Are Annuities in DC Plans Necessary to Produce Optimal Retirement Income?

Some responses to 2018 Advisory Council on Employee Welfare and Pension Benefit Plans’ (ERISA Advisory Council)’s request for comments about Lifetime Income Solutions as a Qualified Default Investment Alternative (QDIA) – Focus on Decumulation and Rollovers call into question the efficiency of offering in-plan annuity options in defined contribution (DC) plans.

The Plan Sponsor Council of America (PSCA) said valid retirement income strategies encompass both annuity and non-annuity approaches.

It noted that it specifically rejects new mandates, saying that a mandate runs counter to the significant level of flexibility participants already have with regard to their individual account retirement savings plans—401(k), 403(b), 457(b) and/or IRAs. 

The PSCA recounted 2005 testimony it gave in which it noted that the baseline of retirement income provided to most workers is Social Security, and it said “there is no evidence that participants who choose not to purchase annuities through their plan (or via an IRA purchase) when they retire are harming themselves.”

The prior testimony also pointed out that DC retirement plan sponsors do not provide annuities for a variety of reasons: a plan sponsor offering an annuity option must manage attendant administrative and compliance requirements; sponsors offering a plan annuity option assume fiduciary responsibly for selecting the annuity vendor; sponsors know that where annuity options are offered they are not utilized; their own employees have not asked for an annuity option; and sponsors know that if a retiring participant wants to annuitize some or all of their lump sum they can do so in an IRA.

According to the PSCA, more recent money purchase pension plan experience and defined benefit plan studies show participants rarely select annuity payouts—even when an annuity is the mandated default payout option.

“Little has changed in the past 13 years,” the PSCA said. “Participant preferences have not changed and are reflected by single digit annuity take-up rates—a level of interest that, for many, perhaps most plan sponsors, does not justify the administrative cost or fiduciary risk involved in offering an in-plan annuity.”

The council also noted that other studies suggest many Americans are well-prepared for retirement and that a substantial number can accommodate their retirement income needs. It said that among financial and economic professionals, some now assert that an immediate annuity’s value changes after a severe health shock—which creates a demand for liquidity (to cover treatment costs, custodial care) and reduces the residual value of the remaining annuity payments. According to the PSCA, “Those researchers assert that for some, perhaps many, particularly those with modest or minimal accumulated assets, the most rational annuity allocation might be zero. These same professionals suggest annuitization may be a better strategy for those in their 80s where the value of mortality credits may overwhelm the health shock risk.

Increasing retirement plan coverage, participation, and contributions while reducing plan leakage can improve retirement preparation and facilitate achieving desired levels of retirement income, PSCA contends.

However, it suggested three voluntary solutions for consideration:

• Encouraging adoption of deemed IRAs so that Roth 401(k) assets can be transferred to a deemed Roth IRA with its more favorable, more flexible distribution provisions,
• Amend Internal Revenue Code (IRC) Section 401(a)(9), Minimum Required Distributions, to cap the mandated, annual payout at 5% of the prior year-end account balance, and
• Department of Labor (DOL) guidance (and potentially a “safe harbor”) for voluntary adoption of a default form of non-annuity, installment distribution payout option designed to maximize guaranteed, indexed retirement income.

As did others providing testimony, the PSCA cited a Government Accountability Office (GAO) report which made recommendations for lifetime income options in 401(k)s. “Many PSCA members would agree with the first two GAO recommendations: Clarifying the safe harbor for selecting an annuity by providing sufficiently detailed criteria to better enable plan sponsors to comply with safe harbor requirements related to assessing a provider’s long-term solvency, and considering providing legal relief for plan fiduciaries offering an appropriate mix of annuity and withdrawal options, upon adequately informing participants about the options, before participants choose to direct their  investments into them,” it said.

“A clear, simple safe harbor is a necessary first step to increase the interest of plan sponsors in adding lifetime income options to their plans,” said Lynn Dudley, American Benefits Council senior vice president, global retirement and compensation policy, in its testimony. The council focused on the numerous obstacles to lifetime income options in workplace retirement plans, including fiduciary liability, lack of demand by participants and the need for greater education. Dudley’s remarks were based on an informal poll of its plan sponsor members with questions related to lifetime income in defined contribution plans.

