longer of a fixed term, often 10 years, or life. This protects against a premature death by the retiree.)
Newer products, called guaranteed withdrawal benefits or GWBs, also guarantee lifetime income – if conditions are satisfied. In a GWB, a participant invests part or all of his plan account in a professionally managed fund (often a target date or balanced fund) with a guarantee attached. At retirement, the participant takes withdrawals from his own account (either still in the plan or in an IRA). A GWB has two parts. First is the equity factor: the account will likely grow with contributions and investment gains. Second is the protection factor: so long as the retiree’s withdrawals don’t exceed a specified percentage of his highest account balance, the insurance company will continue to pay at the same rate if the investments are consumed. Along the way, a retiree is able to take larger withdrawals from his covered investments to pay for unexpected expenses, though this will reduce the guaranteed payments later on. (There are other retirement income products, such as fixed payout mutual funds or managed account services, but they do not provide guarantees.)
The Fiduciary Concern
Despite these participant needs and the availability of products to address them, the fiduciary concerns about selecting the annuities or GWBs may seem daunting. The Department of Labor has addressed this in a regulatory safe harbor. The safe harbor relates to the selection of an annuity provider for defined contribution plans, but by analogy, the concepts would seem to apply to a GWB provider as well.
The DOL regulation says a fiduciary needs to be able to conclude that, at the time he makes the selection, the insurance company is financially able to make all future payments. (This decision needs to be monitored over time as well, unless the product is going to provide for payments starting immediately. There are other issues that need to be considered, such as the cost of the product, but our focus is on the financial soundness of the provider.) Unfortunately, though, the safe harbor doesn’t specify the information you need to look at.
The white papers we have written for TIAA-CREF and Lincoln Financial Group provide checklists of the data a prudent fiduciary should consider in reaching the “financially able to pay” conclusion. (In the Lincoln Financial Group case, we also worked with a well-known insurance consultant to develop a list of the information.) We believe that these white papers are the most comprehensive analysis of the information a fiduciary should gather and consider.
Given the risks that retirees face and their need for in-plan solutions, the time has come for fiduciaries to consider offering some form of guaranteed lifetime income product. For fiduciaries who are used to the process of selecting investment alternatives for their plans, the selection of a lifetime income solution will seem unfamiliar. With the information provided in the white papers we reference earlier, however, we believe that fiduciaries should be able to engage in a prudent process in an informed manner.