Report On The Spend Down Of Defined Contribution Assets At Retirement
This report was produced by the Advisory Council on Employee Welfare and Pension Benefit Plans, usually referred to as the ERISA Advisory Council (the “Council”). This report examines the Spend Down of Defined Contribution Assets at Retirement. The ERISA Advisory Council was created by ERISA to provide advice to the Secretary of Labor. The contents of this report do not represent the position of the Department of Labor (DOL).
The 2008 Council assigned a Working Group to examine and review the Spend Down of Defined Contribution Assets at Retirement to assess the issues and barriers facing:
The Working Group explored how DOL guidance or regulation can enhance the retirement security of American workers by facilitating access to and utilization of income (stream) distributions from DC plans and expand on the success of PPA's auto enrollment, contribution escalation and default investment practices by incorporating similar concepts into the distribution phase.
Testimony to the Working Group was provided on July 16, 2008 and September 10, 2008 by 22 speakers, representing employers, financial advisors, investment managers, insurers, third-party administrators, academics, organizations representing retiree perspectives, attorneys/consultants, and the federal government. After careful debate, consideration and analysis of the issues and transcripts, the Council submits the following recommendations to the Secretary of Labor for consideration:
Recommendation 1: Simplify the proposed annuity provider selection rules and eliminate the requirement for an independent expert – The proposed annuity provider selection rules currently include 14 separate selection criteria for fiduciaries to consider. The rules also explicitly require that, in those cases where a fiduciary lacks the expertise to evaluate these criteria on its own, the use of an independent expert is required to ensure fiduciary protection. The use of an independent expert adds additional cost barriers for the fiduciary who is considering annuity options. Historically, independent experts have been required only in those cases where conflicts of interest arise. These extensive criteria, while offered as a safe harbor, are perceived to create a substantially more stringent standard for fiduciaries considering annuity investments vs. other investments. The Council recommends that the proposed annuity provider selection rule safe harbor be simplified by eliminating the eight criteria contained in Section 2550.404a-4(c)(2) as well as the independent expert requirement so that the fiduciary duties involved in selecting an annuity provider are set forth in the same manner and in the same detail as the duties involved in prudently selecting an investment option, to which companies are quite accustomed. The Council maintains that ERISA’s prudent expert standard suggests that plan sponsors, whether or not complying with a safe harbor, are required to exercise the same prudence when selecting an annuity as is required to be exercised in the selection of any other investment.
On October 6, 2008, the Department of Labor published final regulations regarding the safe harbor for individual account plan when selecting annuity providers. The final regulation (a.) eliminates the eight criteria that had been listed in 2550.404a-4(c)(2),(b.) clarifies that a fiduciary may conclude that it needs the assistance of an expert in selecting an annuity provider, but eliminates the requirement that the expert be independent , and (c.) states that the safe harbor does not establish minimum requirements or the exclusive means for sponsors seeking to satisfy their fiduciary responsibility when selecting annuity providers. The Council believes that these changes have substantially addressed the recommendation that resulted from witness testimony to the satisfaction of the Council.
Recommendation 2: Update, Expand, and Amend Interpretive Bulletin 96-1 - The Council recommends that the Department of Labor expand the reach of IB 96-1 by adapting it to the spend-down phase. As innovation continues in the financial marketplace and greater numbers of retirees rely on DC plans as their primary retirement vehicle, educational initiatives will need to address items heretofore not necessarily addressed in IB 96-1. IB 96-1 needs to address information, education, and advice related to the spend-down of retirement plan assets (distribution options, in-plan vs. out of plan payments) as well as the accumulation of those assets. Plan sponsors need clear guidance about the type of information, programs and education they may provide to participants, without being concerned that they are acting as a fiduciary providing investment advice or that they may be exposed to liability for breach of their fiduciary duty. Further, as product innovation continues in this area, 96-1 needs to be continually updated. This same recommendation was made by the 2007 Council that studied Financial Literacy.
Recommendation 3: Clarify the QDIA with respect to default options incorporating guarantees that extend into the distribution phase - The Council recommends that the Department of Labor clarify that products which are eligible qualified default investment alternatives (”QDIA”) while participants are actively participating in the plan will continue to so qualify when participants are in pay status if such investment products are retained in the plan.
Such a clarification would confirm that fiduciaries receive the same fiduciary protection under the QDIA regulation for amounts that remain invested in guaranteed lifetime income products (that otherwise satisfy the requirements of the regulation to be a QDIA during the accumulation stage) during the spend-down phase of participants’ accounts.
Recommendation 4: Encourage and Allow Additional Participant Disclosure, Specifically the Conversion of Account Balances into Annual Retirement Income - The Council recommends that the Department of Labor encourage, authorize, endorse and facilitate plan communications that use retirement income replacement formulas based on final pay and other reasonable assumptions in employee benefit statements on an individual participant basis. Plan communications should facilitate an understanding of how much income participant account balances will provide, that result in a better understanding of how an account balance converts to annual retirement income. The Department of Labor can facilitate this by providing guidance to plan sponsors on best practices, illustrative model notices as well as assumptions to convert account balances into annual income streams. This builds upon a similar recommendation made by the 2007 Council that studied Financial Literacy.
Recommendation 5: Enhance plan sponsor and participant education regarding the flexibility for distribution options - The Council recommends that the Department of Labor publish and regularly update information which provides useful guidance, education and information to underscore the inherent flexibility (and associated risks) available to participants in defined contribution plans. This information should be directed to plan participants as well as plan sponsors. Existing publications can also be updated to discuss the relative merits of lump sums vs. periodic payments, as well as the merits of leaving money in an employer’s plan vs. establishing a rollover IRA.
Elizabeth Dill, Chair of the Working Group
The Council undertook a study on the Spend Down of Defined Contribution Assets at Retirement. The balance of this report will address the scope of the study, the questions for witnesses, dates of testimony and list of witnesses, current environment for the issues of inquiry, consensus recommendations to the Secretary of Labor and summary of testimony from the witnesses.
Scope Of The Council’s Review
The Council undertook this topic to discern standards and to draft suggested recommendations for the ERISA Advisory Council for the deliberation of the Secretary of Labor to take action as the Secretary deems appropriate. The study focuses upon the types of guidance that could help plan sponsors and plan participants make better informed decisions regarding plan investment and insurance vehicles that provide periodic or lifetime distributions. It also focuses on how DOL guidance or regulation can enhance the retirement security of American workers by facilitating access to and utilization of income (stream) distributions from DC plans and expand on the success of the Pension Protection Act of 2006’s (PPA) auto enrollment, contribution escalation and default investment practices by incorporating these behavioral inertia concepts and fiduciary protections into the distribution phase.
Specifically, the study addresses whether:
The Council recognizes that participants may take distributions upon separation from service that may be prior to retirement age. This topic is focused on the spend-down of defined contribution plan balances at retirement.
Questions For Potential Witnesses
The scope of inquiry for the Working Group and the attendant questions were given to all witnesses in advance of testimony. The witnesses were told that the questions were merely a starting point to generate thought and discussion on the study topic. The questions were not intended to limit the parameters of testimony.
The Working Group solicited testimony of witnesses from employers, financial advisors, investment managers, insurers, third-party administrators, academics, organizations representing retiree perspectives, lawyers/consultants, and the federal government. The witnesses did not answer every question and in many instances, there was not enough information presented to form a consensus as to every inquiry by the Working Group.
The witnesses and the dates of their testimony were as follows:
July 16, 2008
September 10, 2008
Current Environment And Background For The Scope Of Inquiry
Defined contribution plans have moved from being a supplemental benefit to the primary employment-based retirement benefit for most American workers. By the end of 2007, the amount of wealth in tax-advantaged defined contribution plans, including IRA’s had grown to $9.4 trillion.
Based upon 2005 Form 5500 filings, there were 631,000 defined contribution plans covering 75 million participants. It is estimated that only 25% of covered participants are in plans that offer annuity features and utilization of annuities in those plans is extremely low. In fact, recent research conducted by Hewitt Associates LLC showed that over 90% of participants offered a lump sum, take that option over an annuity distribution.
The Employee Benefit Research Institute’s (EBRI) “2008 Retirement Confidence Survey” showed that Americans’ confidence in their ability to afford a comfortable retirement had dropped to its lowest level in seven years. Less than half of workers surveyed indicated that they have tried to calculate what they will need for a comfortable retirement. Savings levels are modest, with 49% of workers reporting total savings and investments of less than $50,000. Another study conducted by Hewitt Associates indicated that fewer than 19% of workers will have enough retirement income to meet 100% of their projected needs.
In addition, the Society of Actuaries conducted a study, “Spending and Investing in Retirement – is there a strategy?” The study’s key findings indicated:
Finally, there are numerous studies that show that life expectancy is increasing. This means that many retirees are going to live beyond the age for which they have saved.
All of these factors provide the backdrop against which the next, and future generations of retirees will be financially ill-prepared for retirement.
