Securing income through retirement
next issue no. 8: Investment corner
As employers continue to navigate the great recession and subsequent war for talent, more and more are looking to their benefits packages, especially their defined contribution plans, as a strategic tool to help attract and retain talent. In doing so, there is increased interest in plan design innovation and a focus on participant outcomes. One area where we see significant potential for innovation and differentiation, fueled by growing attention from Washington D.C., is retirement plans incorporating guaranteed lifetime income.1
Continuous income in retirement
The disconnect between current retirement plans and the need for an income element goes back to the origins of the 401(k), which was never meant to entirely replace defined benefit retirement programs. In the 1980s and 1990s 401(k) plans were supposed to provide a supplemental savings arrangement to complement lifetime income from defined benefit (DB) plans. However, due to multiple factors, including DB liability actuarial funding challenges, the allocation of investment risk to individuals, the fact that newer generations of the workforce are not staying with a single company throughout their careers, and the abandonment of those DB plans at prior companies, the traditional DB pension plan all but disappeared.
This has shifted the burden to the participant. For example, the generation nearing retirement today likely does not have a defined income benefit to their retirement planning beyond social security. They are likely to just receive the lump sum from their defined contribution plans upon retirement that they will not only have to figure out how to invest prudently, but also make this sum of money last through their (unknown but increasing) lifespan. What is known is that at least 50% of workers aged 60 and older now plan to work until they’re at least 70. And this additional delay in retiring can add to an employer’s incremental costs.
Increasing life expectancy (if you remove the opioid crisis and the pandemic from the calculations) means that there are an increasing number of retirees facing a shortfall of predictable guaranteed income for life as they approach retirement. This is a problem that has the attention of Washington, D.C., and it is an area that plan sponsors have to decide now how they want to approach and solve.
The Setting Every Community Up for Retirement Enhancement Act (SECURE Act) passed in 2019 laid the groundwork, and worked toward a path for plans to offer guaranteed retirement income to participants. The Act included improved safe harbor protection for the inclusion of annuities within a 401(k) plan, which is a significant innovation in plan design. There were also sections that helped to address some of the portability concerns of lifetime income vehicles that were an ongoing issue. As a supplemental measure, the Act also requires plans to give participants projections of their current account balance as a monthly income benefit using assumptions prescribed by the Secretary of Labor. This illustration shifts the focus away from a lump sum payout to a projected, dependable monthly income stream, possibly helping participants realize the simplicity of and need for guaranteed income through retirement.
Without enhancements, the current 401(k) system poses several significant risks to participants. One is that participants will gain penalty-free access to a large (hopefully) sum of money without the expertise and discipline needed to make it last through retirement. There are multiple anecdotes explaining this risk, such that a participant upon gaining access to this sum sees it as a windfall cash prize akin to a lottery win, rather than a pool of assets that need to be carefully apportioned out to last throughout an indefinite period of retirement. This risk is one of financial education and a risk associated with misunderstandings of how retirement planning and asset allocation need to account for ever-increasing life expectancy and unexpected expenses.
The second significant concern is an investor realizing that they would like to apportion a percentage of their 401(k) balance to a vehicle like an annuity, to generate a portion of their retirement income that’s guaranteed for life, but that the participant does not realize that they may already have access to institutionally priced annuities and other comparable vehicles within the structure of their 401(k). Instead the participant transfers a portion of the balance to a retail-priced annuity and may pay commissions or expense loads.
The solution: institutional priced annuities inside retirement plans
Keeping the participant’s assets within the 401(k) ecosystem (not necessarily in the plan upon retirement), with the fiduciary oversight that accompanies that, and with the access to institutionally priced offerings, is key to helping participants grow and protect those assets. Further, if an in-plan annuity option is available, it can allow them to generate guaranteed retirement income. We see the 401(k) market bifurcating over the next decade or so into two types of plans: one is the current model of 401(k), which is simply a tax-advantaged savings plan. The other is a “retirement income” 401(k) plan, which provides participants with a holistic view on retirement income strategies, arms them with the tools needed to optimize their outcomes and allows them to use a portion of their balance to select guaranteed income for life in order to replace a predictable paycheck in retirement.
A significant consideration and way to communicate the need for lifetime income to participants is to evaluate recurring living expenses in retirement against guaranteed income from Social Security and, if available, a DB pension, and focus on covering the gap with income through an in-plan annuity product. Although we believe that fears that Social Security is going to go bankrupt are overblown, we do believe that it’s likely that American workers in the future will receive less from Social Security than today’s retirees. Additionally, we think that the amount of income generated from Social Security is not enough to fully replace essential income in retirement.
If Social Security provides $2,000 a month in retirement, but a participant has calculated that they need $3,500 to meet their essential expenditure, there needs to be a fresh element that amplifies guaranteed monthly income to cover the $1,500 gap and provide peace of mind.
