Retirement plan advisers should bone up on lifetime income

The continuing demise of defined benefit plans and increasing concern about the future of Social Security have dramatically reduced the certainty of retirement income for most Americans. Guaranteed income options in defined-contribution plans offer the opportunity to help reverse that trend.

Regulators are now encouraging annuities within target-date funds to address the void in guaranteed income options for retirees. Guidance issued by the Internal Revenue Service and Department of Labor in 2014 made it clear that defined contribution plans can offer TDFs with embedded annuities as default investments and participant-elected options.

However, as noted in a Government Accountability Office study of 401(k) plans published in August 2015, plan sponsors have been reluctant to make annuities available in default options without more explicit assurance from the DOL about protection from fiduciary liability when they do so.

That assurance has recently been provided in the form of a DOL information letter responding to an inquiry from TIAA, a provider of 401(k) products and services.

TIAA requested clarification from the DOL as to whether a plan fiduciary would be prohibited from using the company’s “Income for Life Custom Portfolios” product as a default investment alternative in a participant-directed plan, such as a 401(k). This product is described by TIAA as a custom target-date investment model that includes an annuity component.

Information letters from regulators are important because, while each one responds to a specific inquiry, they serve to clarify regulatory intent more broadly. In this case, the DOL’s response laid out in considerable detail the conditions that would allow annuity products to be used in default investment alternatives and safely selected by plan fiduciaries.

The DOL confirmed that even though the liquidity and transferability restrictions associated with the annuity component of TIAA’s product would prevent it from meeting all the requirements of a qualified default investment alternative, the product can serve as an appropriate default investment alternative by meeting certain fiduciary obligations by other means.

(A QDIA can be one of three investment options, one of which is a TDF. Employers using one of these default funds receive certain legal protections.)

Specifically, a fiduciary can “prudently select an investment with lifetime income elements as a default investment … if it complies with all the requirements [associated with qualifying as a QDIA] except for reasonable liquidity and transferability conditions.”

Additionally, the “fiduciary must engage in an objective, thorough and analytical process that considers all relevant facts and circumstances.”

The DOL elaborated upon “relevant facts and circumstances” that would need to be considered in a prudent process for the selection of a default alternative with an annuity component. Both plan demographics and product characteristics must be evaluated. The investment alternative selected must align with the needs of plan participants and beneficiaries.

Analysis of a specific annuity-related product must include, “among other things, the nature and duration of the liquidity restrictions, the level of the guarantees of principal and minimum interest rates, any opportunities for the guaranteed minimum interest rates to be supplemented with additional credited amounts, as well as the expected lifetime income to be provided in retirement.”

Costs must also be reasonable for the services and benefits provided through the investment alternative. Appropriate disclosures for these products may go beyond what would normally be required for investment alternatives that are more liquid and transferable.

Finally, the Department seized the opportunity to express unequivocal support for lifetime income options for retirees. “The Department, along with the Treasury Department and other stakeholders, identified the need for lifetime income as an important public policy issue and has supported initiatives that could lead to broader use of lifetime income options in defined contribution plans as a supplement to and enhancement of accumulation in retirement savings,” the information letter said.

The math of both retirement saving and retirement income depend on the same four variables: principal, payments, returns and time. During the accumulation stage, plan design can be used to encourage behaviors that will help maximize the values of all four variables, through automatic enrollment, automatic increases in contribution rates, pre-diversified investment options, retirement asset retention incentives, for example. Additionally, the pre-retirement investor has considerable control over these variables.

During the retirement distribution stage, the retired investor generally has much less control over the four variables and far less support for managing them. Principal, payments and returns all generally shift into reverse at retirement and time (longevity risk) becomes the biggest threat to lifelong financial security. Only a guaranteed lifetime income option in a retirement plan proactively provides a high degree of control and certainty over all four critical variables during retirement. The earlier contributions are made to these options during the accumulation phase, the greater the proportion of retirement income that will be guaranteed for life.

Retirement advisers need to get up to speed quickly on the recent regulatory and marketplace developments in guaranteed lifetime income options. Expect rapid product innovation and growing demand in this area, along with improved retirement readiness and considerable business opportunity.

Blaine F. Aikin is executive chairman of fi360 Inc.