Lifetime income solutions have been on many defined contribution (DC) plan sponsors’ wish lists for several years. Now, there’s a wide variety to choose from, and the SECURE (Setting Every Community Up for Retirement Enhancement) Act has removed much of the perceived fiduciary risk that previously made plan sponsors hesitate. How do you arrive at the best selection for your plan? The most important variables to consider are the needs of the individual plan participants—not the averages.
How Certain Must Income Certainty Be?
From plan participants’ standpoint, the certainty of an income stream for life has ranked as the number one desired feature they want from their DC plans in the surveys we’ve conducted over the past decade.1 More than half of plan sponsors want it as well.2 But they’re the ones who have to determine which solution to provide in their plans.
We will review four broad categories:
- Managed drawdown options
- Immediate annuities (single or joint options)
- Deferred fixed annuities, including Qualified Longevity Annuity Contracts (QLACs)
- Guaranteed Lifetime Withdrawal Benefits (GLWBs)—typically used with a target-date fund (TDF)
Plan sponsors should assess those four different approaches on the basis of how well they solve participants’ needs and what the value-cost tradeoffs among the different solutions are.
Well-Known Participant Needs and Risks
Income for life, by definition, stands as the one necessary need to fulfill. Yet theory and practice have a bit of wiggle room here. Investment-only managed drawdown solutions don’t have a lifetime guarantee (as do annuities), but they approach income for life primarily by actively adjusting spending (and asset allocation) so that the account won’t be depleted. There’s a wide range of these solutions, such as laddered-maturity bond funds, high-dividend equity investments, multi-asset income funds, TDFs, managed-payout funds and other options. These solutions have the flexibility to navigate between spending needs and portfolio longevity, although at the cost of income uncertainty and portfolio volatility.
Immediate and deferred annuities typically provide level guaranteed income, although the individual has to surrender their assets in exchange for that guarantee. Since participants are surrendering their assets, annuities tend to provide higher levels of immediate income versus other living benefits. Deferred fixed annuities and QLAC contracts will typically provide even higher income rates than immediate annuities because they delay the start date for providing income. The purchaser chooses the start date—typically at some age between 75 and 85. QLACs can only be purchased with money from DC plans or traditional IRAs, and those QLAC retirement assets won’t be subject to IRS required minimum distributions (RMD) (and taxes) that begin at age 72. However, QLACs have an upper limit of either 25% of your retirement account or $135,000, whichever is less. Deferring the RMD taxation may be helpful, but individuals still need to manage their drawdowns during the period between retirement and the start date of the annuity payments. Also, participants run the risk of dying before the QLAC payout begins.
GLWBs guarantee income by providing a lifetime withdrawal rate on a pool of assets that can be acquired via a single transfer or gradually over time. Participants retain control over their accounts, and assets remain invested in a diversified mix of stocks and bonds—allowing for gains in rising markets and preserving the lifetime income level should markets go down. Participants can also choose to liquidate part or all of the remaining account balance. That means they avoid the irrevocable surrender of account assets that fixed annuities typically require. GLWBs also charge an explicit fee that appears high in comparison to other solutions with implicit costs, as we will discuss below.
The loss of asset control doesn’t often sit well with participants. They’ve spent years—decades—accumulating their savings, and it isn’t easy to let it go. That bird in hand frequently looks better than any number of birds in the bush.
But participants have additional reasons for retaining asset control. They want the flexibility of liquidity for unforeseen emergencies, and they want any unused principal of their hard-earned assets to go to beneficiaries if they die early. While participants can get added flexibility from some variable annuities, there are explicit costs for these benefits. Inflation and rising interest rates also pose concerns for participants. Immediate and fixed deferred annuities—particularly QLACs—have a greater degree of sensitivity to rising rates than either carefully managed drawdowns or GLWBs.
Underappreciated Participant Risks
Living longer has been a continually rising reality in the US for more than a century. In 1900, the average life expectancy for the US population was less than 48 years.3 When Social Security began, it was about 65 years. Now, if you reach age 65 in the US, your average life expectancy is nearly 85.4 But that’s just an average. The retirement time range varies widely, generating significant tail risks for different demographics. These divergencies from the average vary for gender, race, and geographic and environmental conditions, as well as for economic circumstances and medical and behavioral issues.5
That means individual participants face two age-related tail risks: the possibility of living (far) beyond or (far) shorter than the averages. And even for participants with high statistical likelihood of a long life, the possibility of sudden, unexpected death can never be discounted, which the COVID-19 pandemic has starkly illuminated.
Annuities—whether immediate, deferred fixed or QLACs—along with GLWBs certainly solve the longer-life longevity tail risk. But the solutions that accommodate the shorter-life mortality tail risk by providing a death benefit are fewer: managed drawdowns and GLWBs.
Participants may grasp the merits of including higher growth assets in their portfolios during the saving years, but they may not recognize the value of maintaining sufficient growth assets, such as stocks, during retirement. That aspect indirectly detracts from immediate fixed annuities. Essentially, the surrender of assets to an insurer eliminates the potential for decades of portfolio growth for participants, since the assets would be owned by the insurance company. The assets invested alongside a QLAC may provide growth of assets, but short-term drawdown risk needs to be managed as well. Only managed drawdown options and GLWBs retain access to long-term asset and income growth potential through market appreciation. That can make a notable difference to maintaining and even increasing the income stream later in retirement, which may last for decades. It can also help offset inflationary pressures that might otherwise whittle away a retiree’s spending power.