In two days of testimony, witnesses brought forth a number of issues:
The following provides more detail on each of these issues:
Advice vs. Education Regarding Spend Down
A common thread that ran through the testimony of several witnesses indicated that plan sponsors need clear guidance about the type of information, programs and education they may provide to participants without being characterized as a fiduciary providing investment advice or without exposing themselves to liability for breach of their fiduciary duty. Further, as product innovation continues in this area, 96-1 needs to be continually updated.
Review of Interpretative Bulletin 96-1
Under ERISA Interpretative Bulletin 96-1 (“IB 96-1”), a plan sponsor may avoid ERISA fiduciary liability while providing general investment education and information to participants in a plan that permits self-directed investments, if the sponsor prudently selects and monitors the educator. DOL issued IB 96-1 in response to concerns about whether providing such information might be considered “investment advice” under the definition of “fiduciary” in ERISA § 3(21)(A)(ii). Under this provision, a person is a plan fiduciary to the extent she renders investment advice about the plan's assets in exchange for compensation. IB 96-1 was intended to encourage group or individual counseling to plan participants in a manner that is tax-free to recipient employees, deductible by employers, and sanctioned by IRS ( Code Sec. 132(m) ) and DOL (Interpretative Bulletin 96-1). See September 10, 2008 testimony of Steve Saxon, Esq. Groom Law Group. See also, T. Brion “Consumer-Driven” Retirement Plans—Their Evolution and Opportunities (08/16/2004 - Volume 10, No. 35) PBW Practitioner Planning Articles (RIA)
Permitted investment and financial information includes: general financial and investment concepts; tax deferral; historic rates of return among asset classes; inflation effects; estimated retirement income needs; investment time horizons; risk tolerance; and asset allocation. More specifically, there are four categories of information or safe harbors.
Safe harbor treatment applies regardless of who provides the information, how often it is shared, the form in which it is provided (e.g. writing, software, video or in a group or one-on-one) or whether a category of information and materials is furnished alone or along with other categories of information and materials. Note that “safe harbors” apply only to accumulation tools, although there is mention of tools made available to estimate future income needs.
In IB 96-1, the DOL states that there may be many other examples of information, materials and educational activities that would not be investment advice. DOL cautions against drawing inferences from the safe harbors with respect to whether the furnishing of information, materials or educational activities not described therein could constitute the provision of investment advice.
Moreover, the DOL warns that the determination as to whether the provision of any information, materials or educational services not described in 96-1 constitutes investment advice must be determined under the criteria of Labor Reg. § 2510.3-21(c)(1). This regulation relates to the provision of investment advice to a benefit plan and the circumstances under which a person becomes a fiduciary because of advice on the advisability of investing in particular vehicles or where a person has indirect or direct discretion to implement the advice.
Although courts may take into account DOL's view, as expressed in IB 96-1, courts are not bound to follow an Interpretive Bulletin, particularly if the IB is found not to fall exclusively within the scope of the law of qualified plans, nor when it is not issued as a regulation, per se. Bussian v. RJR Nabisco, Inc., 223 F.3d 286 (5th Cir. 2000).
Disclosures to Defined Contribution Participants / Participant Statements
The Council heard testimony from a variety of witnesses regarding the problems associated with participants’ lack of understanding of how their account value translates into a monthly income stream. For example: Anna Rappaport noted that “As a society we do not think of the balances as related to retirement income.” Similarly, Mercer’s Phil Suess expressed concern that most employees do not understand: “…1) the amount of assets they will need in retirement; 2) the amount of contributions necessary to accumulate sufficient assets; 3) the earnings needed on their contributions; and 4) how to invest their assets to have a reasonable probability of adequate earnings. In the spend-down phase, participants: 1) fail to grasp longevity risk; 2) remain disinterested in investments; and 3) prefer to delegate decision-making to third parties. Experience shows the success of educating participants to make informed decisions has been disappointing at best.”
It was noted that the 2007 ERISA Advisory Council had formed a Working Group on Participant Benefit Statements (the Working Group) to study changes to the reporting and disclosure requirements applicable to all pension plans, specifically requiring benefit statements to be furnished to plan participants in all defined benefit and defined contribution plans required by the Pension Protection Act of 2006 and to make recommendations to the DOL regarding the required content, form and timing of the benefit statements. In pertinent part, that group recommended: “….The Department should convene a Task Force of benefit statement stakeholders to develop the content of a model statement. The view of the Working Group is that the content should be minimized, including only that required by the statute. The model statement should be crafted in a way to inspire sponsors to add information and education.”
Nevertheless, Jason K. Chepenik, observed that … “Many retirees are faced with managing a large sum of money far in excess of their former incomes, without a clear understanding of how to make it last through retirement. Bad decision making often results from this lack of understanding. Current gap analytics tend to use assumptions that are no longer based in reality, estimating living expenses at 70-85% of pre-retirement, and inflation at 3-4%. In reality, higher costs faced by retirees, particularly in the area of health costs, tend to skew both numbers significantly higher.” To address that problem, J. Mark Iwry stated that … “Plan sponsors should be required to present benefits as an income stream of monthly or annual lifetime payments, in addition to presenting the benefits as an account balance in accordance with current practice.”
Mercer Investment Consulting’s Neil Lloyd concurred, commenting that plans should “Provide income projections on statements from pension plans and rollover accounts” (although the basis of projections can be a problem). Taken in totality, the Council concluded that a sufficient case has been made to suggest a course of action, as shown in Recommendation Number 4 (below), that goes beyond the recommendation of the 2007 Council by suggesting to the Department that it is appropriate to encourage plan sponsors to include information relative to the income stream that can be provided in retirement from the account balance in their 401(k) or other defined contribution plan.
Several witnesses mentioned the Department of Labor’s publication, “Taking the Mystery Out of Retirement Planning,” and observed that this could incorporate more information and education regarding distribution options at retirement. Currently, “Taking the Mystery Out of Retirement Planning” is available on the EBSA Web site, and is an online document that includes interactive worksheets. The publication provides support to employees evaluating the decision to retire and includes:
Several testified that “Taking the Mystery Out of Retirement Planning” could be modified to address the benefits of utilizing in-plan periodic distribution options. Additionally, there was testimony that the DOL could provide more education for plan sponsors regarding the ability to offer more flexible distribution approaches (e.g. partial lump sum distributions), that would facilitate participants’ ability to realize some of the benefits of leaving their retirement monies in the plans.
Qualified Default Investment Alternatives
Under ERISA, fiduciaries of participant-directed defined contribution plans are not liable for losses when participants or beneficiaries exercise control of the investment of their accounts, if the plan satisfies the requirements of ERISA section 404(c). In general, plan fiduciaries retain fiduciary liability for any loss or breach that results from investing assets in a participant’s account when a participant does not exercise control over investments.
Under the Pension Protection Act of 2006 (PPA), plan fiduciaries of participant-directed defined contribution plans will receive relief from fiduciary liability for default investments, as long as they comply with the Department of Labor (DOL) rules for these investments. These rules:
The fiduciary relief provided in the final rules applies to situations where participants or beneficiaries have not exercised control over the investments in their accounts.
The relief provided by these rules is similar to the fiduciary relief that applies to participants or beneficiaries who exercise control over their investments in plans. In other words, if employers comply with these rules, investments in QDIAs will be considered to have been “directed” by participants.
A QDIA must meet five specific requirements. The one requirement relevant to the Council’s topic is that a QDIA must be one of the following permissible investment types:
Even though fiduciary relief is provided only if one of the investment alternatives described above is used as the default investment alternative, it is important to note that the DOL acknowledges that the use of other investment alternatives may still be prudent. For example, investments in money market funds, stable value products and similarly performing investments may be prudent for some participants and beneficiaries, even though those investments are not QDIAs. Additionally, the regulation states that an investment fund, product or model portfolio that otherwise meets the QDIA requirements is eligible to be a QDIA even though it is offered through variable annuity or similar contracts or through common or collective trust funds or pooled investment funds and without regard to whether the contract or fund provides annuity purchase rights, investment guarantees, death benefit guarantees or other features ancillary to the investment fund, product or model portfolio.
The Council understands that increasingly plan sponsors designate as the plan’s QDIA a target maturity fund product that contains a guarantee or guarantees issued by an insurance company. The plan sponsor would rely on Section 2550.404c-5(e)(4)(vi) of the QDIA regulation which states “an investment fund, product or model portfolio that otherwise meets the requirements of this section shall not fail to constitute a product or portfolio for purposes of paragraph (e)(4)(i) or (ii) of this section solely because the product or portfolio is offered through variable annuity or similar contracts or through common or collective trust funds or pooled investment funds and without regard to whether such contracts or funds provide annuity purchase rights, investment guarantees, death benefit guarantees or other features ancillary to the investment fund, product or model portfolio” to support the qualification of the contract as a QDIA during the active participation or accumulation phase.
