In-Plan Retirement Income

It has been a decade in the making, but In-Plan Guaranteed Retirement Income solutions are now readily available to plan sponsors and participants. As a result, for many plans, optimal participant outcomes—now the accepted metric for best-in-class defined contribution (DC) solutions—are at hand. PLANADVISER founder Charlie Ruffel talked to two Prudential Retirement executives about these new constructs: Sri Reddy, senior vice president and head of institutional income and capital markets; and Kurt Mansfield, vice president of marketing strategy for institutional investment solutions.

PA: Before we dive into retirement income solutions themselves, let’s talk about some of the research that Prudential commissioned to analyze the interest that participants themselves have in guaranteed income solutions.

Mansfield: Right. We have access to both plan sponsors and participants to give us critical mass for such research. Currently, Prudential Retirement’s innovative solution is available in more than 7000 plans. In the participant study, we asked participants who had adopted the income solution and those who hadn’t, a series of questions to determine their overall confidence around retirement. In the second study, we analyzed outcomes, with the specific intent to discover the differences between those who adopted the income solution and those that didn’t.

PA: And Prudential is in the singular position of having had in-plan income solutions in place for some time now.

Mansfield: That’s right. The first thing that became clear—and I think more and more plan sponsors are coming to terms with this—is the vast majority of participants are neither confident nor well-prepared for retirement. Two findings jumped out at us: Some three out of five Americans claimed that they were behind schedule or didn’t know where they were with respect to their retirement savings; and only one out of five were confident in their ability to endure market volatility and retire as planned. Exactly the same number—that is, one in five—were confident that they’d have enough retirement income to last a lifetime. In conjunction with that, nearly three out of four were concerned about their retirement income. Those findings are echoed elsewhere: As an example, a recent Aon Hewitt study found that more than 80% of employers did not believe that their employees would be able to manage their income in retirement.

PA: And the reflexive conclusion to that has been, somewhat simplistically, that we’ll have to work longer.

Mansfield: Exactly. But, as we are increasingly beginning to understand, that’s a flawed strategy. For a start, as illustrated by research from the Employee Benefits Research Institute [EBRI], one out of every two employees leaves the work force earlier than they planned to. In other words, they are not determining their retirement date. So working longer is all too often not an option.

Reddy: And that’s just one of many challenges that the present defined contribution construct doesn’t adequately resolve. Market volatility, retirement date uncertainty, healthcare: These are all issues that are not properly addressed if, as we have for the past 25 years, we focus only on getting participants to retirement. What our research indicates is that retirement income solutions do more than just resolve the post-retirement date challenges—they positively impact the accumulation phase as well.

PA: How so?

Reddy: We analyzed the outcomes for participants who opted into in-plan income solutions to those who didn’t, and compared and contrasted the behavioral differences. What we discovered was compelling. The first thing to note is that, for a vast majority of participants, having a focus on an income solution significantly increased their confidence in their ability to get to and through retirement. And that confidence impacted their savings and investing behavior for the better. Our research showed that in times of significant volatility, participants with retirement income options were two-and-a-half times more likely to stay the course than their peers without income options—in other words, they were two-and-a-half times more likely to stay invested when they had a safety net.

PA: A virtuous circle, effectively.

Reddy: Exactly right. Likewise, when it comes to understanding exactly what is ‘enough,’ without retirement income solutions that comes down just to a guess or, at best, an estimate. We found by shifting the conversation to having people focus on outcome orientation, you drive better results. Specifically, we found that participants who had access to in-plan guarantees saved 38% more than average 401k plan participants contribute. We also found that the level of systematic withdrawals being taken from plan’s with these safety nets and those without them differed greatly. In contrast to what we see as a safe withdrawal rate—say, 4%—participants without these safety nets were taking systematic withdrawals of anywhere between 7% and 15% of their account balance. With those withdrawal rates, savings are not going to last. By contrast, where the plan had a guaranteed retirement income option, participants were significantly more cautious about withdrawals.

