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Annuities in 401(k)s: New Regulations Highlight Importance, Create Opportunities

On February 2, 2012, federal officials from the Council of Economic Advisors to the President as well as the U.S. Treasury and Labor Departmentsreleased statements that highlight the importance of workers using financial products—annuities—that provide guaranteed lifetime income. They also released new regulations designed to increase workers’ access to such financial products within their employer-sponsored 401(k) plans.

These regulations will gradually create new opportunities for 401(k) plan participants who desire guaranteed lifetime streams of income. However, they also remind advisors of opportunities currently available to better serve their clients.


Trends Highlighted by the Council of Economic Advisors to the President

 

In a report entitled “Supporting Retirement for American Families,” the Council of Economic Advisors to the President noted the trend that traditional defined benefit (DB) pension plans—the type of plans that provide guaranteed lifetime income have become less prevalent. Today 401(k)-style defined contribution (DC) plans are far more common and workers frequently take advantage of lump sum distribution options from their traditional pension plans.

 

The report stated that this trend “has transferred substantial risk from employers to workers. The combined effect of increased 401(k) popularity and more frequent lump sum distributions is that workers increasingly are exposed to market, inflation, and, in particular, longevity risk that threatens their retirement security when lump-sum assets have become exhausted.”


It went on to state that “The shift in the retirement saving landscape away from lifetime income products has raised particular concern over longevity risk – the risk that retired workers will outlive their assets. The continued movement away from traditional DB plans towards 401(k) and hybrid DB plans means that fewer people can count on a guaranteed stream of pension income in retirement. Given declining but uncertain mortality, retirees are faced with the difficult task of choosing how much of their DC plan assets and other savings to spend in any given year. Retirees who live longer than expected may find themselves without sufficient assets at the point in their life when they are most vulnerable.”


The Council of Economic Advisors solution? Annuities. “Annuities can help to mitigate some of the risk faced by retirees. In particular, annuities protect retirees against the risk of outliving assets. This risk is substantial. In 2007, the average 65 year-old male could expect to live an additional 17.2 years, but many will live much longer; nearly a fifth of 65 year-old men could expect to live to at least age 90. As already noted, at older ages, a significant share of individuals have essentially exhausted their other assets and are almost entirely dependent upon their Social Security benefits. For those individuals with the good fortune to live long lives, annuities augment the longevity insurance provided by Social Security benefits.”

 

It went on to state, “If anything, these facts understate the need for improved retirement security among elderly women, since women have longer life expectancies, and more uncertainty about lifespans, than men.”


Challenges Highlighted by the U.S. Treasury Department


Another statement from the U.S. Treasury Department noted “Managing longevity risk is a challenge. While we know average life expectancies, it is difficult or impossible for particular individuals to know how long they will live. As a result, many retirees are exposed to the risk of outliving their savings or, alternatively, unnecessarily limiting their spending in retirement because of the fear of outliving their savings.”


Plan participants often have a choice between lump sum distributions or lifetime guaranteed annuity benefits. Government officials are concerned that too many people opt for the lump sum option. In addressing this, they said, “One reason many employees decline annuity choices and take their entire pension benefit in the form of a single lump-sum cash payment may be the perception that they are confronting an all-or-nothing choice. While plans typically permit employees to receive their benefit in one of several alternative forms, many employees may
prefer a combination of options. One potentially attractive combination would pay some of the benefit as a stream of income for life (to provide protection against the risk of outliving one’s savings) and the rest of the benefit as a lump sum which provides liquidity. Many plans do not offer this type of option… If employees are faced with a choice between an annuity and a single-sum cash payment for their entire benefit, many—reluctant to invest everything in an annuity without also keeping flexible liquid assets—will opt for the cash.”

 

New Regulations to Encourage Annuity Use Within 401(k) Plans


The Treasury Department’s report stated “To help address these issues, the Treasury and Labor Departments have undertaken an initiative to give employees and employers more options for putting the ‘pension’ back in our private pension system.”

