The Department of the Treasury and the Department of Labor have proposed new regulations focused on providing 401(k) plan participants more choices to invest in annuities that guarantee a stream of lifetime income. However the proposals aren’t enough to persuade plan sponsors to offer such “longevity annuities,” experts contend.
These annuity products give people the option to defer up to 25 percent of their account balances into an annuity that starts paying out further into retirement, such as age 80 or 85. A recent Aon Hewitt survey reported only 16 percent of plan sponsors offer such a choice. Martha Tejera, a retirement-plan consultant, says only about 1 percent of participants in those companies take advantage of the opportunity, though for most, she says, a longevity annuity would be a better bargain than taking distributions straight from the plan balance upon retirement.
The government’s proposal has four components, two of them key. First is a rule change in calculating annuity payouts, which could make plan sponsors more eager to provide plan participants the option of putting some of their retirement savings into an annuity while receiving the rest in cash. That should be appealing to new retirees hesitant to give up control of their retirement savings as well as those who find annuities hard to understand.
The second key proposal is that the value of the longevity annuity would no longer count in determining the required minimum distributions that participants must start taking at age 70. Thus, participants may more likely want such an option and, supposedly, plans would more likely provide it.
Pension experts view the proposals as small advances. The proposals don’t speak to the most important factors keeping plan sponsors from offering guaranteed retirement income products.
There are potential liability issues. Many insurance firms offer such products (including several recently launched), but each insurer provides only its own solution. This undermines a plan sponsor’s fiduciary duty to prudently select investment options.
Gregory Marsh, vice president and corporate retirement plan consultant at Bridgehaven Financial Advisors, says, “You’re supposed to compare several different options for things like performance, appropriateness, and cost. … But if your provider offers only one solution, how can you make a prudent decision? Providers are going after clients, saying theirs is the greatest thing since sliced bread. But they have no fiduciary liability whatsoever.”
The plan sponsor also has a duty to pick an insurer with the capability of making annuity payments long into the future. They need to choose a provider that’s going to be around for 50 years or so. But many insurance companies have financial challenges and took bailout money, making employers reluctant to offer an annuity option.
And, how about if a plan sponsor tells a participant that, based on what the employee has saved, he will get a $500-a-month annuity — and then receives only $300 a month? Is the sponsor liable? That answer is not clear, says Tejera.
Until such issues are resolved, experts say longevity annuities will be unlikely to catch on, though plan sponsors have more reason than ever to see that employees adequately prepare for retirement. With the economic downturn, many workers have delayed plans to retire, even if past their most productive years, now afraid they won’t have enough retirement money. The slow economy “has shone a spotlight on how limited defined-contribution plans are in helping companies manage” age-related attrition, says Tejera.
A plan for your 401(k)
Many 401(k) strategies — such as maximizing performance, spurring greater participation, or achieving regulatory compliance — are practically formulaic for plan sponsors. But sponsors may want to look at taking other, specific measures in response to recent events and trends in 401(k) investments.
1. Fee-allocation methodologies review. The new, required disclosures of fee and compensation that service providers and sponsors must make starting Aug. 30, 2012, should put fees under greater scrutiny. Plan committees should review and document the methodology for allocating fees to participant accounts, whether it’s through revenue sharing or other methods.
Revenue sharing means any portion of the expense ratio (the total fees charged to an investment option, expressed as a percentage of assets invested in that option) that is used for administrative fees other than investment costs. As for other methods, more plans are now charging administrative expenses directly to participants’ accounts. Revenue sharing doesn’t show on account statements, but is instead embedded in the fund’s returns. Charging costs directly to accounts makes them more visible.
Some experts note that it seems to make sense to charge investment costs pro rata based on account assets. But administrative costs don’t depend on how much money you have; a $400,000 account costs the same to administer as a $4,000 account. Making the expense ratio available to pay for administrative costs, which until now has been the usual procedure, not only is somewhat illogical but also has not led to much openness and scrutiny.
2. Stable-value options: be aware. Most 401(k)s provide at least one capital-preservation option, usually money-market accounts or stable-value funds. Both are designed to always trade at $1 so participants don’t lose their capital — they are paid as income on investments. The income can be held until retirement or withdrawn at any time. The difference between the two: money markets trade in short-term fixed-income securities, while stable-value funds invest in long-term instruments.
Stable-value funds historically have generated much higher long-term returns than money-markets, but the stable-value market is under stress at the moment. The insurance companies that guarantee investments will always trade at $1 (book value rather than market value) have become much more risk-conscious since the last time a fund “broke the buck,” three years ago. The response has been to increase pricing for stable-value funds while adding new investment restrictions.
3. Re-evaluate custom target-date funds. Custom target-date funds are made to fit a plan’s specific participant demographics rather than having the same retirement date for all of a plan’s clients. Such funds and other default investments are now cost-effective at much lower asset levels, mostly due to efficiency gains from the expanding number of plans that use automatic enrollment and automatic escalation of contribution levels.
4. Think about a diversified inflation option. These options are intended to maintain good performance when inflation goes up. They provide access to asset classes not usually in defined-contribution plans, like Treasury inflation-protected securities, commodities, real estate, and inflation-sensitive equities and bonds.