New Territory for Income?

This year, as the stock market nose dived and inflation hit fresh highs, as expectations for economic growth declined, many investors were reminded of a risk that tends to be forgotten during the good times: How will they make money stretch over a longer life span, and potentially with a higher cost of living than expected?

Over the past 40 years, as defined contribution plans have come to represent a larger percent of retirement income, individuals have been asked to shoulder their own investment and longevity risk, says Wade Pfau, a professor at the American College of Financial Services and author of “The Retirement Planning Guidebook.” Participants have been left to solve for retirement income by themselves, relying on market infrastructure, tools and support that have traditionally focused on the accumulation phase, Pfau says.

Joseph Boan, managing director of distribution and business development for Annexus Retirement Solutions, in Scottsdale, Arizona, says the industry is at a retirement income inflection point.

Last year, 85% of DC plan participants said they wished their employer’s retirement plan had an option to help generate income once they retire, according to Greenwald Research’s 2021 In-Plan Insights Program survey, and eight in 10 plan sponsors agreed that participants need in-plan income options.

“As an industry, we’ve been trying to solve the guaranteed income problem with little success,” Boan says. “If we really want to drive better participant outcomes, then we need to accept that the reality is, people want income. That’s what the desired outcome should be.”

Overall, the Greenwald survey indicates that 75% of participants prefer income stability over principal preservation, according to the Employee Benefit Research Institute in 2020. Yet, only about 10% of company-sponsored plans offer annuities.

Boan, Pfau and Tamiko Toland, head of lifetime income strategy and market intelligence at TIAA in Ithaca, New York, all say this is changing, though, and retirement income’s moment may have finally arrived. Slowly but surely, more income options by more providers are being offered inside company plans. This represents an evolution in the industry and, as some have pointed out, a transformation of 401(k)s from savings vehicles into retirement income plans.

According to Pfau, the passing of the Setting Every Community Up for Retirement Enhancement Act of 2019 was a turning point for retirement income.

“With the SECURE Act, we see more options developed that are focused on retirement income and not just the accumulation phase,” Pfau says.

The law provides safe harbor protections for companies that offer annuities inside retirement plans. In February, the Lifetime Income for Employees, or LIFE, Act was reintroduced in the House of Representatives. That legislation would enable more employers to benefit from the safe harbor. It would also allow annuities to be a default investment, with the stated goal of supporting workers as they seek to build a steady, guaranteed income stream for their retirement.

“Before, an employer plan was taking on a lot of risk if it offered an annuity,” Pfau says. “It’s good that employers may now provide retirement income options without taking on a whole new level of responsibility,” he says. “Effectively, plans can offer approaches more aligned with defined benefit pensions once again, instead of defined contribution.”

There is no one best approach, he notes, having focused recent research on four retirement income styles:

• A total-return style. Many registered investment advisers use this style, where, in the decumulation phase, the focus is on taking distributions and generating income from diversified investments.

• A time-segmentation approach. Here, retirees use investments for retirement. They cover short-term expenses with bonds and leave stocks for long-term expenses.

• An income-protection style. This method provides a base of income, such as through an annuity, with additional funds invested.

• A risk-wrap approach. Investors have a protected income floor, for instance, through a variable annuity, but can still invest for upside gains and maintain some liquidity.

Pfau’s research shows that only one-third of the population has a retirement income style that resonates with the total-return approach, though that is the most popular with advisers. “If that’s the only option a 401(k) plan offers, it’s one that only appeals to about a third of the population,” he says.

Out-of-Plan Annuity Compensation Models

Individual adviser commission structures have played a role in putting more of an emphasis on participant accumulation vs. decumulation. Fee structures based on assets under management incentivize investment managers to keep as much as possible in the portfolio. If advisers sell an annuity to generate retirement income, that potentially damages the practice by lowering assets under management, Pfau notes.

Now, however, annuity providers are offering fee-based annuities that allow investment managers to earn compensation on assets held within an annuity.

“If I’m managing $1 million for a client, and I charge a 1% fee on that, I can now also charge that 1% fee on the value of the annuity,” Pfau explains.

A New Focus on Retirement Income

Other initiatives show what Pfau describes as a “slow evolution” of the market to meet unaddressed needs regarding advice, education and structures that support decumulation and retirement income. They include new industry associations such as the Retirement Income Consortium, with AllianceBernstein, Allianz, BlackRock, Income America, Nationwide, Principal Financial Group, Prudential Financial and TIAA-Nuveen as members, among others.

A research initiative by the Organization for Economic Cooperation and Development has focused on how to improve the certainty of retirement income. The OECD has also issued a formal recommendation for DC plans to include lifetime income by default, by pooling longevity risk among participants.

TIAA is educating advisers and plan participants about their options to secure guaranteed lifetime income. A provider of in-plan annuities, TIAA, in June, published “Separating Facts From Perception: The valuable role that in-plan annuities can play in retirement SECURE-ity.”

Toland says the approach to income should be fundamentally different than the way the industry has traditionally viewed accumulation.

“People need an income strategy,” Toland says. “We want people to stop thinking that if they have a certain amount in the bank, they’ll be OK. With the swings of the market, a systematic-withdrawal strategy isn’t safe. We’re in the middle of a major evolution of the 401(k). It was never designed to replace a pension. We are seeing a technical and philosophical retooling of the 401(k) to meet that purpose.”

Interest in embedding annuity solutions into plans has also taken the form of new, financially engineered products.

In 2018, TIAA launched RetirePlus, a way for plan sponsors and consultants to create models that include guaranteed income investments within a target-date-like structure. This year, RetirePlus surpassed $10 billion in assets, TIAA says. Now it is offering guaranteed lifetime income solutions to the corporate 401(k) retirement market.

Annexus, has created a product that works the way a traditional target-date fund works, combined with a group fixed annuity. Annexus’ Boan notes that, instead of owning equities and fixed income in a TDF, participants own equities, fixed income and shares of a group fixed annuity.

“How to move from non-income-generating solutions to income-generating solutions should be a core talking point for every plan and all advisers in the market,” Pfau says. “It was a turning point when TDFs became the default option. When income solutions become the default option, that’s when we’ll really see the industry take off.”

Art by Jam Dong