Out of Plan? In Plan? Default Potential?
Plan sponsors can provide many of these approaches as a postretirement out-of-plan option. Any annuity solution would move participants out of the plan due to the contractual nature of the annuity. If a DC plan offered an annuity, that fiduciary act would receive safe harbor protection by the US Department of Labor (DOL) if executed appropriately. More importantly, it would give participants access to institutional pricing that they couldn’t get if they bought an annuity on their own. Some plan sponsors may want an in-plan solution that remains in place through the retirement drawdown period. Managed accounts and GLWBs (coupled with a TDF) satisfy that condition, and they could be used as a plan’s default or Qualified Default Investment Alternative investment.
Fees vs. Costs: Assessing Value for Money
In our view, fees are for a service, such as managing a portfolio. Costs, however, also include what you receive with an economic value in return, such as a stream of lifetime income, payment upon death, etc. Therefore, comparing only fees for guaranteed solutions remains a difficult task that’s far from straightforward as well as incomplete. GLWBs provide explicit fee information, which includes the insurers’ obligations to provide future lifetime cash flows if the assets are exhausted. Annuities typically lack that transparency and instead operate with implicit costs, including the typical requirement to surrender 100% of one’s assets in exchange for future lifetime income. Actual insurance costs are likely to be relatively similar when shopping with institutional pricing power, but other implicit fees, such as opportunity costs should also be assessed.
Plan sponsors need to consider a variety of explicit and implicit costs to make an informed decision about the full value of each solution.
One implicit cost consideration is who benefits from the potential market gains and losses through the investment of the participant’s assets? Investing, after all, is the purchase of stocks or bonds with a look to the future market growth and cash flow these vehicles can produce. Participants retain that potential asset growth through GLWBs and managed drawdowns, but insurance companies hold that potential market growth with fixed annuities and QLACs. That market growth from potentially 20 to 30 years of investing could be substantial. Relinquishing this opportunity should be considered as an opportunity cost for participants, even though it doesn’t appear in any implicit or explicit disclosure of annuity calculations.
Making the Plan Work for Plan Participants
Before the end of this year, the DOL’s lifetime income disclosure requirement will go into effect. With it, participants of all ages and demographics will likely take a keener interest in their retirement saving efforts as well as the help and guidance offered by their current employer. Plan sponsors may experience increased calls for providing some lifetime income solution—not only from participants but also from the company’s leadership and board of directors.
As plan sponsors evaluate lifetime income solutions, the primary question that needs to be answered is: Who, among your participants, needs and will benefit the most from the various lifetime income solutions? With that in mind, here’s a sample matchup of solutions with participant personas:
- Managed drawdown options: Sufficiently wealthy to self-insured. Participants would need significant assets for this solution to provide a long-term sustainable payout rate. Pragmatically, given the current interest-rate environment, the withdrawal rate should stay in the 2%–3% range to provide a consistent income and avoid running out of money.
- QLAC: Investment-literate. Because of the deferred start date for the annuity payouts (as late as age 85), these participants have substantial confidence in managing their drawdowns and sustaining risk during the interim. They probably aren’t concerned about inflation eroding the future value of their QLAC. They can move up the starting age of their annuity payments to their mid-70s rather than waiting, although the payouts will be lower.
- TDF with GLWB: These participants prefer simplicity—they want the robust retirement-readiness investment work done for them, similar to the experience of past generations with DB plan benefits who simply showed up to work and retired with income for life. They grasp the financial risks of longevity and want a guaranteed income for life. But they’re also wary of dying young and of later-life liquidity needs, so they want to retain control of their assets and the flexibility of providing for themselves and their beneficiaries.
- Immediate annuity: Singularly focused on maximizing immediate income. These participants want to eliminate longevity risk, and they’re comfortable with exposure to other risks/opportunity costs (e.g., mortality, market or inflation risk). Certainly, immediate annuities can incorporate riders to address additional risks, but those riders become significantly expensive.
Many plan participants need all the help they can get while saving for retirement. Plan sponsors can now help guide them through their retirement-spending phase. With fiduciary safe harbor support as well as a range of suitable lifetime income solutions, plan sponsors can offer participants the potential for a better financial journey throughout their retirement years.
- Christopher Nikolich
- Head of Glide Path Strategies (US) —Multi-Asset Solutions
1. Inside the Minds of Plan Participants, AllianceBernstein
2. Inside the Minds of Plan Sponsors, AllianceBernstein
3. “Health, United States, 2019,” Trend Table 4, US Department of Health and Human Services, Centers for Disease Control and Prevention, National Center for Health Statistics, 2019
5. “The Racial Life Expectancy Gap in the US,” by Rosemary Carlson, the balance (website), April 5, 2021, https://www.thebalance.com/the-racial-life-expectancy-gap-in-the-u-s-4588898
“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.