In recent years a number of investment products have become available that can help provide some element of security for participants in the post-retirement withdrawal process.
Products have been introduced that offer far more flexibility than conventional life annuity contracts. For example, some permit the participant to make an emergency withdrawal of more than the annual amount of income otherwise available, and some also provide a death benefit equivalent to the remaining asset base in the product. The products typically offer a lifetime withdrawal guaranty feature with an element of guaranteed return on the undistributed withdrawal base.
Although the market is in a state of constant evolution and refinement, existing products have reached a sufficient level of sophistication to deserve careful consideration by a defined contribution plan sponsor wishing to offer a valuable option to assist participants in the draw-down phase. A recent study sponsored by LIMRA finds more than 23,000 plans currently offer in-plan post-retirement guaranty programs.
Some of the risks to which participants will be subject upon retirement include: longevity risk, interest rate risk, investment risk, behavioral risks and cost risk. Discussions of the way an appropriate qualified retirement income product can partially or completely deflect each risk follows.
Longevity Risk. The median lifespan for a 65-year-old male annuitant is approximately 22 years. However, this is simply a median figure, and individuals at the higher end of the probability percentile will live a significantly longer life. To the extent that a retiree begins to withdrawal money pursuant to an assumed rate of return and an assumed life expectancy, survival beyond the presumed life expectancy will put a severe strain on the individual’s ability to continue with an unbroken lifestyle. Retirement income products that pool longevity risk should allow a participant to obtain a larger payment stream than if the participant self-insured against longevity risk.
Interest Rate Risk. Interest rate risk involves the pressure of having to purchase an annuity in an environment of low interest rates which requires significantly greater dollars to achieve the same targeted level of annuity benefit. Some retirement income products provide for a guaranteed conversion rate at which the accumulated account can be converted into an annuity lifetime stream of payments, using a pre-determined formula that is not dependent upon interest rates at the moment of conversion.
Investment Risk. Market declines immediately before or after retirement can drastically affect a retiree’s account balance. The adverse effect is made worse by the fact that he or she will be withdrawing funds for living expenses and effectively locking in the market losses. Some retirement income products are designed to protect retirees against this “sequence of returns” risk by building in a guaranteed annual payment amount or a guaranteed withdrawal base.
Behavioral Risk - Mystique of Large Account Balance. There is a very real phenomenon where a participant who is accustomed to seeing a large account balance may balk at the notion of converting the lump sum into a stream of relatively small annual payments. If a retirement income product is introduced early in the accumulation cycle, the individual will have an opportunity to develop a mindset associated with lifetime streams of payments. In addition, the reluctance to convert a large account balance into a stream of smaller payments may be addressed with a lifetime income product that permits emergency withdrawals and a death benefit of the unspent asset base at the time of death.
Behavioral Risk – Performance Chasing. A participant who is committed to a self-managed program to make modest ongoing withdrawals from a large account balance may still fall victim to the common investment phenomenon of not “staying the course” during up and down market cycles. Attempts to time the market almost inevitably produce inferior long-term returns. This risk is removed with many of the available retirement income products.
Cost Risk – Higher Cost of Individual Products. If a participant wishes to invest in a retirement income product and there is no such product offered through the plan, he or she will be forced to pay the higher costs of a non-institutional version of the product. This could include fees that are more than 100 basis points higher than the fees associated with an in-plan product.
While there are still questions about the process for selection of products, and there may be portability issues for participants who change employment, offering an in-plan retirement income product could be advantageous to plan sponsors. It may reduce lump-sum distributions from the plan with a corresponding increase in asset retention. In addition, offering a retirement income product may address the reluctance of senior employees to retire due to concerns about not having adequate means to finance their retirement years. An employee who has developed some appreciation of his/her retirement needs and who has taken steps to fund some or all of such needs through an appropriate retirement income product will feel more comfortable about the decision to retire.
Now that the market currently offers a number of retirement income products that address risks participants face when entering retirement, defined contribution plan sponsors are well-advised to consider these options to maintain a plan that proactively addresses participant needs. An in-plan solution is vetted by the employer and is going to be much less expensive than an out-of-plan or “on-the-way-out-of-the-plan” solution for which the participant essentially will pay retail price for the solution.
William Charyk is president of the Institutional Retirement Income Council (IRIC) and is a partner in the Employee Benefits and Executive Compensation Practice Group at the law firm of Arent Fox LLP.
Bruce Ashton is a partner in the Employee Benefits and Executive Compensation Practice Group at law firm Drinker Biddle & Reath LLP and an IRIC adviser.NOTE: This article is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice. This contributed article was not written by PLANSPONSOR or Asset International staff and the opinions of the author(s) do not necessarily reflect the stance of Asset International or its affiliates.