PA: So the takeaway is that exposure to in-plan retirement income has benefits to the overall health of the plan.

Reddy: That is what the research indicates. There are clearly dynamic benefits that come from offering in-plan guaranteed income solutions that are not just at the tail end or the finish line of retirement, but also at the starting point.

PA: And yet this is a trend that is still considered very early in its development. Why do you think this is so?

Reddy: Awareness is one issue. Even when these solutions exist, they are often not effectively communicated to participants. But, as we view it, there is an unprecedented opportunity to incorporate these guaranteed income solutions, and all the advantages they bring with them, into target-date funds [TDFs]. What’s become clear is that target-date funds are here to stay, and the vast bulk of new defined contribution flows are going into target-date funds. But it is also clear that there are both misconceptions about target-date funds—a recent study found that more than half of plan participants believed that target-date funds provide guaranteed income—and problems for those retiring during times of excessive market volatility. Target-date funds with retirement income components built in seem to us to represent the best of both worlds, and we anticipate significant take-up in the near future.

Mansfield: As an industry, we’ve come to understand that target-date funds are a wonderful investment solution. The challenge is that the goal of the individual is to solve for retirement income and guarantee a stream of payments for as long as he or she lives. That means that target-date funds are by definition an incomplete solution. However, there is a definite marriage of best practices here. Our research shows that in-plan guaranteed retirement options make Americans feel more prepared for retirement, and that they produce better retirement outcomes. What makes the most sense is to pair target-date funds with a retirement income option. And ideally to pair it as a QDIA [qualified default investment alternative] option with an opt-out provision: That is the real opportunity that is now at hand.

PA: What did your research tell you about the target-date/retirement income combination?

Mansfield: Two findings jumped out at us. The first finding was two out of three people that were currently invested in an in-plan guaranteed retirement income solution would recommend them to their colleagues. They feel that these products are valuable for them, and they feel that their colleagues should be investing in them as well. The second finding was even more explicit: We asked participants whether they believed that having retirement income solutions in the plan as an automatic feature with the ability to opt-out would be a good thing, and three out of five said yes. We think that speaks volumes of how participants will respond to these plan design improvements.

PA: So, finally, we might get to that elusive goal of a defined contribution plan that in key ways looks to a participant like a defined benefit [DB] plan.

Reddy: That is exactly right. We all know that we’ve undergone this major shift from defined benefit to defined contribution, and we all understand the good reasons why that happened. But at the same time it has become clear that there are challenges with the defined contribution construct, and the biggest challenge of all is post-retirement income security. This is how we get to that. It is more than desirable, it is necessary. Not only does it offer that critical feature of a defined benefit plan, which is guaranteed lifetime for as long as we live, but, as our research indicates, we also have seen that it drives greater confidence, greater retirement readiness and greater retirement outcomes.

PA: How close do you think we are as an industry to connectivity solutions that allow streamlining these options in plans?

Reddy: There are a couple of ways to think about portability. There’s participant level portability, then there’s recordkeeper portability. Participant portability—that is, if someone’s retired or separated from service—many providers, in addition to Prudential, also provide IRAs [individual retirement accounts] that allow for the benefit or the value to port.

From a plan sponsor level or a recordkeeper portability level there has been good progress made in the last three years. The early evolution or stage of our industry was to build one-to-one connections. Now the challenge with that model was twofold; it was very expensive and it wasn’t scalable, so if a recordkeeper built a connection to one product provider, if a plan sponsor chose another product provider, they had to build another set of connections.

So the industry has solved for this in two stages. Stage one was standardizing the file formats and data layouts, and that occurred in 2010 with early adopters, both recordkeepers and plan product providers following these standards starting in 2011. And two, the other major development in progress is middleware. There are multiple providers who are looking at offering middleware for these types of solutions. Middleware very simply, as the name implies, a platform that sits between a plan administrator and a plan provider, using universal connectivity to port among one another in a much simpler and more readily available way.

