More Regulation Might Not Be Needed To Boost Use of DC Plan Lifetime Income

It was back in 2014 that the U.S. Department of the Treasury and the Internal Revenue Service (IRS) first formalized guidance for the use of retirement income annuities within target-date fund (TDF) products set as qualified default investment alternatives (QDIAs) in tax-advantaged retirement plans.

The guidance was published as Notice 2014-66 and provided directly that plan sponsors can include deferred income annuities within TDFs used as QDIAs in a manner that complies with plan qualification rules. The guidance made clear that plans have the option to offer TDFs that include such annuity contracts either as a default or as a participant-elected investment.

Simply put, under current rules, a TDF may include annuities allowing payments, beginning either immediately after retirement or at a later time, as part of its fixed-income investments, even if the funds containing the annuities are limited to employees older than a specified age—and this will not impact the plan’s QDIA safe harbor status, all else being equal. In an accompanying letter, the Department of Labor separately affirmed that TDFs serving as default investment alternatives may include annuities among their underlying fixed-income investments without running afoul of Employee Retirement Income Security Act (ERISA) fiduciary safe harbor standards.

Important to note, however, is that the move from IRS and DOL was referring particularly to annuities contained within professionally managed target-date funds that have daily trading liquidity. The IRS notice and DOL letter did not represent a blanket approval of annuities as QDIAs, and instead seemed to indicate that investment portfolios built exclusively around annuities, while wholly appropriate for DC plans in their own right, are probably not a great fit in the “QDIA slot,” i.e., for default investors.  

This position is further evidenced in a more recent information letter sent by request to Christopher Spence, senior director, federal government relations at TIAA. In this letter the DOL actually rejected a TIAA product including lifetime income provisions seeking preapproval as a QDIA. For context, the letter to Spence and TIAA was sent by DOL in response to a request regarding the application of ERISA to TIAA’s Income for Life Custom Portfolios (ILCP).

Responding to this request, the DOL reminded fund manufacturers that one of the conditions for any option qualifying as a default investment alternative is that any participant or beneficiary who is defaulted into an investment option serving as the QDIA must be able to transfer such assets “in whole or in part to any other investment alternative available under the plan with a frequency consistent with that afforded participants and beneficiaries who elect to invest in the QDIA, but not less frequently than once within any three month period.” As the DOL determined, the ILCP’s annuity sleeve does not meet this requirement, so the ILCP cannot constitute a QDIA.

Also important to note, in his rejection letter to TIAA, Louis Campagna, chief of the Division of Fiduciary Interpretations, Office of Regulations and Interpretations at the DOL, further pointed out that the DOL, along with the Treasury Department and other stakeholders, feels there is a pressing need for greater use of lifetime income as an important public policy issue. As such, the letter goes on to state outright that investments with lifetime income elements, such as the TIAA product in question, “can be a prudent investment option in DC plans, even if not a QDIA.”

Balancing plan sponsor concern with concerted action

Where does all this leave retirement plan sponsors contemplating their role in offering lifetime income products to employees? Confused, in a word. But Drew Carrington, head of institutional defined contribution at Franklin Templeton Institutional, broadly speaking, says plan sponsors should feel encouraged to offer more opportunities for lifetime income planning within their DC plan offering.

“When I talk about retirement income, I usually suggest that we need to step back from talking about the notion that any single industry solution or regulatory-legislative change will be a silver bullet when it comes to controlling decumulation,” Carrington says. “I have been thinking about the challenge of in-plan retirement income for years now, and when I talk to plan sponsors, advisers and regulators about it, there is still this sense that we are searching for the analog of the target-date fund for the decumulation phase. What I mean by that is, folks are widely preoccupied by this idea that we could create a one-size-fits-all, set-it-and-forget-it option for in-plan lifetime income.”

Frankly this a pipe dream, Carrington says: “It’s like having a goal without a plan, or a fantasy. It’s a unicorn, as we sometimes say in my shop. A singular lifetime income solution that works for broad plan populations is like a magical beast with fantastic powers—it doesn’t exist now and it won’t exist tomorrow, and so by sitting here and waiting for it we are not actually doing what we can today.”

Instead of waiting for more regulation, Carrington likes to talk about what plan sponsors can do right now with respect to retirement income—and their options are broader than any single investment option.

“Addressing lifetime income in the qualified plan context is about building out a tool kit and building out a series of solutions that will actually help your employees as they structure and spend down their retirement assets,” Carrington observes. “Specifically, this would include implementing plan design optimization in terms of permitting systematic withdrawals that can be tailored to a given individual’s outlook; designing and sending highly targeted communications for those folks in the plan who are age 50 and older, urging them to take advantage of the increased catch-up contribution limits and to start learning about what their options might be for crafting lifetime income streams, either inside or outside the plan; providing Social Security calculators and claiming optimizer tools; and of course the final piece is the actual investment options that participants might elect to use if they remain in the plan, coupled with additional tools and solutions to help put their current assets into the context of their whole household’s financial future.”

Thinking about all this together, Carrington draws a few conclusions: “Yes, there probably are regulations or legislative approaches that could make small tweaks that would help plan sponsors feel more comfortable here, but even more important is for the plan sponsors to step back and understand that decumulation will never be as simple as we have made accumulation through TDFs. If they provide the right ecosystem of tools, communication, education and investment opportunities, they can go a long way towards helping participants, even with the lack of a single answer or strategy for the challenge of building lifetime income.”

Important role for the plan adviser

According to Tim Brown, senior vice president and head of life and income funding solutions with MetLife’s retirement and income solutions group, advisers who can communicate how to convert accumulated retirement savings into a lifetime income strategy or draw-down strategy add great value to their business with plan sponsors and participants.

Brown says most plan sponsors believe the safe harbor needs to be strengthened, but he also points out an important caveat: Insurance carriers have to abide by strict state regulations, and part of the DOL’s guidance in this area with respect to satisfying the fiduciary duty of prudence is to allow plan sponsors to rely on state audits and regulations for judging the appropriateness and strength of annuity providers. As Brown explains, until recently many plan sponsors had thought they needed to be certain the annuity provider would be around in 30 years to make good on the annuity payments, but DOL has confirmed a sponsor need only determine whether the provider reasonably appears to be financially viable for the long-term future at the time of the selection. This is a markedly lower hurdle to jump.

Brown suggests it would be helpful for advisers to educate plan sponsors about the risks participants face when it comes to choosing not to invest in lifetime retirement income products. He points out that, according to the Society of Actuaries, 65% of Americans now age 65 will live to 85, and 25% will live to 95, with some surpassing 100. According to MetLife’s Paycheck or Pot of Gold Study, one in five retirement plan participants who selected a lump sum from either a DB or DC plan (21%) have since depleted it. Those who depleted their lump sums ran through their money in, on average, 5.5 years.

“Think about the popularity of TDFs,” Brown says. “Many participants view them as set-it-and-forget-it investments. When they shift into retirement, one thing an annuity can provide is a set-it-and-forget-it type of draw-down strategy.” The potential for a participant’s cognitive decline is another reason for a set-it-and-forget-it strategy, he adds.

Annuities are often framed inappropriately as investments, Brown concludes, but they are more properly thought of as income insurance. “People don’t look at their auto or homeowner’s insurance and say, ‘Well I should get a nice return on my premium.’ The return is protection. Advisers using the term ‘protection’ will help plan sponsors and participants take the right actions,” he says.