Guaranteed lifetime income products mark a new era of retirement plan design

The past 50 years have witnessed intense competition among asset managers, banks, insurance and mutual fund companies to capture market share in the $39 trillion retirement plan marketplace. Each new shift in plan design and product development has created new spheres of dominance for these various players. Now, for the first time on a large scale, creative collaboration between mutual fund companies and insurance companies is generating new products that could easily prove to be category killers: guaranteed income products. These new products will usher in a fourth era of retirement plan design.

The full brunt of these creative forces will be brought to bear on retirement plan fiduciaries, who will be forced to evaluate and sign off on guaranteed income products, a skill historically outside of their core competency. As in any evolutionary process, there will be winners and losers. Plan fiduciaries must adapt. The stakes are high.

Prior to the Employee Retirement Income Security Act of 1974 — the first era of plan design — the retirement plan marketplace was dominated largely by insurance companies. Most plans purchased annuity contracts to generate income streams matching the liabilities of the defined-benefit plans that existed then.

To the great detriment of the insurance industry, however, the passage of ERISA — the second era of plan design — facilitated a tidal wave of assets flowing from insurance companies to banks and asset managers, as plan sponsors opted to manage their own plans with the advice of pension consultants. Over time, plan sponsors balked at the high costs associated with defined-benefit plans and replaced them with defined-contribution plans. The dominance of 401(k) saving plans characterizes the third era of plan design and clearly established mutual fund companies as the behemoths of the retirement industry.  

In the early years, plan participants were empowered by the ability to manage their own 401(k) accounts. This confidence, however, was deeply shaken by the financial crisis. Account balances declined significantly, and plan participants viscerally felt the burdens and risks associated with managing their own retirement nest eggs. This change in investor attitude enabled the mutual fund industry to double down on its marketing efforts related to target-date funds — investment options designed to manage investment risks over a time horizon corresponding to the duration of a participant’s working career.

Plan participants embraced target-date funds enthusiastically. Currently target dates are both the largest and fastest-growing product in the retirement marketplace: a veritable home run for the mutual fund industry.

And yet, while target-date funds are effective vehicles for generating savings, they provide little in terms of guaranteed income. Plan participants are on their own when it comes to withdrawing assets from their accounts upon retirement. This is a knotty problem. In fact, no less a finance expert than Nobel laureate William Sharpe described decumulation as “the hardest, nastiest problem in finance.”

Finally, 50 years after the passage of ERISA, the long-excluded insurance industry has come to the rescue with solutions to address this “nastiest problem.” Guaranteed income products have been the bread and butter of the insurance industry for well over a century.   

This recent collaboration between insurance and mutual fund companies is producing a new generation of retirement products: guaranteed lifetime income strategies. These new investment options use annuity contracts as fixed-income alternatives to generate a guaranteed income stream in retirement for the plan participant. Often, these insurance contracts can be embedded within target-date funds. Effectively, these new product offerings replicate the two most valued aspects of traditional defined benefit plans: professional management and guaranteed income. Plan design is coming full circle.

For plan fiduciaries, this adds yet another layer of responsibility to their plates. While the SECURE Act provides a safe harbor regarding the selection of insurance providers, plan providers will still be required to evaluate the prudence of the terms and pricing of these products. Over the past decades fiduciaries have invested sizable resources to develop processes and competencies in evaluating investment and securities products. Few have expertise in assessing pricing and terms of annuities. They will need to acquire these skills or seek out trusted advisors who can provide it for them.

Nonetheless, this fourth era of lifetime income funds appears to be a win-win for all stakeholders. Plan participants benefit from professional management of their retirement accounts, while receiving reliable income payments starting either upon retirement or a later date. The attraction to the insurance industry is obvious: access to a previously elusive market. The mutual fund sponsors view these products as enabling them to keep participants in their funds long past retirement. Lastly, the plan sponsors are motivated because employees view these features as enhancements to their benefit packages. 

The Interests of many stakeholders are aligned by the creativity of integrating important elements of different products into a single product. This product integration could very well lead to category-killer status.  

Due to this alignment of interests among product providers, plan sponsors and employees, significant momentum is building around this product category and will create intense pressure on plan fiduciaries. Plan sponsors must critically assess whether their plan fiduciaries are equipped with the required skills to evaluate these new products. Plan fiduciaries must develop the same level of expertise regarding guaranteed income products as they have developed over the years with respect to investment and securities products. Prudent preparation and analytics will be the key to managing the energy behind this fourth era of plan design.  

Mitchell Shames is founder and managing director of Harrison Fiduciary.