PA: You talked about the dynamic benefits that your research shows when you introduce these in-plan guaranteed income options. Clearly there are some real benefits that come alongside this new option; it shifts the dynamics in favor of in-plan income.

Mansfield: One of the reasons why we are so positive around the idea of partnering the target-date fund solution with the in-plan guaranteed income solution is that the opportunity to overcome today’s retirement security challenge is not dissimilar to the challenge we had previously around diversification. Prior to the advent of target-date funds, you had a lot of participants who were picking funds based on performance or they were picking one fund, or if there were twelve funds offered they had an equal allocation across all twelve funds. There really was no rhyme or reason; it was very scary, caused a lot of inertia, caused a lot of fear, caused a lot of chasing of the “hot” fund or the “hot” asset class. When target-date funds became available it was a very simple way for the participant to get built-in diversification so that you as the plan sponsor knew that you were providing them with a tool that was really valuable and meaningful—something that, quite frankly, would provide them with the results and the outcomes that they were looking for.

We feel the same here when you look at the income challenge, which is, “I don’t know what I need, but I know I probably don’t have enough, and I need some certainty around the fact that it will be there for as long as I’m here.” An in-plan guaranteed income solution is a great way to solve for those problems.

Reddy: And to build on that, one more behavioral benefit, which we didn’t address earlier, is that many times once participants make a decision they don’t go back and periodically evaluate that decision. They don’t make changes. Now why is that important? We know that we can’t foresee what sectors will do well, or what markets will do, but we do know that a diversified portfolio is the best option for most people to have exposure to the markets but still have some risk mitigation.

We tested our book to understand “For people age 50 or older, what are they invested in?” Staggeringly, we found that 40% are either 100% invested in equities or 100% invested in fixed income. A hundred in either direction is probably not the ideal portfolio you want to have, so having target-date funds as a default leads to a better diversified participant base.

PA: So, if I’m a plan sponsor and these solutions are creating better participant outcomes, what are the benefits to me and is there any kind of additional fiduciary risk for me?

Reddy: We, as an industry, continue to push for further refinement of regulatory standards issued to make sure that plan sponsor concerns are addressed.

But typically when plan sponsors express concern it’s around two issues. One is, “How do I pick an insurer today that I know will be around for a long time, and won’t get sick in the future?” A secondary question that comes up is, “How do I make my participants aware of these types of solutions?”

Our experience indicates that plan sponsors realize that if they make a prudent decision similar to the other investment decisions they make in their plan—with the same level of fiduciary scrutiny—that they are appropriately covered. The primary reason plan sponsors are getting over their fear is the other side of the statistic, which is 10,000 Americans are retiring every day with the vast majority—six out of ten—underprepared or feeling like they are not prepared at all. The risk of not doing anything with that many people approaching retirement is one that’s also abating some of the fear.

Mansfield: Our white paper, “What Employers Lose in the Shift from Defined Benefit to Defined Contribution ... and How to Get It Back,” published last year, identifies real intrinsic value to the employer for adding in-plan income solutions to allow employees to retire on time. One key challenge we found was that employees don’t retire on time. We all know somebody, or we know someone who knows somebody, who did not retire on time because of the market crisis of 2008. They were there, they were ready, they had six months or a year left; 2008 came along and completely changed their plans, and that has some pretty significant ramifications for an employer.

An employer’s work force costs, if your employees are aging, are going to go up because of things like increased cost around health care. Morale is most likely going to go down, because if you’re six to twelve months away from retirement and now you’re looking at needing to work two years to three years to five years more, you’re probably not as engaged and as excited in coming into the office as maybe you were prior.

And third, succession planning: The next level of leaders in your organization may have nowhere to go but to leave your organization if the employees who are nearing and ready for retirement can’t retire.

The 7,000-plus plans that offer our in-plan income solution have recognized that it’s not just a great thing to do for a participant, it’s also a pretty good thing to do for the company as well.