However, the Council believes that there is significantly less certainty about the status of the contract as a QDIA when the contract continues in effect after a participant’s retirement during the distribution phase. This uncertainty exists if the participant makes an affirmative election to take a lifetime income stream of payments or in those cases in which the plan’s terms provide that the income stream is triggered automatically (in the absence of an affirmative election to the contrary by a participant to receive a different form of distribution offered by the plan).
For this purpose, the Council assumes that a plan sponsor has determined that it is prudent to utilize a specific provider’s contract and is otherwise satisfied that it has discharged its fiduciary responsibilities with respect to the selection and on-going monitoring of the provider.
Annuity Selection Rules
Testimony before the Council revealed concern about the complexity and detail surrounding the DOL’s current annuity selection criteria. The following is background of the applicable rules related to annuity distributions from defined contribution plans.
DOL annuity selection standards. Under the PPA, Congress directed the DOL to issue regulations clarifying that the selection of an annuity contract as an optional form of distribution from a defined contribution plan is not subject to the safest available annuity standard under DOL Interpretive Bulletin 95-1. Further, the DOL was to confirm that the selection is subject to all otherwise applicable ERISA fiduciary standards (Section 625 of PPA).
In response, in November of 2007 the DOL issued an interim final rule in response to the Congressional directive enacted in PPA. In addition, the DOL issued a proposed regulation that provides a safe harbor for defined contribution plan fiduciaries when selecting an annuity provider and purchasing an annuity. This safe harbor contained a number of conditions that a fiduciary must satisfy in order to get the safe harbor protection. Specifically, the proposed regulation provides that the fiduciary should:
In addition, the DOL provided eight additional factors that a fiduciary must consider for purposes of showing that the fiduciary: gave appropriate consideration to information sufficient to assess the ability of the annuity provider to make all future payments under the annuity contract; and appropriately considered the cost of the annuity contract in relation to the benefits and administrative services to be provided under such contract. These factors the fiduciary must consider are:
Several witnesses expressed concern that, taken as a whole, these 14 separate factors are difficult to satisfy completely. The rules also explicitly require that, in those cases where a fiduciary lacks the expertise to evaluate these criteria on its own, the use of an independent expert is required to ensure fiduciary relief. Historically, independent experts have been required only in those cases where conflicts of interest arise. In addition, some witnesses expressed the concern that, although the proposed regulation is designed to be a safe harbor, having these detailed and somewhat complex criteria “on the books” may create a higher fiduciary hurdle for plan sponsors who may be interested in adding an annuity distribution option to their plan, thus deterring some plans from adding the option.
Witnesses suggested that even though the annuity selection rules provide a “safe harbor”, they create a framework which suggests a more stringent set of criteria to meet fiduciary requirements when selecting annuity providers. They suggested that either the safe harbor rules be modified to reflect the same fiduciary standard applied to other investments, or at least be scaled back – for example, eliminating the eight additional factors.
On October 6, 2008, the Department of Labor published final regulations regarding the safe harbor for individual account plan when selecting annuity providers. The final regulation (a.) eliminates the eight criteria that had been listed in 2550.404a-4(c)(2) ) (the 8 criteria outlined above), (b.) clarifies that a fiduciary may conclude that it needs the assistance of an expert in selecting an annuity provider, but eliminates the requirement that the expert be independent , and (c.) states that the safe harbor does not establish minimum requirements or the exclusive means for sponsors seeking to satisfy their fiduciary responsibility when selecting annuity providers. The Council believes that these changes have substantially addressed the recommendation that resulted from witness testimony.
Adding Annuity options: Settlor or Fiduciary decision?
During the course of testimony, there was some discussion regarding whether adding an annuity option to, or making it the default distribution in a defined contribution plan, is a “settlor” or fiduciary function.
The Council heard testimony from Robert Doyle, of the Department of Labor, that it is the Department’s view that certain decisions to offer distribution options or choices that are intended to provide or increase the likelihood of lifetime income for retirees are made by a plan sponsor as a matter of plan design and are “settlor” (as opposed to fiduciary) in nature.
The Department also has consistently taken the position that the implementation of such a provision, such as the duty to prudently select and monitor the provider of a guaranteed lifetime income product, would always be subject to fiduciary responsibility requirements.
It is important for plan sponsors who are considering adding guaranteed lifetime income as a plan distribution option, or making it the plan’s default distribution choice, to understand this distinction. It is anticipated and the Council believes that the clarity with which the Department delineated this position in its testimony has addressed any remaining uncertainty about plan sponsors’ roles and responsibilities in this area. This may lead to greater dissemination and utilization of these types of distribution choices.
In other words, the addition of an annuity distribution option is a plan design decision, and therefore a “settlor” function. The selection of an annuity provider is a fiduciary function.
Several witnesses testified that solutions for income adequacy in retirement, tied to the issue of spend down of retirement assets, cannot ignore the issue of “leakage” during the accumulation of retirement assets. Leakage is defined as the outflow of monies from a defined contribution plan prior to retirement. There are a number of ways in which leakage occurs:
Cross Agency Collaboration
Many witnesses testified that revisions to the Qualified Joint and Survivor Annuity rules covered in Internal Revenue Code Section 417 would facilitate broader offering of annuity options in plans. Many observed that compliance with the rules attendant to obtaining spousal consent is a barrier for many sponsors considering life annuity options in defined contribution plans. Authorizing the use of electronic technology such as electronic notarization would ease the manner in which spousal consent is obtained and addresses one significant concern. Some urged that consideration be given to DOL and Treasury sponsoring legislation to extend the spousal consent rules to lump sum distributions so as to level the playing field for selection of all distribution options in defined contribution plans or amending the qualified plan rules to require all tax favored retirement plans to offer a guaranteed lifetime income form of distribution.
Additionally, many of the issues related to “leakage” (in-service distributions, 70½ distributions, stock distributions and loans) are under the purview of the Department of Treasury and the Internal Revenue Service.
Therefore, many recommended that the Department of Labor take the lead to promote cross agency collaboration in the hope that such action would lead to greater reflection, focus and consideration of these retirement security issues.
The Council posited a number of questions to exploring how the DOL guidance or regulation could enhance the retirement security of American workers by faciliatating access to and utilization of income stream distributions from defined contribution plans.
Three of our consensus recommendations ask for some changes to regulations and other publications such as interpretive bulletins. The Council believes that:
The remaining two recommendations focus on the ways in which broad education can be provided to participants. The Department of Labor has the ability to influence plan sponsors short of formally changing the written law or regulations. Specifically, the Council would like the Department of Labor to:
Recommendation 1: Simplify the proposed annuity selection rules and eliminate the requirement for an independent expert – The proposed annuity selection rules currently include 14 criteria for consideration when selecting an annuity provider. To ensure fiduciary relief, the rules also explicitly require the use of an independent expert in those instances where the fiduciary lacks the expertise to evaluate these criteria on its own. The use of an independent expert also adds additional cost barriers for the fiduciary who is considering annuity options. It is customary to require independent experts only in those cases where a conflict of interest has arisen. These extensive criteria, while offered as a safe harbor, are perceived to create a more stringent standard for fiduciaries considering annuity investments vs. other investments. The Council recommends that the proposed annuity selection rules be simplified so that the fiduciary duties involved in selecting an annuity provider are set forth in the same manner and in the same detail as the duties involved in selecting an investment option, to which companies are quite accustomed. The Council maintains that the prudence requirements suggest that plan sponsors, whether or not complying with a safe harbor, are required to exercise the same prudence when selecting an annuity as with any other investment.
On October 6, 2008, the Department of Labor published final regulations regarding the safe harbor for individual account plan when selecting annuity providers. The final regulation (a.) eliminates the eight criteria that had been listed in 2550.404a-4(c)(2), (b.) clarifies that a fiduciary may conclude that it needs the assistance of an expert in selecting an annuity provider, but eliminates the requirement that the expert be independent , and (c.) states that the safe harbor does not establish minimum requirements or the exclusive means for sponsors seeking to satisfy their fiduciary responsibility when selecting annuity providers. The Council believes that these changes have substantially addressed the recommendation that resulted from witness testimony
Recommendation 2: Update, Expand, and Amend 96-1 - The Council recommends that the Department of Labor expand the reach of IB 96-1 with updates that include educational initiatives needed to anticipate innovations in the financial marketplace. IB 96-1 needs to address information, education, and advice related to the spend down of retirement plan assets (distribution options, in-plan vs. out of plan payments) as well as the accumulation of those assets. Further, as innovation continues in this area, IB 96-1 needs to be continually updated.
The Council believes that retirement and distribution options are effectively communicated to retiring and withdrawing participants in terms of timing, media and content. However, the Council heard from many witnesses that there is an “information gap” that exists between the participants receiving qualified plan distributions and plan sponsors. Specifically, the Council finds plan participants are not afforded access to decision making tools that effectively facilitate individual management of retirement plan assets. Finally, the Council believes that the reason for the information gap is primarily the confusion that exists at the plan sponsor level concerning the potential exposure to fiduciary liability for tools or information provided to assist plan participants on plan distributions.
