Regulators Give Annuities a Green Light for Retirement

Why does this matter to investors?

As the retirement landscape has shifted investors from the predictable payments of defined-benefit plans to the relative uncertainty of saving for their own retirements via defined-contribution plans, plan sponsors and industry practitioners have sought to combine aspects of both worlds: provide investors with guaranteed income and still give them flexibility with their assets. The U.S. Department of Treasury and the Internal Revenue Service issued guidance on Oct. 24, 2014, that paves the way for strategies designed to help 401(k) participants accumulate a guaranteed income stream within a defined-contribution plan. 

The Treasury’s guidance is potentially momentous. In some ways it resembles the Department of Labor's Pension Protection Act of 2006, which opened the floodgates for target-date funds by naming them a Qualified Default Investment Alternative. Plan sponsors receive safe harbor protection when defaulting participants do not make an investment election into a QDIA, and target-date funds have emerged as the predominant QDIA. As a result, those investments have seen significant inflows over much of the past decade and now receive the preponderance of new retirement savings assets. Similarly, this guidance emboldens plan sponsors to pursue a groundbreaking investment for their 401(k) investors.

As outlined in an example, the guidance (Notice 2014-66) allows target-date funds to purchase deferred annuities with a portion of investors’ assets beginning at age 55. An investor’s allocation to these annuities increases until reaching age 65. At that time, the investor receives a certificate stating his claim to annuity payments. The Treasury received confirmation from the Department of Labor that target-date funds with deferred annuities still meet QDIA requirements, raising the potential for this new breed of target-date funds to reach a vast audience in relatively short order.

Interestingly, the Treasury explicitly states that the Notice does not cover two specific solutions, namely target-date funds with a guaranteed lifetime withdrawal benefit or a guaranteed minimum withdrawal benefit. Investors in these solutions pay an explicit cost to an insurer in return for a guaranteed payment that continues even if they deplete their assets. The Treasury has not yet decided if it will provide guidance on these solutions.

Not in the Clear Yet
401(k) investors should not expect target-date funds with deferred annuities to crop up in plan lineups just yet, though. Interested plan sponsors must first gain comfort with the idea and then go through the process of evaluating the universe of potential alternatives as they come to market. The inclusion of insurers adds an extra wrinkle to that process. Also, plan recordkeepers may need time to develop the ability to administer this type of strategy and to make it portable for investors who may see multiple job changes and retirement plans before they retire. Both of these hurdles can be expected to delay, or possibly even derail, the adoption of target-date funds with deferred annuities. While annuities could improve retirement outcomes, as these strategies surface, plan sponsors and investors should be aware of the costs and counterparty risk--the risk that the insurance company fails to make payments--that accompany them.

Providing Clarity
The Notice serves to alleviate 401(k) plan sponsors’ concerns with offering target-date funds that include deferred annuities. Click here for the Treasury’s summary press release and here for the notice itself.

The Notice clarifies that plan sponsors may offer target-date funds with built-in deferred annuities to a subset of its participants without infringing on nondiscrimination requirements. The target-date series must be available to all plan participants, but the funds that include deferred annuities may be limited to older participants. This addresses concerns that a plan sponsor would be discriminating against some of its workers by offering deferred annuities exclusively to older, typically higher-paid participants.

In response to the Treasury’s request, the Department of Labor confirmed its view that target-date funds’ holding of deferred annuities does not preclude them from meeting the requirements of a QDIA. Click here to read the DOL’s letter.