Income needs in retirement pose big challenges as participants face the unknowns of how much they can spend, how they should manage (invest) their retirement assets, how long they are going to live and what inflation they may face during retirement. In response to these growing concerns, DC plan sponsors have become more engaged in adjusting plan designs and priorities towards addressing participant’s retirement income needs.
Plan sponsors need to pay careful attention to their participant’s unique challenges and other sources of retirement income when weighing the benefits and shortcomings of in-plan guaranteed income alternatives. No single income alternative protects against all of the risks that participants may encounter and certain features accommodating certain risks may not be appropriate and/or may prove to be a problem for a participant in the future.
In-Plan Guaranteed Income Alternatives
Based on current plan sponsor acceptance, there are three common approaches used to furnish participants the guaranteed lifetime income feature as an in-plan option. First is the Deferred Income Annuity (DIA), second is the Guaranteed Minimum Income Benefit (GMIB) and third is the Guaranteed Minimum Withdrawal Benefit (GMWB).
The DIA is designed to provide a participant with guaranteed retirement income that is unaffected by equity market volatility. Each contribution a participant makes in the plan purchases a specific amount of retirement income for life. The guaranteed amount of income purchased is based upon the contribution amount and the current annuity purchase rate (determined periodically based on participant’s age/mortality, interest rates and product fees). The contributions are typically invested in the insurance company’s general account, earning a minimum guaranteed rate. Liquidity is available only during the accumulation period at market value. At retirement, annuitizing is required, and each of the individual income amounts is combined into one monthly income payment.
The GMIB is designed to provide participants the opportunity to capture capital appreciation through a variable annuity (typically balanced allocation), with the added protection of a minimum guaranteed income stream regardless of investment performance. The income provisions of this type of variable annuity is exercisable after a specified period of time has been met, allowing the participant to lock-in an income stream (current annuity rates) by annuitizing the higher account balance generated by either the minimum income guarantee or the variable annuity market value for a single of joint lives. During the accumulation period the participant maintains liquidity and control of the product. But once the guaranteed income provision is exercised, annuitizing is required and liquidity is generally lost. Implicit and explicit fees apply to the variable annuity during accumulation of assets, but once annuitized, the fees are embedded in the annuity purchase rates.
In a GMWB, participants pay an explicit fee in exchange for the insurance company’s promise to pay a guaranteed income stream in retirement. This guaranteed income is equal to a percentage (e.g., 4% to 5%) of the benefit base accumulated in the participant’s account when retirement withdrawals begin. Throughout the accumulation period and retirement, the participant’s account is normally invested in a target-date or risk-based balanced fund. The benefit base is determined by combining all contributions, plus any appreciation in the account as of a specific anniversary date. Any increase in account value on the anniversary date resets the benefit base to the new, higher amount, which cannot be lowered due to poor investment performance in the future. Since the product’s income stream is not annuitized, it gives the participant complete control over the assets market value with liquidity at any time. Including payment of the account’s market value balance at death to the participant’s designated beneficiary.
When evaluating whether to add a guaranteed income alternative, or deciding which one works best for plan participants, important considerations include: what are the plan’s retirement income priorities, what additional fiduciary duties are required, and what product criteria needs evaluation.
An in-plan income alternative will have a great impact on the plan, increasing its complexity and fiduciary risks. However, in-plan alternatives typically provide participants additional protection against market and behavior risk, as well as longevity risk.The decision to offer an in-plan income alternative, as with any investment offered to plan participants becomes a fiduciary one. Since DIAs, GMIBs and GMWBs are not the same, and each product within each alternative is different, fiduciaries must engage in a prudent process in order to make an informed decision regarding the alternative to be offered to participants. Once the income alternative has been implemented fiduciaries must monitor it using the same process to ensure that the decision continues to be prudent.
Working through an effective prudent process starts with determining the relevant criteria needed to make an informed decision. The following criteria are considered among the most relevant when reviewing and evaluating guaranteed retirement income alternatives: 1.) Financial strength, stability and experience of the insurance company; 2.) Unique product features; 3.) Costs associated with the guarantee or insurance premium; 4.) Underlying investments, including asset allocation, performance and expenses; 5.) Portability of the product by plan sponsor or participant; and 6.) Available product materials and participant education.
As the number of workers who rely on their DC plans’ accumulated account balance to provide financial security during their retirement years continues to grow, there will be an increased demand for guaranteed lifetime income alternatives. Increased market volatility and longevity will continue to generate concerns for participants nearing or at retirement, and promote the importance of the potential benefits provided by these alternatives.
While the promise of guaranteed lifetime income sounds desirable, these types of products are far from simple. And it is essential that plan sponsors as well as participants have a good understanding of the mechanics and nuances associated with each of the alternatives, and balance the benefits of providing a guaranteed income alternative versus the costs and potential risks.
Jerry Huggins, CFP, MBA, vice president at Innovest Portfolio Solutions in Denver
NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.