The Council believes that neither the DOL nor employers need provide any new brochures, worksheets, or pamphlets etc. for participants. Instead, the Council suggests that regularly scheduled, constant vigilance of marketplace innovation be reflected in possible future regulatory relief and clarity being afforded in follow-up pronouncements to Interpretive Bulletin 96-1 pertaining to retirement income planning, keeping that Bulletin timely and relevant.
In witness testimony, the Council heard that numerous factors have led to a complex, specialized financial services marketplace requiring plan participants to be actively engaged in order to manage their finances effectively. Driven by increased competition, the forces of market technology and market innovation have resulted in a sophisticated industry in which plan participants are offered a broad spectrum of services by a wide array of vendors. Compelling regulatory issues, such as predatory marketing and suitability of products, have also added to a sense of urgency regarding financial literacy in a ‘participant-directed’ world.
The “safe harbors” of IB 96-1 are accumulation tools. Safe harbor treatment applies regardless of who provides the information, how often it is shared, the form in which it is provided (e.g. writing, telephone, internet, software, video or in a group or one-on-one) or whether an identified category of information and materials is furnished alone or in combination with other identified categories of information and materials.
In IB 96-1, the DOL noted that information and materials described in the four graduated safe harbors detailed within the bulletin merely represent examples of the type of information and materials that may be furnished to participants without such information and materials constituting “investment advice” for purposes of the definition of “fiduciary” under ERISA Sec. 3(21)(A)(ii).
The first of the safe harbors under IB 96-1 states that providing information and materials that inform a participant or beneficiary about the benefits of plan participation, the benefits of increasing plan contributions, the impact of pre-retirement withdrawals on retirement income, the terms of the plan, or the operation of the plan that are made without reference to the appropriateness of any individual investment option for a participant or beneficiary will not be considered the rendering of investment advice.
The second safe harbor of IB 96-1 states that general financial and investment concepts such as risk and return, diversification, dollar cost averaging, compounded return and tax deferred investing, historical rates of return between asset classes based on standard market indices, effects of inflation, estimating future retirement needs, determining investment time horizons, risk tolerance, provided that the information has no direct relationship to investment alternatives available under the plan.
The third safe harbor of IB 96-1 allows asset allocation information to be made available to all participants and beneficiaries - providing participants with models of asset allocation portfolios of hypothetical individuals with different time horizons and risk profiles. These models must be based on accepted investment theories. All material facts and assumptions on which the models are based must be specified, and disclosures are mandated.
The fourth safe harbor of IB 96-1 allows interactive investment materials such as questionnaires, worksheets, software and similar materials that provide participants a means of estimating future retirement income needs, provided that requirements similar to those for asset allocation (above) are met.
Further, in IB 96-1, the DOL stated that there may be many other examples of information, materials and education services which, if furnished to participants would not constitute the provision of investment advice. Accordingly, the DOL advises no inferences should be drawn from the four graduated safe harbors with respect to whether the furnishing of information, materials or educational services not described therein could constitute the provision of investment advice. The DOL cautions that the determination as to whether the provision of any information, materials or educational services not described in IB 96-1 constitutes the rendering of investment advice must be made by reference to the criteria of Labor Reg. Sec. 2510.3-21(c)(1). That regulation establishes the criteria for deeming the rendering of investment advice to an employee benefit plan. Specifically, investment advice is rendered where recommendations are provided as to the advisability of investing in particular vehicles and whether the person has indirect or direct discretion to implement such advice.
The Council believes that as the Baby Boom Generation moves into the de-cumulation phase – i.e. asset accumulation demographically shifting toward income planning – IB 96-1 will need to be amended, updated and expanded to stay relevant within the regulatory construct viz a viz the innovative marketplace. By way of example, while ‘retirement calculators’ are ‘educational’ under 96-1, it should be contemplated and communicated that regulatory relief extend to advising plan participants concerning mandatory 20% tax withholding, early withdrawal 10% tax, guaranteed income for life, outliving income stream et. al.
The Council believes that the recommendations for clarity and relief are applicable not only to single-employer plans, but also to multiemployer plans.
Recommendation 3: Clarify the QDIA with respect to default options incorporating guarantees that extend into the distribution phase - To further help plan sponsors and fiduciaries better understand their obligations and responsibilities and avail themselves of appropriate and available protections relative to offering lifetime income distributions, the Council believes that it would be useful for the DOL to clarify that products which qualify as qualified default investment alternatives (”QDIA”) while participants are active will continue to so qualify when participants are in pay status if such investment products are retained in the plan. Such a clarification would confirm and clarify that fiduciaries receive the same fiduciary protection under the QDIA regulation for amounts that remain invested in guaranteed lifetime income products (that otherwise satisfy the requirements of the regulation to be a QDIA during the accumulation stage) during the spend-down phase of participants’ accounts.
The Council understands that it is common practice for a plan sponsor to designate, as the plan’s QDIA, a target maturity fund product that contains a guarantee or guarantees issued by an insurance company. The plan sponsor would rely on Section 2550.404c-5(e)(4)(vi) of the QDIA regulation which states, “an investment fund, product or model portfolio that otherwise meets the requirements of this section shall not fail to constitute a product or portfolio for purposes of paragraph (e)(4)(i) or (ii) of this section solely because the product or portfolio is offered through variable annuity or similar contracts or through common or collective trust funds or pooled investment funds and without regard to whether such contracts or funds provide annuity purchase rights, investment guarantees, death benefit guarantees or other features ancillary to the investment fund, product or model portfolio” to support the qualification of the contract as a QDIA during the active participation or accumulation phase.
However, the Council believes that there is significantly less certainty about the status of the contract as a QDIA if the contract were to continue in effect after a participant’s retirement during the distribution phase through the exercise of annuity purchase right features. This uncertainty exists if the participant makes an affirmative election to take a lifetime income stream of payments or in those cases in which the plan’s terms provide that the income stream gets triggered automatically (in the absence of an affirmative election to the contrary by a participant to receive a different form of distribution offered by the plan).
For this purpose, the Council assumes that a plan sponsor has determined that it is prudent to utilize a specific provider’s contract and is otherwise satisfied that it has discharged its fiduciary responsibilities with respect to the selection and on-going monitoring of the provider.
The Council believes that plan sponsors and fiduciaries would be encouraged to offer these products and utilize these features with greater frequency if they had greater confidence that QDIA protection were available in the distribution phase.
While the Council believes that the most typical situation for which a clarification of the QDIA regulations would be helpful involves defaulting retiring participants into the guaranteed lifetime income distribution feature of a QDIA, the Council is aware of other situations involving distributions of plan benefits in the form of guaranteed lifetime income where QDIA protection should be available and additional clarifications by the Department are warranted. These include the following situations: 1) participants’ accounts are not invested in the contract during the accumulation phase but are placed into this choice at the time distributions commence; 2) participants terminate employment prior to retirement but their funds remain in the plan and regardless of how the funds were invested prior to the time distributions commence, the funds are placed into a guaranteed lifetime income product meeting the QDIA requirements at the time a distribution takes place under the plan; and 3) the plan provides that only a part of participants’ funds are defaulted into an income product.
Recommendation 4: Encourage and Allow Additional Participant Disclosure, Specifically the Conversion of Account Balances into Annual Retirement Income - The Council recommends that the Department of Labor encourage, allow and facilitate plan communications that use retirement income replacement formulas and final pay multiples in employee benefit statements on a personal participant basis. Plan communications should facilitate an understanding of how much income participant account balances will provide, that result in a better understanding of how an account balance converts to annual retirement income. The Department of Labor can facilitate this by providing guidance to plan sponsors on best practices, generating illustrative model notices, as well as assumptions to convert account balances into annual income streams. This builds upon a similar recommendation was made by the 2007 Council that studied Financial Literacy.
Recommendation 5: Enhance plan sponsor and participant educations regarding the flexibility for distribution options - The Council recommends that the Department of Labor publish and regularly update information which provides information which underscores the inherent flexibility available to participants in defined contribution plans. Existing publications can also be updated to discuss the relative advantages of lump sums vs. periodic payments, as well as the advantages of leaving money in an employer’s plan vs. establishing an IRA.
Summaries Of Witness Testimony*
David Wray, Profit Sharing/401(k) Council of America
DC plans are vehicles for building retirement wealth. However, Mr. Wray contextualized how DC plan assets fit in with the annuity benefits paid by Social Security. He described how these retirement assets must be distributed under the minimum required distribution rules. Most current retirees roll over their lump-sum distributions of any size to IRA and are exceedingly (even to a fault) conservative in their spend down of retirement assets.
