Big change is coming for 401(k)s

Gold watches and monthly checks used to be the hallmarks of retirement, symbols of the American Dream. However, with employees now changing jobs every five years, watches are quaint remnants of a bygone age, and monthly retirement checks were quashed by the shift from traditional pension plans to 401(k) plans.

While plan participants have been left largely to fend for themselves when it comes to investing for their retirements, market forces are now coalescing to revive the monthly retirement check in form of guaranteed lifetime income products. The 401(k) marketplace is in the midst of a tectonic shift that will transform retirement planning. Plan fiduciaries will need a new host of skills for evaluating and selecting this new potential onslaught of products.

Since the passage of ERISA in 1974, players in the financial services market have been caught up in a zero-sum game in the asset-gathering race. Pre-ERISA, the insurance industry held a firm grip on retirement assets by providing annuity contracts that supplied guaranteed income streams against accrued pension liabilities. The 50 years since ERISA's passage witnessed the flow of ERISA plan assets first to investment management firms and then, with the advent of 401(k)s, to mutual fund companies. 

Most recently, target-date funds offered by mutual fund companies have become the category killer of retirement investment products. These funds enable plan participants to appoint managers (mutual fund companies) to manage their retirement assets to their retirement date (or beyond, if so selected) in a manner that focuses on day-to-day management of the portfolios, but also takes into account shifting risk tolerances as plan participants approach retirement. Target-date funds are both the fastest growing and the largest investment category for ERISA qualified retirement plans.

While target-date funds are effective vehicles for generating investment savings, they don't traditionally provide for retirement income or lifetime income. This gap opens a huge opportunity for insurance companies with experience in offering guaranteed income products. These complementary disciplines and skill sets are now, for the first time, giving rise to a new set of products: target-date funds with lifetime income features.

Collaboration among financial services firms is becoming the new normal. Never before have the interests of Wall Street, mutual fund companies, insurance companies, fintech product innovators and plan sponsors been so aligned. Many of the largest names have invested significant time and talent in developing sophisticated and creative products for this significant market. BlackRock, Nationwide, Capital Group (American Funds) and Prudential, to name a few, all have cutting-edge products in the pipeline.

Post-pandemic employers are struggling to forge new relationships with their employees. The whole nature of the employer/employee relationship is shifting, most particularly with respect to younger employees. Plan sponsors will likely be keenly interested in this new array of products. However, the enthusiasm will need to be tempered by prudence and rigorous analytics.

Months of intensive research reveal that plan sponsors have a challenging road ahead in the selection of guaranteed lifetime income products. The greatest challenge is that no two product offerings are the same. In fact, there are a wide array of product structures. At one end of the spectrum, certain products allow for the purchase of annuity contracts “outside of the plan” whereas at the opposite end, other products have annuity contracts hardwired within the plan. And there's a broad middle range which adopt elements of both.

The purchase of annuity contracts (either group or individual) lies at the heart of these new products. However, most plan sponsors have little experience evaluating annuity contracts in a fiduciary context. Over the decades, they have developed skills and systems to help assess a broad range of investment products, from index funds to actively managed strategies, including alternatives such as private equity, real estate, venture capital and hedge funds. But decisions related to annuity contracts were left to the plan participants when they cashed out of a plan.

Like the lifetime income products themselves, no two annuity contracts are alike. They aren't standardized like securities such as equities, bonds and mutual funds. They're individualized contracts with unique and specific terms relating to each contract. Before offering a guaranteed lifetime income option in a retirement plan, plan sponsors will have to master these contractual terms.

Fortunately for plan sponsors, the Secure Act took one important piece of annuity contract analysis off the table by providing a safe harbor with respect to the credit quality of annuity issuers. Plan sponsors will be entitled to rely upon representations made by annuity issuers related to their creditworthiness. However, the safe harbor doesn't apply to the pricing of annuity contracts. Plan sponsors will have to dig into the opaque process of contract pricing to assess whether the price of a contract is reasonable. 

One can only speculate that for guaranteed lifetime income products, “pricing” will become the new “fees and expenses” focal point of class-action litigation. Given the seemingly daily announcements of class-action suits against target-date fund sponsors, annuity contract pricing will likely give rise to years of litigation. Plan sponsors need to be not just prudent, but proactive. Prudence is the best defense.

Target-date funds with lifetime income options represent a unique collaboration among previously competitive financial firms. The joint creativity is staggering and has great potential to benefit participants. The products address two fundamental concerns of plan participants: management of investment accounts over the arc of a working career and guaranteed monthly retirement income.

These factors are sparking a dizzying array of new products. Plan sponsors will need to dig through layers of complexity on products that previously weren't integrated: target-date funds and annuity contracts. Failure to master these products could be costly and a significant drain on senior management time as they are forced into the ever-expanding quicksand of ERISA litigation.

Mitchell Shames is founder and managing director of Harrison Fiduciary.