Cracking Open the Annuity Dilemma

Tamiko Toland

As plan sponsors lean into lifetime income, they must decide what form to offer their participants. Most people are familiar with traditional annuitization, but there is also the newer option of the guaranteed lifetime withdrawal benefit.

Both guarantee lifetime income for an individual or a couple. Both offer death benefits, although in different forms. The primary difference often boils down to liquidity: The money used for annuitization evaporates after purchase, whereas the GLWB gradually draws down from assets, enabling the participant to access the full remaining balance if they want.

Who Doesn’t Want Liquidity?

The answer may not be as simple as you think for two reasons. First, not all liquidity is equal. Second, every choice has trade-offs, and liquidity is no exception (spoiler alert: the most important trade-offs may come as a surprise—and they’re different for the participant and the sponsor).

Liquidity With an Asterisk

Not only is there no free lunch for the GLWB, but the detailed explanation of the benefit ventures into the realm of fractions. As a benefit, the GLWB always has a cost, either through an explicit fee or a lower interest rate; both methods allow the insurer to pay for the cost of the guarantee.

The benefit uses rules for withdrawals linked to a percentage of a theoretical value that is disconnected from the cash value of the contract. These rules, on the one hand, preserve the guarantee. On the other, they allow for the flexibility of taking out more than the annual allowance in what are called “excess withdrawals.” Tapping that flexibility comes at the cost of the income guarantee.

Excess withdrawals reduce the guarantee in the same proportion as the withdrawal relative to the balance (I did mention fractions, didn’t I?). This means that an excess withdrawal of half of the remaining balance also reduces the guarantee by 50%.

A drastic reduction of the income guarantee is always consequential. When the account balance is high, an excess withdrawal may represent only a small percentage of the balance and, therefore, a slight reduction to the income. However, it’s a different story when these withdrawals take place after the balance has gotten extremely low, as we would expect late in retirement. A nominally small withdrawal can greatly reduce or eliminate a significant guarantee that a retiree may have expected to rely on as other assets have dwindled.

For this reason, Wade Pfau refers to the liquidity of the GLWB as “technical liquidity.” It means that you can technically access the balance, but it will affect your income guarantee.

Indeed, the control and choice of the GLWB are so appealing because they allow people to access liquidity during retirement if they reach a point when they value the lump sum more than the future income. Some designs also increase the income guarantee based on market or other factors, which can mitigate this effect, particularly earlier in retirement.

However, these rules have benefits and pitfalls of which participants need to be aware when they are making important decisions. At the beginning of retirement, this means when to start taking income, but later, it equates to the cost of using the flexibility of the guarantee.

Implications for the Sponsor

The sponsor needs to consider the trade-offs for the participant and how the implementation of lifetime income fits into the overall portfolio. There are important questions about exactly what percentage of a participant’s retirement plan is ultimately linked to guaranteed income and how nonguaranteed portions are managed.

The transition into retirement is a key factor in the evaluation of any individual solution and of the plan as a whole. These topics are worth mentioning here, but deserve to be properly addressed separately.

In the decision about which lifetime income path to take, plan sponsors must understand the implications of that choice for the plan. Here, I highlight some of the considerations with the generous caveat that each product is different, implementations can vary, and legal perspectives are all over the map when it comes to lifetime income.

Annuitization

Annuitized assets are no longer administered by the plan, and the future income becomes the responsibility of the insurance company. There is some understandable confusion in nomenclature around the term “out of plan,” but there are essentially two different mechanisms for annuitization of retirement plan assets.

Annuitization can take place either directly as a distribution from the plan or after a rollover into an individual retirement account. A distribution directly from the plan requires that the investment policy statement allow an annuity as a distribution option. The plan may need to amend the IPS and, in the absence of another party doing so, the plan sponsor acts as the fiduciary for the selection of the insurer. The Employee Retirement Income Security Act requires gender-neutral rates, and the plan benefits from group pricing, though the specific advantage of that varies.

If the assets roll into an IRA, the annuity transaction takes place outside the direct purview of the plan. These annuities may have gender-based rates, and the pricing depends on the specific solution and situation.

GLWB

GLWB assets may or may not remain within the plan, depending on the product design. Either way, the withdrawals are just that, not annuity distributions.

As with annuitization, if a strategy rolls the benefit into an IRA, the sponsor is no longer responsible for the decumulation from the assets (nor can it oversee that process).

However, the GLWB allows plan sponsors to keep assets within the plan in retirement. For any solution, guaranteed or otherwise, plan sponsors that prefer to do so need to be mindful of concerns related to aging and financial management for all retirement assets in the plan. In this way, the GLWB is no different, but plan sponsors should evaluate what education and safeguards a given product offers to protect participants against accidental or malicious erosion of the income guarantee.

No Silver Bullet

There is no single “ideal” format for guaranteed income, as annuitization and the GLWB each have merits and limitations. Plan sponsors are still learning about these products and how the benefits and trade-offs of different solutions match their preferences and the needs of their participants.

Ultimately, the value proposition of any of these products is the same: to give retirees peace of mind that their retirement savings will sustain them through retirement. Survey after survey demonstrate participants’ interest in guaranteed lifetime income, but employers are a diverse lot, and no single approach will ever address the need. Some sponsors may even end up using both annuitization and a GLWB, possibly through a plan design that supports a default solution and an at-retirement alternative.

The industry has developed an array of differentiated solutions to suit sponsor preferences oriented around the single idea of giving workers the option of guaranteed lifetime income when they retire. In the face of that variety, the distinction between annuitization and the GLWB is one topic that sponsors can explore to ask meaningful questions about these products and associated implementation choices.

Source: Tamiko Toland

Tamiko Toland is the founder of the 401(k) Annuity Hub. An award-winning industry expert on annuities and retirement income who is known as the “annuity Yoda,” she has focused on simplifying the complex topic of lifetime income for 25 years.

Toland has held leadership roles at TIAA, Strategic Insight and Cannex Financial Exchanges, the annuity data and analytics firm. She is also co-founder of IncomePath and an education fellow at the Alliance for Lifetime Income.

This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of ISS STOXX or its affiliates.

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