Mr. Wray commented on the tax considerations of distributions from DC plans and how they impact the participants’ after tax income. He described options for limiting tax implications by creative distributions of amounts in tax deferred accounts.
He noted the innovation that is occurring in the DC industry, citing an example (Income Solutions) which is different from those offered by earlier witnesses. He listed the benefit of this approach to underscore the necessity of refraining from excessive regulation as a way to encourage additional innovation. He suggested several considerations looking forward, including defining the employer’s role in helping former employees, noting smaller employer concerns to avoid future fiduciary responsibility for separated employees (essentially the traditional approach). Yet, larger employers tend to encourage participants to leave their assets in the plan to take advantage of economies of scale to reduce costs and maximize performance. Employers appear to be encouraging employees, who are looking for income stream distributions, to consider annuity products provided by vendors with whom they already have relationships.
Mr. Wray discussed the extent some companies are involved in financial counseling (using a “holistic” approach) to help employees understand future financial obligations and options, noting direct correlations between such practices and company size. He reiterated his concern about excessive regulation since there is still much unknown about retiree behavior over periods immediately after retirement as well as how behavior may change over time. It is difficult to predict the needs of younger employees over the long-run, and he observed that the behavior of participants who take a lump sum, including whether and when they decide that annuitization makes sense for them.
He suggested it may be time to re-evaluate the gender-based longevity differences, especially for married women, to find appropriate individual solutions. The current rules governing annuity distributions within plans (requiring the use of unisex tables) tend to act against the best interests of men. Similarly, long-term care is clearly more appropriate for women as a planning device, as the likelihood of women to need such care is far greater than that for men.
In conclusion, Mr. Wray emphasized what he believes is the potential for evolutionary change in the area of DC plans urging restraint in placing any new restrictions on the way DC plans will function in the future.
Dallas Salisbury, Employee Benefit Research Institute
This move away from Money Purchase Plans is indicative of a few trends that will impact retirement financial adequacy over the life span of all Americans: 1) Plan sponsors have no burning desire to offer life income annuity options; 2) Participant interest is low in such options -- less than 5%; and 3) Movement from employer-funded retirement plans to those that rely on the worker as the primary funding source.
Over recent decades, research documented the lack of interest in life income annuity products. Yet, actual participant behavior, which is monitored by plan sponsors, is more important.
There is a regular flow of sponsors shifting from traditional defined benefit plans to either hybrid plans or defined contribution plans which offer participants a single sum distribution option. As they move from a defined benefit plan into retirement, workers have opted out of low cost annuities with excellent survivor features and PBGC guarantees. Even with the above, between 66 percent and 99 percent opt for single sum distributions.
Based on these facts and patterns, it will be difficult to move large numbers of participants into choosing income annuities as they leave defined contributions plans for retirement. Still, some participants will find these options attractive. Since the QDIA regulations did not embrace stable value products, such annuity defaults may be the easiest way for participants to place dollars in the low risk option, while retaining the option for single sum distributions.
Mr. Salisbury directly answered questions which the Working Group posed to witnesses, as follows:
What type of income streams should be available, and what
are the advantages and disadvantages to participants?
How do current practices in plan distribution design
support retirees abilities to manage income through retirement?
How could they be enhanced?
What are the current obstacles to offering income options
vs. lump sums? Why do participants select lump sum options more
prevalently than periodic income options? How can these obstacles
What are the barriers to offering a default periodic
distribution option to participants who either leave balances in
the plan or who roll account balances out of plans? How can these
What data is available or that can be shared regarding
how participants utilize account balances at retirement? What are
the key findings?
What is the best manner to provide participants with
education about distribution options and the importance of these
Mr. Salisbury commented that few plans offered today are more than tax deferred savings plans. They are not retirement plans alone. His rationale related to the fact that single sum distributions from job changes provides access to these funds throughout life.
Robert J. Doyle, Employee Benefits Security Administration
While much attention has been devoted to assisting defined contribution plan participants increase retirement savings, called the “accumulation” phase, Mr. Doyle noted the recent focus on post-employment retirement issues. With this in mind, he said it is important to evaluate the approaches, from a fiduciary standpoint, that can assist a worker in determining an appropriate income level upon retirement.
Mr. Doyle referred to a recent study, prepared for the Americans for Secure Retirement by Ernst & Young, that concluded almost 3 out of 5 new middle class retirees will outlive their financial assets if they attempt to maintain their pre-retirement standard of living. He commented, “whether and to what extent ERISA’s fiduciary principles apply will depend on how employers decide to assist their employees in addressing distribution and post-employment money management issues.”
Employers have two options, The first is “the distribution alternatives available to participants and beneficiaries under the plan.” The second is the availability of education materials and financial planning services to assist plan participants and beneficiaries in understanding their distribution options of post-employment money management issues.
Concerning the distribution options, the determination by an employer to include such an option or options in the plan is a matter of plan design. It is a “settlor” activity that does not implicate ERISA’s fiduciary responsibility rules. Implementation of such provisions, however, constitute fiduciary acts governed by ERISA and must be undertaken “prudently and solely in the interest of the plan’s participants and beneficiaries.”
Implementation of such options will involve the selection and monitoring of service providers and contracts and/or investment alternatives. This process must be undertaken objectively, allowing plan fiduciaries to assess the provider’s qualifications, quality of services offered, and reasonableness of fees charged for the service. It must avoid self-dealing, conflicts of interests or other improper influence (Field Assistance Bulletin 2007-1). Specific fiduciary considerations will depend on the particular nature of services and the product under consideration. Mr. Doyle noted that annuities are offered as a distribution option.
To assist plan fiduciaries in discharging their ERISA responsibilities when selecting annuity providers and contracts, Mr. Doyle stated that DOL had published a proposed safe harbor in September 2007. This safe harbor set forth steps that fiduciaries could take and to have satisfied their duties to act prudently and solely in the interest of the plan’s participants and beneficiaries. Mr. Doyle’s office is currently working on the final regulation, and he hopes “that the clarity and simplicity of the final ‘safe harbor’ will encourage more employers to consider annuity options, or investment options with annuity features, in their defined contribution plans.”
Mr. Doyle emphasized the provision of education and information about distribution options and financial considerations may assist plan participants in appreciating the importance of any such distribution arrangement. He said the mere fact that education advice might take into account financial resources outside the plan, would not, itself, limit the plan’s ability to treat expenses for such services as reasonable expenses of the plan for purposes of various sections of ERISA, 403(c), 404(a)(1)(A) and 408(b)(2). But if the advice and recommendations focus primarily on the participants’ non-plan financial resources, it is Mr. Doyle’s view that the expenses attendant to such advice may not be reasonable plan expenses.
In the course of his presentation, a point of emphasis by Mr. Doyle was that employers should understand that if a presentation to its workers involves a discussion of investment options under the plan, rather than general financial planning or educational information and materials, the employees may well view the presentation or seminar as being endorsed by the employer, with consequent legal implications.
Jeffrey Fishman, JSF Financial, LLC
Mr. Fishman began noting statistics that indicate significant debt burdens for many retirees as well as a common preference for lump sum distributions from qualified retirement plans over annuity options. He gave numerous reasons why these situations currently exist and believed a big key for American workers is to minimize or eliminate their debt at or before retirement.
In an effort to ensure larger amounts of guaranteed retirement income, Mr. Fishman thinks it would be highly beneficial to offer participants a variety of distribution or annuitization options in addition to the lump sum method.
Mr. Fishman proposed three options regarding immediate annuitization: 1) fixed immediate; 2) inflation-adjusted fixed immediate; and 3) variable immediate annuities. All three options should offer single life, joint and survivor, life with period certain, and period certain distribution modes. Another possible attractive option is hybrid alternatives, whereby participants are allowed to take a partial lump sum distribution and combine it with an annuity type option.
Mutual fund families have introduced funds to help provide income streams for plan participants whereby the fund companies make the asset allocation choices and decisions about how best to meet systematic withdrawals. Such funds do not provide guaranteed income.
Education is vital to helping people make the best possible decisions. Mr. Fishman recommends participants should be mandated to integrate their “real-life” situation into some form of capital needs analysis. While no one can accurately predict the future, this approach would lead to more informed decision making. Employers should be given incentives to provide education to their employees in order for them to make informed plan distribution decisions.
Financial advisors should be seen as educators and guides for plan participants. Advisors should be encouraged to work with participants on a one-on-one basis without fear of being susceptible to liability due to general investment volatility. Computer models and programs cannot take into account all the subjective concerns that a financial advisor can consider in offering one-on-one personalized services to participants.
Expanding the number of distribution options is a good idea, but recall that simple methods often are most effective. Any innovation in plan distribution options needs to take this concept into consideration.
Jody Strakosch, MetLife Institutional Income Annuities
Most participants take a lump sum distribution and do not use it wisely. Education is a critical element and should continue past retirement. Tools, education, and periodic reports that help participants determine target levels of income would be helpful. Participants need access to financial advisors. MetLife suggests educational brochures on decumulation would be useful. Retirees underestimate their retirement financial needs and underestimate their life expectancy.
