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Asset Class Focus | Published in December 2014

Annuity Choices

  Are plan sponsors choosing annuity products—or not? 

By John Keefe | December 2014
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PS1214_ACF_Story_NaftaliBederArt by Naftali BederOver time, a glacier that has built up over many years of accumulation can slowly turn to liquid and begin to shrink—what glaciologists call “ablation.” Retirees face a similar challenge in preventing their buildup of savings from dissolving too quickly to yield sufficient funds for the rest of their lifetime. Now that the first 401(k) participants are retiring, the industry is early in its own ablation phase, and providers are bringing to market investment products designed to ensure that participants’ hard-earned savings will see prudent liquidation into retirement income.

Retirement income products aimed at the defined contribution (DC) market come in several forms. One is managed distribution accounts, where a retiree turns over his assets to an investment manager charged with adopting a suitable strategy that allows systematic payouts through his final years.

A second, “safety-first” approach involves insurance products, where the retiree buys an annuity to guarantee a stream of income for the long term. Annuities reportedly date back at least to ancient Rome, and many varieties have evolved since. Still, the classic and simplest form is a fixed annuity where the retiree pays a lump sum to an insurance company, then receives regular payments of a given amount, or perhaps another amount adjusted for inflation, for life. These can begin right at retirement or be deferred to start at a future point—say, age 80 or 85—often called a longevity annuity.

As a matter of public policy, the federal government wants to encourage the protection of retiree incomes, and in late October, the Department of Labor (DOL) issued guidelines for including certain types of annuities in target-date retirement funds (see Washington Although simple in form, fixed annuities present a complex decision to the retiring saver: The insurance company takes complete ownership of the annuitized assets, so that an annuity purchase is more or less irreversible. Moreover, the pricing of fixed and deferred annuities is opaque, so they can be expensive—especially in times of low interest rates—and future payments would not adjust to reflect favorable changes in the markets.

The insurance industry has evolved its products to work around some of these drawbacks, creating annuities that offer lifetime payments but leave retirees with some control over their hard-won assets. One is known as the guaranteed lifetime withdrawal benefit, or GLWB. An example is the IncomeFlex annuity offered by Prudential Retirement, available in conjunction with Prudential’s own target-date funds (TDFs), as well as those of Fidelity Investments, T. Rowe Price Group, Vanguard Group and J.P. Morgan Funds. The investor in that offering pays an annual fee of 1% of the account value, as well as any asset management fees; once he chooses to start receiving income, he can withdraw up to 5% annually for life based on that starting benefit base. If markets and the account value drop, the output stays consistent, but rising markets can increase the withdrawals. Retirees also may increase their regular distributions or even make large withdrawals, albeit with commensurate adjustments in account value. Payments continue for life, even if the account is exhausted, and at death any market value remaining is passed on to heirs.

Choosing among annuity products, however, is not the most difficult decision, observes Scott Brooks, head of defined contribution investment at SEI Investments headquarters, in Oaks, Pennsylvania. “A more complex question is whether to offer retirement income options at all. Sponsors wonder: ‘When people retire and are not working for us anymore, are they still our responsibility?’”

Although the investment providers have brought a new generation of products to market, distinct patterns of behavior among sponsors have yet to emerge. “To date, many employers—those who are paternalistic—have asked about annuities, and certainly insurance companies have been pushing the concept, but there hasn’t been much acceptance from sponsors,” says Robyn Credico, national director of defined contribution consulting at Towers Watson in Arlington, Virginia. Only about 12% of sponsors offer annuities, up from 6% in 2012, she says, and fewer than 5% of employees have taken advantage of the solution.

Retirement income, as well as other aspects of aging, have been given thoughtful consideration by the Stanford Center on Longevity, affiliated with Stanford University. The center has published outstanding papers on retirement planning, design and best practices in retirement income, available at longevity3.stanford.edu/publications.

Steve Vernon, consulting research scholar at the center, points out that, paternalism aside, sponsors and participants both can benefit from offering a retirement income program. With built-in retirement income features, retirees are more likely to leave their assets in the plan, resulting in lower administrative costs. Moreover, with an integrated income program, the plan stands a greater chance of carrying out its mission of retirement security for participants. He also believes that sponsors are better positioned to conduct the due diligence needed in a bewildering annuity market and to find better pricing through wholesale channels. Thus, sponsors are able to assemble a small menu of quality products and insurers that are likely to live up to their promises over the next 20 years or more.

“But the hardest decision for sponsors,” says SEI’s Brooks, “is whether to put the annuity in the plan or recommend a menu of annuities outside the plan.” Annuities are not mutual funds with daily trading, nor are they designed for purchases in small amounts over many years. Importantly, they cannot currently be rolled over from a 401(k) plan to an individual retirement account (IRA). “Transferability is a big hurdle,” Brooks adds. Some providers have developed annuity exchanges to which sponsors can direct retiring employees.

The complexity and irreversibility of annuities may pay off, however, as data show that retirees who have annuitized a portion of their wealth are happier in their golden years. So say two consultants at Towers Watson, Steve Nyce and Billie Jean Quade, both in the firm’s Arlington office, who analyzed the 2010 details of the University of Michigan’s biennial Health and Retirement Study and presented their findings in a September 2012 paper, available on their company’s website at www.towerswatson.com/en-US/Insights/Newsletters/Americas/insider/2012/Annuities-and-Retirement-Happiness.

A satisfying retirement is the product of many factors, the leaders being health and wealth. In their analysis, however, Nyce and Quade were able to isolate the impact of annuitization. They found that, other things being equal, higher levels of annuitized income were associated with greater happiness in retirement, owing to a greater sense of security. Their results echoed similar findings on annuities by other researchers in 2003 and 2005. Nyce and Quade were careful to not overstate annuities’ importance, but pointed out that these products had the biggest effect on the satisfaction of retirees who held less wealth or were in poor health.

The survey was conducted not long after the financial crisis. Although some of the panic of that time has waned, Nyce says, workers and retirees both remain closely focused on income security. “Nothing has changed the landscape on future health care costs; since employees are bearing most of the risk with DC plans, they’re still concerned about the certainty of their retirement”—and getting all the liquidity they can from their retirement glaciers.

 

 

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