Of the 93 company responses received by the council, only 13 (14%) indicated that their organization offers a lifetime income option as part of their DC plan. Of the 76 organizations that do not, almost two-thirds might consider such an option in the future, but for these organizations the leading cause of hesitation was “potential fiduciary liability,” followed closely by “lack of demand from participants.”

When asked to identify the most useful potential policy change to address these concerns, the most popular response was the establishment of a “better safe harbor for selecting an annuity provider,” to protect employers from lawsuits under ERISA’s fiduciary standard.

“With this low demand for lifetime income options, employers may be hesitant to take on potential fiduciary liability for an option for which few employees have expressed an interest,” Dudley said.

In its testimony, the Defined Contribution Institutional Investment Association (DCIIA) said the idea of long-tenured DC plan participants retiring and utilizing the lifetime income features in a QDIA may be less common than initially anticipated. DCIIA member feedback found the most common lifetime income solutions are various diversified investment options as well as managed accounts (36% and 34%, respectively). The prevalence of annuity-based solutions actually offered by sponsors is somewhat less (21%).

As for including lifetime income solutions in a QDIA, the DCIIA cites studies and member experiences which show as participants get older, they are less likely to hold their assets in QDIAs, therefore, not getting the benefit of lifetime income solutions.

However, the DCIIA provided ideas to encourage participants’ use of lifetime income products:

• In general, DC plans need to become more retiree friendly. For example, if one wants to encourage lifetime income products within the plan then as a start, plan sponsors need to be encouraged to allow partial withdrawals;
• The solutions offered need to work given participant preferences and their unique situations. We know that participants have very different circumstances, needs and wants. While a “one size fits all” solution may be reasonable for the plan’s QDIA, for many participants this may not be the ideal fit;
• Reframing the retirement income discussion and moving the focus away from a purely asset/wealth focus could help shift participants’ mindset when considering lifetime income products;
• Given that most participants will have retirement assets in a number of places (due to their different employers), consolidation of assets may be a key issue to facilitate a more manageable retirement. Currently it is far easier to consolidate outside of the plan. If more plan sponsors encouraged participants to consolidate other balances into their DC Plan (and other providers made it easier for people to transfer/consolidate their balances) more participants are likely to consider staying in the plan; and
• Providing exchange or quotation services where participants can compare quotes/rates could help them feel more confident that they are getting a good deal.

The testimony highlighted that the DCIIA Retirement Income Committee is currently focused on developing a white paper addressing the “Retirement Tier.” This essentially is the suite of services, products and solutions that can be made available to assist those approaching retirement and within retirement.

Fred Reish and Bruce Ashton, partners at Drinker Biddle & Reath, LLP, agreed with DCIIA’s idea about reframing the retirement income discussion. In a statement to the ERISA Advisory Council they said, “Participant-directed defined contribution plans are, by and large, currently viewed as creators of wealth. For example, the plan document most widely read by participants is the quarterly statement, which shows a lump-sum balance in the participant’s account and the investments held by the participant—in other words, the participant’s retirement “wealth.” And, 401(k) plans are commonly referred to as 401(k) savings plans. The labels, and the conversation, need to be re-directed to 401(k) retirement income plans. That includes both a change in terminology and a change in presentation.

In addition, Reish and Ashton recommend addressing the fiduciary fear DC retirement plan sponsors have about offering lifetime income products. They say, in our experience, the greatest impediment to the continuing inclusion of retired participants in defined contribution plans, and to the introduction of new products and services into those plans, is the fear that plan sponsors have of being sued for a fiduciary breach. That fear includes: possible increased damages where retirees continue to have money in a plan; claims of fiduciary breaches where a plan sponsor changes to another recordkeeper, resulting in a loss of guaranteed benefits; and litigation about annuities provided by insurance companies if their financial condition weakens. As a result, plan sponsors prefer safe harbors where compliance is objective and obvious.”