It’s important to note that participants shouldn’t be expected to annuitize their entire 401(k) balances. The annuitization of a portion of a 401(k) balance can provide the missing link and fill the income gap. This then allows for discretionary income to be allocated from the rest of the 401(k) and its remaining balance. We believe the right method is to calculate the necessary monthly income required in retirement and annuitize to generate that monthly income. The calculations will be different for each participant but this shifts the burden away from just relying on the balance of a 401(k) to be managed through retirement.
A 67 year old participant with a $750,000 401(k) account balance might annuitize $300,000 (40%) through a fixed annuity covering their own life product at age 67, and for illustrative purposes, let’s say the annuity pays them $1,500 per month (i.e., $18,000 per year, or a 6% Income Payout Rate); they’ve created a more solid foundation of predictable income for life to complement Social Security and can meet their recurring living expenses.
As such, they can leave the remaining $450,000 invested and take systematic withdrawals, use it for discretionary purposes, emergency expenses, or pass down to heirs.
It’s important to note that participants shouldn’t be expected to annuitize their entire 401(k) balances.
How plan sponsors can implement annuities
The ability to include guaranteed income in 401(k) plans is not a new concept, but is nascent in terms of actual implementation. As the legislation and best practices evolve in this regard, there will likely be two broad approaches taken by plan sponsors.
One idea is to approach securing income in retirement accounts in a way that simply checks the box (“yes we offer lifetime income”). This can be as simple as adding optionality to target date funds with a Single Premium Immediate Annuity (SPIA) or a Deferred Income Annuity such as a Qualified Longevity Annuity Contract (QLAC) available to be used to purchase lifetime income at retirement with a portion of a balance. This approach has the benefit of simplicity as the participant can convert a preset portion of a 401(k) balance into a lifetime income stream once the participant reaches the declared start date. We see this as the option that plan sponsors will choose if they want to say that they are offering something. It is better than nothing, but it is not a fully integrated plan that truly meets the needs of participants to guarantee lifetime income in retirement.
We see the second option as realizing the true benefit of wrapping income into a 401(k) plan throughout the participant’s savings and investment journey in a much more integrated way. This would include an annuity that participants invest in during their entire working career that’s coupled with robust education and lifetime income projections so that participants begin to think of a portion of their 401(k) balance as an income amount. By exposing the annuity vehicle to the participant earlier in their career, this can allow for the growth in accumulation units over a much longer period which can translate to more lifetime income in retirement.
This touches on one final consideration, which is the matter of timing and frequency of annuitization. For some products, the annuitization option is an all-or-nothing decision at retirement and if the interest rate environment isn’t favorable then participants might get less income than if they waited several months to convert to lifetime income. However, there are other annuity vehicles that allow participants to annuitize multiple times during their retirement. In addition there are products that allow participants to select multiple payment frequencies to meet their financial needs. The benefit of an integrated annuity offering within a 401(k) plan is that participants become accustomed to thinking about lifetime income and with the right product with the right flexibilities coupled with expert guidance, a participant annuitizing through a 401(k) plan can have the same peace of mind in retirement that their parents with DB pensions had. After all, it’s not likely that many DB pension recipients are dismayed when their income payment shows up in their bank account every month!
The SECURE Act is providing safe harbor for annuities, and we believe that we could see significant growth in annuities as a result.
Providing the security of a paycheck
To conclude, including guaranteed income more broadly in DC plans is a way of redressing the balance that shifted when defined benefit plans faded away. Increasing numbers of participants are entering retirement without a guaranteed income stream, and many are ending up going back to work to supplement retirement funds. Annuitizing a portion of a retirement balance can provide the second income that a job in retirement could, guaranteeing that income for the lifetime of the participant. It can provide the security of a paycheck in a way that participants are used to.
The inclusion of a guaranteed income element within a 401(k) plan is a development that is an inevitability. It has the attention of Washington to the extent that it is a matter of when, not if, new legislation is passed. The time is now for plan sponsors to start to think broadly about their retirement benefits philosophy and how a strong 401(k) “retirement income” plan can attract and retain talent. The sooner they can address questions of integration the better. Plan sponsors who are aligned on the value of in-plan, institutionally-priced lifetime income need to start addressing these questions to determine what partners they want, what technology providers they wish to integrate, and to what level of depth they want the integration to occur. There are still technological developments occurring in this area to allow for seamless integration into plans, and making the process as simple as possible for participants is most likely to lead to significant uptake, but work is developing rapidly.
In 2005 there were approximately $70B allocated to target date funds. Then the Pension Protection Act was passed, which provided safe harbor for asset allocation products. Now there is almost $3T allocated to target date funds. The SECURE Act is providing safe harbor for annuities, and we believe that we could well see similar growth in annuities as an asset class as a result. Plan sponsors have to decide now how they want to approach this coming change and how dignified a retirement they want their workers to be able to enjoy.
In this issue
1 Any guarantees are backed by the claims-paying ability of the issuing company.
2 Mass Mutual, “Is delayed retirement impacting your bottom line,” 2018
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A word on risk
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