In a little more than 35 years, 401(k) plans have become the dominant employer-sponsored retirement plan.
401(k) plans place the investment risk and reward squarely on the participant. The employee’s ultimate benefit is his or her accumulated account balance. The employer has no obligation to contribute additional amounts if an employee’s account doesn’t produce the desired level of retirement income.
But, therein also lies a central conundrum of 401(k) plans. An employee has an account balance, but what does that mean in terms of “retirement income?” What level of retirement income (for example, monthly or annual withdrawals) can the 401(k) account support? And, might the employee “out-live” his or her retirement assets? For most employees, including near-retirees deciding whether they are financially able to retire, there is not a straight-line path that easily translates for the employee the periodic income that the account balance can reliably produce and the likelihood that a retiree will “out-live” his or her retirement income stream. For example, a participant in a defined contribution plan, or a taxpayer with an IRA balance, might (and after age 72, must) take annual installment distributions, but there is no guarantee of life-time income. Depending on the amount withdrawn each year and investment experience (since the participant or taxpayer bears the investment risk), the account balance might or might not be sufficient.
In contrast, defined benefit plans generally provide a fixed monthly benefit. A pension benefit is subject to its own set of risks, including the possibility that inflation might diminish the purchasing power of the fixed monthly benefit over time, thus making the benefit inadequate even though the payment amount is the same. However, the retiree with a monthly pension benefit will never “out-live” his or her monthly pension. The pension benefit is structured to provide a monthly income for the retiree’s life, and possibly monthly survivor benefits following the retiree’s death.
Very few 401(k) plans provide true lifetime income options, such as the monthly lifetime retirement benefit in a pension plan or a plan design feature in which the accumulated account is used to purchase an annuity contract providing a guaranteed monthly retirement income benefit. And, there currently is no legal requirement that a 401(k) plan include annuity or similar lifetime income options.
However, the federal government has expressed an interest in this subject, as evidenced in the recently enacted SECURE Act. Although this aspect of the SECURE Act is not yet effective, the SECURE Act will require that defined contribution benefit statements include an illustration of the monthly payment amount that the employee would receive if he or she received payment in the form of a life annuity. As noted, very few plans currently provide annuity payment options, but, when effective, the required disclosures might pique participant interest in such options. The benefit statement disclosure requirements take effect one year after the Department of Labor publishes regulations (which it has not done yet).
The SECURE Act also created a safe harbor with respect to the process followed by plan fiduciaries in selecting an annuity carrier (if the plan offers or is amended to offer an annuity option). One of the objections frequently raised by defined contribution plan sponsors to the possibility of offering an in-plan annuity option is that while the decision to amend the plan to add an annuity option is not a fiduciary decision, the selection of the annuity provider is a fiduciary function, meaning that the addition of an annuity distribution option increases potential fiduciary exposure. The SECURE Act safe harbor is designed to help plan fiduciaries mitigate that risk by allowing fiduciaries to rely on written representations from the insurers regarding their status under state insurance law.
Ultimately, the question is whether there will come a time when the federal benefit rules will mandate the inclusion of an annuity distribution option in 401(k) and similar plans. As noted, such a legal mandate is not currently in effect. However, lest anyone think that the government isn’t serious about this issue, note that the federal government’s Thrift Savings Plan includes an in-plan annuity option and the Annual TSP Participant Statement already includes an estimate of the lifetime monthly annuity that can be provided with the employee’s account balance.
Of course, the government’s interest is only part of the story. Defined contribution participants are expressing increased interest in lifetime income products. In EBRI’s 2019 Retirement Confidence Survey, 73% of respondents indicated that they are very interested or somewhat interested in putting some or all of their workplace retirement plan savings into an investment option within the plan today that would guarantee monthly income for life following retirement.
Lifetime annuities are not the only option available or potentially available. For example, some defined contribution plans offer a managed account feature under which a professional manager determines the investment allocation and manages the annual amount paid from the plan. While this option does not guarantee lifetime income, it is a feature used by some plans both to encourage retirees to leave their retirement assets in the plan and to assist retirees in providing retirement income over an extended period of years. A plan sponsor might also make available online modeling tools or apps to help participants determine how much they can spend each year in retirement.
Fees must also be considered. Managed accounts and annuities will involve (potentially significant) additional fees, which should be carefully scrutinized. With respect to annuities, a retiree might always use a portion of his or her retirement savings to purchase an annuity product outside of the plan, and plan sponsors have frequently taken this view as a reason for not adding annuity options within the plan. Depending on the size of the employer’s plan, the counter-argument might be that the plan (acting on a group basis) could negotiate more favorable terms on behalf of its participants who elect the annuity option.
This article is not intended as a sales pitch for annuities or other lifetime income products. However, there seems to be a growing interest—both from the government and on the part of plan participants—for lifetime income planning and, perhaps, lifetime income products. It would behoove every employer to stay abreast of legal developments in this area, but perhaps more importantly, to understand what its employees want and expect in terms of 401(k) design and available assistance.