PA: How do these next generation target-date funds with in-plan retirement income components answer the challenge?

Reddy: There are a couple of things I would encourage plan sponsors think about when it comes to target-date funds. Is the target-date fund that you’re utilizing with your participants meant to get them to retirement or get them through retirement? In either of those instances, what level of equity exposure are your participants actually getting? When you evaluate target-date funds, clearly they’re not all the same and some of them will lower your market participation quite a bit as you approach and enter into retirement. That is heightened when you think about life expectancy today.

PA: Can you make that a default?

Reddy: You absolutely can make it a default. And quite simply, philosophically target-date funds make sense: As you get closer to retirement you shouldn’t be as exposed to risk. Prudential believes, within ten years of your retirement date, you may not want to take on as much risk, but you also really should have some guardrails or protection in case you have market events that will disrupt your plans. So that’s when the guarantee component comes on and starts tracking a guaranteed value and allows a static level of risk going forward, because you always have that safety net in place.

Clearly people understand target-date funds, they get it; they put their money in and they hope that when they get to retirement they’ll be okay. When you pair a target-date fund with an in-plan guarantee, the big change is you get rid of the word “hope,” and you get them to where they need to be when they retire.

PA: The cost effectiveness of these options now is significantly more marked than when we first started talking about the cost of guarantees six or seven years ago in this space. It’s a different picture these days when it comes to costs, is it not?

Reddy: Cost, when this solution is offered through the worksite, is going to be a lot less expensive than if you were to access it on a retail basis. The primary difference is the purchasing power of the employer.

However, unlike a lot of other products where the longer you wait the cheaper technology gets, with these types of solutions the longer you wait the more we’re learning about increased life expectancy, and the pricing challenges might actually increase. So the impact of delaying adoption should be a consideration for plan sponsors.

Mansfield: Especially around the cost of waiting, there are really two components here. The first component is the guaranteed lifetime income that provides the certainty by which participants can retire and know that they’ll have a stream of payments for as long as they live.

The second is that the longer you wait to enact the protection, the less protected you will be. There’s always the theory of, “Well, I’ll just wait until I retire.” But the result of that thinking is whatever number you have at retirement, that’s your number, you have no other options. If you have the protection prior to the ten years before your target date and you see a 2008 scenario, anyone who was invested in an in-plan guaranteed income solution has the protection against that loss that year.

PA: Are you seeing interest in in-plan income as a QDIA with an opt-out provision?

Reddy: We have been offering that as an option for the last two years. One, when your retirement income solution is a QDIA, it’s not in lieu of a target-date fund; it is in conjunction with a target-date fund. So everything else leading up to the ten years before looks, smells and feels like what the participant is already used to in a TDF QDIA. Not only have we had a level of interest rising among plan sponsors, we have well over 250 plan sponsors that have used this approach. And more importantly, there are also plan sponsors who have had the in-plan solution, realized that because of inertia they don’t have as much uptake as they’d like—they’ll go back in, use this as a QDIA and employ a re-enrollment process to ensure that all of their participants take advantage of this. At the same time, anyone who doesn’t want it is free to opt-out.

PA: When this discussion started five years to seven years ago in defined contribution plans, it was initially difficult to get plan sponsors to understand that going down this path was not taking them on a challenging fiduciary path that they might have otherwise avoided. At least anecdotally, it seems that there is a sense out there now that there’s as much fiduciary risk not going down this path as there is going down it. As you interact with plan sponsors out there, large and small, has that been your market experience, too?

Reddy: There are a couple of things that are happening. Early on we saw very paternalistic plan sponsors who were doing this because they believed it was the right thing to do for their employee base. That’s still happening today.

Given the additional benefits to the employer, plan sponsors are making the decision today because it’s good business. These solutions improve the effectiveness of a DC plan, support employees in achieving their retirement goals and address work force management challenges. In-plan guaranteed retirement income options produce better outcomes for participants and plan sponsors alike.

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