Annuities can be helpful as both an accumulation and distribution option. All annuities have a minimum $100,000 State Guarantee Insurance Association coverage. To respond to potential loss of control issues, the insurance industry has responded with flexible features.
Few employers offer annuities due to administrative difficulties and fiduciary concerns. The DOL should clarify plan sponsors’ fiduciary obligations when selecting annuities. Plan sponsors should adopt retirement income policy statements and also provide participants with conversion estimates.
In conclusion, the DOL should simplify regulations: provide a safe harbor for annuities and simplify the Qualified Joint and Survivor Annuity (QJSA) notice and disclosure requirement. Defined contribution plans should provide a lifetime income option.
Fred Conley, Genworth Financial
Mr. Conley discussed Genworth products and why employees should buy them. The 401(k) annuity investment options that combine an account balance with a retirement income focus allow participants to maintain a balanced portfolio with equity exposure up to and through retirement, with a guaranteed floor of income that provides protection against longevity risk and down side market volatility. Participants make contributions into the group variable annuity as they would any other investment option – through payroll deduction or transfers of existing balances. Unlike most options, however, each contribution into the annuity contract has a specific amount of guaranteed retirement income that participants will receive for the rest of their lives. They know the guaranteed income amount ahead of time, which helps them have more control over their retirement planning. Participants can transfer money into and out of the annuity at any time prior to retirement without penalties, and participants have access to emergency cash post-retirement. Rather than asking participants to self-insure longevity risk through their own investment and withdrawal decisions, Genworth assumes a longevity risk and provides an income guarantee regardless of the performance of the underlying portfolio. This is only one example.
Another example given was the option to use a guaranteed income product as a QDIA within a 401(k) plan. Including a guaranteed income product as a QDIA would improve lifetime financial incomes for participants in 401(k) plans. Mr. Conley noted plan sponsors demand lifetime income options.
Clarification of the financial standards that apply to the selection of an annuity contract in defined contribution plans could facilitate the use of annuities and increase the level of annuitizations in these plans. In the Pension Protection Act (PPA), Congress asked the Department of Labor to clarify that IB 95-1 does not apply to individual account plans, and thus participants can buy annuities in their individual accounts. The proposed annuity regulations, he said, are too complex.
Mark Foley, Prudential Retirement
Since the level of annuitization is abysmally small, Prudential helps sponsors design plans to provide lifetime income. The solution – called guaranteed minimum withdrawal benefits – is attractive because it “take[s] characteristics that individuals like about an annuitization, the security of guaranteed income, the certainty of withdrawal amounts, and repackage[s] those into an offering that addresses those behavioral concerns, that gives them … the flexibility to control the transparency, as well as retains them within the investment framework that most individuals view their 401(k) plan.”
According to Mr. Foley, we need to complete what PPA started. We have automated enrollment, automated contribution escalation, we have automated default investing. Now we need income solutions.”
The Qualified Default Investment Alternatives (QDIA) regulations made it clear that including a guarantee did not invalidate the QDIA. They did not, however, clarify how that can be incorporated, what standards need to be evaluated, and what testing needs to be met in order to ensure prudence in that election. The guidance should be broadened to take into account innovation and new ideas around the nature of providing guarantees.
Sara Holden, Investment Company Institute
ICI research shows retirees have vastly different needs for their retirement assets which depend on a wide variety of factors, such as age, health, and other sources of income at retirement. There is no universally accepted, or generally applicable, way of spending down retirement assets. That said, ICI research supported the conclusion that most retirees are clear about why they make their choices at the time of a retirement distribution decision. Lastly, in response to these varied retiree income needs, Ms. Holden noted ICI has seen significant recent product and distribution payout option innovation.
Ms. Holden summarized ICI’s recommendations as follows:
Ann Combs, Vanguard Investments
Ms. Combs stressed that the public policy goal should not favor certain solutions over others. Rather, public policy should foster approaches that allow plan sponsors to make informed choices on behalf of their participants, in turn enabling participants to make choices among those options.
While traditional annuities are a valuable tool for managing longevity risk, Vanguard believes that many plan participants will choose not to annuitize most of their assets for important reasons. One reason is that many households, especially low-income households, receive a substantial level of replacement income through Social Security. While some prefer predictable incomes for regular living expenses, many households are concerned about maintaining liquidity and control to tap savings for unexpected costs like heath care.
For many of these reasons, there are significant innovations in devising products that convert asset balances into income streams. Vanguard has recently introduced managed payout funds designed for investors who have dual goals of investing assets during retirement and taking some measured risk with their savings while also seeking some regular payments from that pool of assets. With these payout funds, Ms. Combs noted that the fund manager assumes the uncertain and time-consuming responsibility of determining and implementing an effective retiree spend-down strategy.
Vanguard’s research shows that participants are much more active decision makers at retirement than during their accumulation phase. Research indicates retirees are willing to work actively to overcome the federally-mandated joint and survivor annuity default rules that currently exist for defined benefit plans.
Ms. Combs opined that current fiduciary rules for selecting and monitoring investment and insurance products do not require significant revision. In her view, the current general fiduciary rules are sufficient as they require plan fiduciaries to consider the risk, return, the cost, as well as the credit quality, solvency, and nature of an annuity contract.
Lastly, Ms. Combs urged the DOL to clarify the guidance offered under Interpretive Bulletin 96-1. Interpretive Bulletin 96-1 confirms plan sponsors can give general investment education without taking on fiduciary responsibility, which should also apply at the time of spend-down. Essentially, many plan sponsors would like to educate their participants – or allow a service provider to educate their participants – about annuity, payout, and other income options that are available outside the plan, without fear of taking on ERISA fiduciary liability.
Douglas Kant, Fidelity Investments
Mr. Kant explained that participant disclosure is an important area of focus. It would be helpful to participants, plan sponsors and service providers if the DOL provided guidance on what would be necessary and useful disclosure to participants.
Annuities differ significantly in terms of product design. Some products are designed to be liquid while others are semi-liquid. It would be helpful to have guidance under ERISA section 404(c) addressing the issue of restricted annuity liquidity measured against the level of expected investment volatility, as contemplated under existing ERISA section 404(c) regulations.
Mr. Kant commented that his firm has an insurance company and an insurance agency. Notwithstanding the lack of insurance product activity in 401(k) plans, his firm does have significant IRA insurance product activity. In his firm’s experience, individuals who roll over their money to an IRA from their 401(k) plan, and who buy an annuity with some of that money, tend to wait an average of three years before making the annuity purchase in their IRA. Mr. Kant confirmed this delay indicates individuals are thoughtful about the annuity-purchase process.
Mr. Kant described his firm’s income replacement fund, which allows the investor to pick a future date and to receive an income stream that culminates in that year. This design allows the fund-manager to bear the responsibility for managing the investment mix during the pay down rather that the participant.
Answering a question, the panel confirmed their income products are not intended to be “one-size-fits-all” products. Rather, these products serve as part of a package of planning.
Responding to another question, Ms. Combs reaffirmed her call for a level playing field for defined contribution annuities as special rules or tax breaks that incent individuals to invest in one product type over another should not exist. Mr. Kant responded that changing to an annuity default in defined contribution plans may not make sense, because retirees appear as fairly active as decision makers and may opt out of the annuity completely.
Mr. Kant again confirmed, in answering another question, the DOL would help the field by clarifying the boundaries for employers discussing rollover and other retiree options, without concerns over ERISA fiduciary risk. Mr. Kant reiterated that plan sponsors would like to permit service providers to educate participants about their outside-of-the-plan-options without taking on fiduciary responsibility.
In response to a final question about the level of proliferation of payout-oriented funds in the mutual fund industry, Ms. Holden confirmed that target date funds have been popular on the accumulation side since the early 1990s. On the decumulation side, Ms. Holden noted that there are some firms, including Fidelity and Vanguard, offering innovations in payout funds. For years, there have been fixed-income or balanced funds that generate income and many of the target date sweeps include a retirement income fund that can either be converted to or exchanged to at retirement.
Neil Lloyd, Mercer Investment Consulting
An optimal spend-down strategy considers a retiree’s: 1) needs vs. wants; 2) risk tolerance; 3) all resources; 4) need for simplicity; 5) wishes for bequests; and 6) longevity. Most retirees and planners underestimate life expectancy. Retirees may select the easier to understand option, even if it is inferior. Avoid the “misery of choice.” Much industry analysis focuses on the roles specific products play while very little analysis looks for an optimal combination of products. Hence, analysis tends to suggest a larger product variety, even “when if looked at holistically” a product may not be part of the optimal combination.