 

The new regulations make four changes to the regulatory landscape to encourage employers to offer lifetime income annuity options within their pension plans:

 

  1. They provide a simpler method of calculating partial annuities so that plans will be more willing to offer and emphasize options of a partial annuity with a partial lump sum, rather than forcing participants into an all-or-nothing choice to take their entire plan benefit in a single form.
  2. They encourage the purchase of longevity insurance, such as annuities that provide a guaranteed income starting at an advanced age (suggested at age 85). Such annuities cost
    relatively little because the payout starts far in the future, yet they provide important protection to those who end up living to an advanced age. New regulations encourage their purchase by specifying the value of the longevity annuity would no longer count in determining required minimum distributions.
  3. They specify how employers can offer their 401(k) plan participants the option of purchasing an annuity from the employer’s defined benefit plan.
  4. They also specify what spousal consent rules are necessary when employees choose a deferred annuity option with the 401(k) plan.



In many cases, the new regulations are meant to clarify ambiguities in the prior regulations that prevented employers from offering certain options because employers felt exposed to regulatory and litigation risk due to unclear regulatory guidance.


New Choices for Workers Within Their 401(k)s

 

Regulators are not mandating employers provide annuity options. Rather, they are making it easier for them to do so. Expect insurance carriers that offer annuities to more aggressively develop product solutions for the 401(k) market as a result.


One particular product mentioned in the report of the Council of Economic Advisors to the President is longevity annuities. The report stated, “Because longevity annuities typically
are purchased at or near retirement but do not begin paying benefits until considerably later, they can be offered at a fraction of the cost of annuities that pay immediate benefits. For example, an annuity for a 65 year-old that offered a guaranteed stream of payments of $20,000 per year beginning immediately might cost $277,500, while a deferred annuity offering the same
annual benefits starting at age 85 might cost just $35,200. The primary benefit to a longevity annuity is that it offers retirees protection against the risks of extended longevity at an affordable price, while also allowing them to retain most of their wealth for other purposes.”


The report stated “Despite the potential that lifetime income products have to mitigate risk, few retirees elect to purchase either immediate or longevity annuities. Economists refer to this disconnect as the ‘Annuity Puzzle.’ A variety of explanations have been offered. Individuals may avoid annuities because of concerns over the irrevocability of the choice to purchase an annuity; the desire to retain liquid assets in case of unexpected medical costs or as a bequest to heirs; concerns over the complexity of annuities, their lack of transparency, or the long-term financial soundness of annuity providers; a lack of understanding of longevity risk and how lifetime income products can help manage it; or a lack of familiarity with annuity products, among other factors. Individuals may also be dissuaded from purchasing annuities due to their price.”

 

Now that it is easier for employers to provide annuity options within their 401(k) plans, expect insurance companies that offer annuities to work to provide new and better solutions to these challenges.


Opportunities for Advisors to Better Serve Their Clients


For financial advisors, these commentaries highlight retirement planning challenges that their clients face. Fortunately, the annuity products to address these challenges already exist in the individual market.


Steve Kerns, President & CEO of InsurMark, an annuity marketing firm, says, “Most people, when asked to consider their priorities for their retirement savings, will agree that their top priority by the time they retire will be stability. They want their retirement savings to generate a steady income that they can spend without having to worry that money will run out, no matter how long they live. Other desirable qualities are to be able to know, at all times, what retirement income they can rely upon, without guesswork, to have access to their remaining funds in case their needs change, to leave any leftover money they don’t use to their children, and for the solution to be easy.”


Many fixed indexed and variable annuities offer a benefit called a guaranteed lifetime withdrawal benefit (GLWB). An annuity with a GLWB does what Mr. Kerns just described.


Jeff Maxey, Vice President of InsurMark, says, “In many ways, it can be even better than the part lump sum, part lifetime annuity option that 401(k) plans will be able to provide. A client who puts their retirement savings into an annuity with a GLWB will have the benefit of a guaranteed lifetime annual payment based upon their entire retirement savings, yet still have access to the remaining balance of their entire retirement savings.”

Advisors often recommend that clients roll over money from their former employers’ 401(k) plans into an IRA. Over time, the effect of these new regulations will make options within the 401(k) plan more attractive than they are now, which some advisors may consider a threat to their business. However, the changes resulting from these new regulations will better highlight the value of using guaranteed lifetime annuity options. This gives advisors annuity options to create potentially improved results for their clients.

 

by Chris Conklin