Ideally, participants near retirement should tailor investment strategies to likely spend-down patterns. Here are ways to encourage this pre-retirement:
Anna Rappaport, Anna Rappaport Consulting
In her opening comments, Ms. Rappaport explained her “dream distribution options” for a 401(k) plan. The fundamental drivers of this “dream” are 1) giving the participant enough time to think through irrevocable decisions, 2) allowing the participant to annuitize over time, 3) allowing additional withdrawals during the period where a longer term plan is put in place, 4) assuring an individual considers the choice of an annuity, 5) providing the opportunity of dollar cost averaging, and 6) viewing the decision from a holistic portfolio point of view. Since many Americans use short-term thinking in their planning, better planning is needed to maintain income in retirement. A stand alone 401(k) plan is fundamentally different than a DB plan with a supplemental 401(k) plan.
There are obstacles to life income options. Lump sum payments are common practice, even though participants say they want lifetime income. Their decisions appear to be intuitive. Education is needed on the income stream and the trade-offs associated with the decision. There are also complex regulations to understand as well as the differences to be considered between men and women. Innovations in financial products continue in the market place presenting challenges for comparison and basic understanding of products and options.
Ms. Rappaport’s short term specific recommendation for the DOL was to develop education to help people better understand the trade offs in their decision making process. Education is needed on guaranteed income, costs and fees, longevity risk, Social Security, irrevocable decisions and liquidity needs. Participants need to understand this is the money they will live on for the rest of their lives. Key questions that need to be raised include: 1) How much of the portfolio should be annuitized? 2) How should spouses be protected? 3) How does this fit into the total portfolio? 4) Should income be guaranteed? 5) Is the decision irrevocable? 6) How do the minimum distribution rules come into play? 7) What kind of trade-offs are there? 8) When should Social Security be claimed?
Ms. Rappaport outlined the barriers to a plan sponsor offering a default periodic distribution as: 1) participant expectations - as a society we do not think of the balances as related to retirement income; 2) many income options are irrevocable; 3) a tendency to use the entire balance in the same way, and 4) the plan sponsor is subject to increased fiduciary risk and complex administrative tasks in order to offer annuity benefits or alternative arrangements.
Phil Suess, Mercer
Participants confront issues in decumulation akin to accumulation. Participant success in the spend-down phase is highly dependent upon prior success in the accumulation phase. Yet, the vast majority of DC plan participants do not know: 1) the amount of assets they will need in retirement; 2) the amount of contributions necessary to accumulate sufficient assets; 3) the earnings needed on their contributions; and 4) how to invest their assets to have a reasonable probability of adequate earnings. In the spend-down phase, participants: 1) fail to grasp longevity risk; 2) remain disinterested in investments; and 3) prefer to delegate decision-making to third parties. Experience shows the success of educating participants to make informed decisions has been disappointing at best.
Over the past several years, the insurance and money management industries have introduced retirement income products. Money managers focus on asset allocation, liquidity and control while the insurance industry emphasizes assumption of risk and guarantees. Increasingly, age-based lifecycle products are based on a participant's anticipated life expectancy rather than anticipated retirement date. The mutual fund industry offers distribution products to provide ongoing income over a specified number of years while the insurance industry increasingly offers guaranteed products at lower cost combined with increased liquidity, relative to prior products. The incorporation of annuities within a broad asset allocation, and the establishment of minimum guarantees within asset allocation products may be desirable since the guarantees are embedded within the products and do not require separate plan sponsor and participant election decisions.
The challenge to plan sponsors and to participants is to evaluate the benefits of the products, which incorporate the features of both industries. Despite innovations, sponsors and participant maintain basic objections to distribution products. Plan sponsors are concerned in offering products to participants who are no longer active employees. They worry about fiduciary liability in offering guaranteed products in their plans. Participants fear being unable to access their assets if needed. In response, newer products provide some level of guarantee and participant access to their money (at the expense of reducing or eliminating the underlying guarantee).
Mr. Suess concluded:
Jason K. Chepenik, CFP, AIF, Managing Partner, Chepenik
Financial, an NRP Member Firm
The role of the investment advisor must be not only to make recommendations but also to educate plan sponsors about fiduciary responsibility, understanding revenue sharing, legislative changes and the nature of relationships, and, moreover, what defines a successful retirement plan. Plan sponsors who lack knowledge do not know the risk they are exposing themselves to.
The products consultants sell or recommend are typically the same, and are not necessarily designed to enhance the employee experience or financial security. The vast and ever changing array of products begs the question of whether the products are really better for employees or merely a vehicle for maintaining a steady stream of income for product manufacturers, vendors, and plan advisors. The distinguishing factor among consultants is the creativity and knowledge of the person providing the advice. Many retirees are faced with managing a large sum of money far in excess of their former incomes, without a clear understanding of how to make it last through retirement. Bad decision making often results from this lack of understanding. Current gap analytics tend to use assumptions that are no longer based in reality, estimating living expenses at 70-85% of pre-retirement, and inflation at 3-4%. In reality, higher costs faced by retirees, particularly in the area of health costs, tend to skew both numbers significantly higher.
Costs of products are difficult to understand. Portability allows flexibility but at higher cost and greater risk. Systematic withdrawal from investment accounts is a common recommendation, but is not always easy to achieve under current plan designs. The concept of “guarantee” is used in many contexts, sometimes inappropriately. The confusion over this term leads to misunderstanding and frustration on the part of plan sponsors and participants.
Mr. Chepenik’s recommends better educating sponsors and participants with statements that clearly show “assumed monthly income” on contribution statements, increasing penalties for early withdrawals to encourage savings, and providing tax incentives to participants who select systematic withdrawal options. In addition, participants should be able to choose from a variety of annuity payouts. Plans that utilize economies of scale to purchase institutional annuity contracts will provide a lower cost option to participants.
The DOL should consider requiring gap analytics that are true and accurate with more realistic assumptions. Mr. Chepenik recommends using 100% of pre-retirement income with 5% or more inflation as better metrics. This would allow greater cushion for unanticipated expenses in retirement. The DOL should also consider qualifying how firms can use the word “guarantee” in this particular segment of the marketplace.
Steven Saxon and Louis Mazawey, Groom Law Group
According to Mr. Saxon, if the risks are too great, plan sponsors will not offer annuities, especially since these options are available outside the plan. Mr. Saxon provided the following guidance with regard to the questions posed above.
The decision to provide an annuity distribution option is a plan design decision and, therefore, is a non-fiduciary settlor decision. The implementation of this decision is a fiduciary act and a plan sponsor would be acting as a fiduciary in connection with the selection and ongoing monitoring of an annuity provider. The DOL has proposed regulations under Section 625 of the Pension Protection Act (the “PPA”) which directed the Department of Labor to issue regulations that clarified that the selection of an annuity contract as an optional form of distribution from a defined contribution plan is not subject to the “safest available annuity” standard contained in DOL Interpretive Bulletin 95-1. The proposed regulation provides a procedural safe harbor but contains many requirements and considerations that are applicable to the selection of annuities that do not apply to other plan investment choices. These requirements discourage plan sponsors from offering annuities and despite the intent of Section 625 of the PPA, the proposed regulation makes no significant changes that would result in greater utilization of annuities. For example, the proposed regulation would impose 14 separate conditions for fiduciaries to consider when selecting an annuity provider. If any one of these is not satisfied, including the hiring of an independent expert (when appropriate), a fiduciary would lose the protection provided by the regulation. Mr. Saxon suggested simplifying the regulation to require fiduciaries to act prudently in the selection of annuity providers by eliminating section (c)(2) and the need to hire independent experts that are usually required only in cases where a conflict of interest is present. It should also specify that a selection that does not meet the regulation’s approach may nonetheless still be prudent.
Mr. Saxon offered other suggestions that would encourage plan sponsors to offer annuities. These included a recommendation for the DOL to issue a statement countering the negative impression created by the Qualified Default Investment Alternative (QDIA) regulations about the value of annuities, and other guaranteed products such as guaranteed minimum withdrawal products, in providing retirement security to participants. As well, Mr. Saxon suggested that the DOL clarify that products which qualify as a QDIA while a participant is active will continue to so qualify when the participant is in pay status, so that a plan fiduciary will receive the fiduciary protection of the QDIA regulation for amounts that remain invested in the plan as a participant begins spend-down of his or her account, so long as the other requirements of the regulation are met.
Mr. Saxon also suggested that the Department should clarify and extend Interpretive Bulletin 96-1 to permit plan fiduciaries to provide participants with information on issues relating to the decumulation stage of retirement, including estimates of the amount of money needed and calculations of the best method to ensure that retirement savings last throughout a participant’s lifetime. Finally, Mr. Saxon testified that DOL needs to resolve the issue of a fiduciary’s status when the fiduciary provides assistance with respect to a distribution and a participant makes a decision with respect to the investment of that distribution outside of the plan.
Mr. Mazawey testified about the burdens to plan sponsors resulting from the qualified joint and survivor annuity rules of Internal Revenue Code Section 401(a)(11). Most defined contribution plans are not required to offer annuity forms of distribution. These compliance burdens arise only if a defined contribution plan offers an annuity distribution option and a participant expresses an interest in receiving an annuity. These requirements do not apply to the election of lump sum distributions or installment payouts. According to Mr. Mazawey, many plan sponsors and fiduciaries believe that the administrative burdens outweigh the benefits of offering an annuity option. He encouraged the DOL to work with the Treasury Department to streamline these requirements, simplify the procedures for obtaining spousal consents and clarify that these rules do not apply to guaranteed minimum withdrawal options.
Alison Borland – Hewitt Associates LLC
Ms. Borland began by her testimony by citing that fewer than 19% of Americans will meet 100% of their estimated needs in retirement. She believes that this is because as more Americans rely solely on a 401(k) plan for their employer-provided retirement income, they are not equipped to effectively manage income streams after retirement.
Ms. Borland’s testimony outlined four topics to be addressed to facilitate a more thoughtful spend down of defined contribution assets.
Current Payment Options and Participant Elections. Currently 89% of participants take lump sums from 401(k) plans upon retirement, while only 3% elect annuities. Ms. Borland suggested that more flexibility related to periodic distributions and increased participant education would help participants make more informed distribution decisions.
Benefit of participants managing income from within a 401(k). Hewitt research shows that almost one third of participants leave their retirement savings in their employer’s 401(k) plan, 26% roll their money to an IRA, and the remaining participants withdraw it. Ms. Borland pointed out that participants need to be educated about the benefits of keeping their assets in the employer’s 401(k) plan. These benefits include: More effective plan management, access to lower-cost, higher-value investment options, and greater access to scaled purchasing power of investment products and tools.
Regulatory and design changes needed. In order to make 401(k) plans more attractive retirement income vehicles, Ms. Borland suggested the following: Increase distribution flexibility, add longevity insurance protection, allow post-termination loans, facilitate account balance consolidation, eliminate barriers to converting to a Roth 401(k), and elimination of “total distribution” requirement for company stock distributions in order to qualify for more favorable tax treatment.
Study distribution behavior in defined benefit plans. When lump sums are available, over 90% of participants elect lump sums over annuities. Identify opportunities to improve retirement income adequacy in these plans, too.
In conclusion, Ms. Borland stated that plan sponsors, providers and the federal government can and should work together to explore new and innovative ways to eliminate existing barriers and encourage the use of 401(k) plans—and pension plans-- as effective, long-term retirement income vehicles.
Joan Gucciardi, ASPPA
Ms. Gucciardi noted two key categories to the spend down issue: 1) encouraging retirees to manage retirement funds wisely and 2) encouraging pre-retirees to not spend retirement savings before actually reaching retirement. Plan sponsors can facilitate this process by design changes to their plans. Government can facilitate this process through legislative changes to both ERISA and the Tax Code.
She recommends encouraging plans to allow partial lump sums and partial annuity options. Plans should offer participants the opportunity to elect a portion of their benefits in a lump sum IRA rollover and a portion as an annuity. She reasons that there is a psychological desire to have a portion available as need for unanticipated living expenses or for the initial expenses of the transition to retirement.
Ms. Gucciardi recommends that annuity options be encouraged. This would make the qualified joint and survivor annuity the default option and require spousal consent for lump sums. Electronic consent should be allowed under these arrangements. Removing roadblocks to offering an annuity option in defined contribution plans would help protect non-working spouses or spouses that have non-continuous work history.
Another recommendation is to allow for advance IRA designation for defined contribution plans. This idea would reduce leakage from the system. Employees would be allowed to make a revocable IRA designation at the time the employee enrolls in a defined contribution plan and at the time the plan sponsor might move to a new plan provider. This measure would also promote participants’ consolidation of their retirement assets in fewer accounts for easier monitoring.
She also advocates permitting tax-free distributions to participants from defined contribution plans if the proceeds are used to purchase qualified long-term care insurance on behalf of themselves, their spouse, their dependents, or qualifying relatives (as defined in the Code). She sees long-term care as a retirement savings protection mechanism. It is affordable and can protect against the rapid deterioration of retirement savings and the escalating costs of assisted living.
Ms. Gucciardi further recommends that small balances be exempt from minimum required distribution calculations. The current rules impose unnecessary administrative burden to both the plan sponsor and the participant where small balances exist. She proposes an exemption for any individual whose aggregate balance does not exceed $50,000.
She recommends an amendment to 401(a)(9) to allow for purchase of longevity insurance. This type of deferred annuity should be allowed in qualified plans. Such annuities currently cannot be purchased or used effectively inside qualified plans or IRAs because of restrictions in the Code.
In order to minimize leakage, she proposes elimination of active employee access to benefits at plan termination. She feels the event of terminating a plan should not, in of itself, provide access to qualified plan benefits for employees who have not severed employment with the plan sponsor or met one of the plan’s retirement age conditions.
Lastly, Ms. Gucciardi recommends that IRAs be allowed to accept rollovers of 401(k) loan balances. Acceptance of loan balances and periodic loan repayments will allow this money to remain in the system. This would apply only to existing loans, not to new loans within IRAs.
Jack Richie, Vice President, Human Resources, Rogers
Mr. Richie explained the process the firm went through to understand what employees understood about the retirement savings opportunities available to them and the impediments that employees perceived that prevented them from participating in the program. He explained that employee objections fell into three categories: those who did not know how to invest the money; those who feared losing the money; and those who do not know how to take the money out after retirement. In response to these concerns, the company conducted extensive educational sessions to help alleviate their fears. When automatic enrollment became available, the company enrolled all employees in the program at a three percent contribution rate, with an escalation feature. He explained that the efforts were very successful and expressed concern that employers not be restricted from implementing comprehensive retirement programs of the type his firm has adopted.
Mr. Richie responded to questions from Council members to clarify certain terms referenced in his testimony and explained that Rogers’ objective was to provide a fully comprehensive program, including the educational component and a wide variety of investment options. He also noted that one of the goals was to make sure that the program and options were easy to understand.
Council member Helmreich asked whether their firm was aware of the requirements that apply to employers regarding the design and fiduciary protections of the Department of Labor’s regulations. Mr. Richie noted that Rogers used outside consultants in the implementation of the plan. He also responded to questions regarding the “IncomeFlex” product implemented for older employees (this non traditional life cycle fund with guaranteed lifetime income features product is only available for participants age 50 and older) including the take-up rate; how they evaluated this product in selecting it; and what other distribution options that are available to them.
Other Council members inquired as to the payment of administrative fees for the program, which are all borne by the participants; and the independence of the “independent” advisors. He also responded to a question from Council member Wiggins as to the firm’s experience with the requirements of the Department of Labor regarding the adoption of the Income Flex product and the choice of the vendors. Mr. Richie responded that Rogers did not find the requirements overly burdensome (primarily because it had outside help).
Council members Brambley and Koeppel asked and Mr. Richie responded to questions about the process the firm would engage in if the firm determined it was desirable to change vendors. He explained that one of the basic tenants of the Company’s benefit programs is choice, and he felt that any product they selected would need to maintain the same level of choice provided by the current program
J. Mark Iwry, Retirement Security Project
Offer a "test drive" of a lifetime income product. A substantial portion of each account would default into a two-year trial income product at distribution. The automatic trial income arrangement would make 24 monthly payments, if the participant did not opt out. At the end of the trial period, retirees could elect an alternative. If retirees did nothing, they would default into a permanent payment program. This could accustom individuals to the security and simplicity of a “pension paycheck” over a lump sum. It may become the presumptive form of benefit.
Reframe the choice. Plan sponsors should be required to present benefits as an income stream of monthly or annual lifetime payments, in addition to presenting the benefits as an account balance in accordance with current practice.
Encourage lifetime income by gradually introducing it as a default investment during the accumulation phase, including, specifically, embedding it in the target maturity QDIA. Target maturity, or life cycle default investments, are increasingly prevalent in 401(k) plans and are generally well accepted by employees as a means of achieving asset allocation and diversification. Typically, these funds increase the percentage of fixed income assets over an employee’s career. The fixed income component might be comprised of annuity income units that grow gradually. If plans chose to offer such funds, they would spread the risk of interest rate fluctuations at the point of purchase – a kind of “dollar cost averaging” – that allows a portion of an account balance to be invested in deferred annuities. Because annuity income units would accumulate gradually, there is no single “moment of truth” at which one irrevocably disposes an entire nest egg.
Encourage lifetime income by gradually introducing it via employer matching. A portion of the incoming employer matching contributions could be directed to the accumulation of deferred annuity (mandatory or by default). New limits on investing matching contributions in employer stock opens the door to employer contributions in retirement security. Participants who are skeptical about turning assets over to an insurance carrier may invest “employer money” in annuity income. This can occur gradually during accumulation and foster the notion that the “employer matching” portion will provide lifetime income. This may mitigate the interest rate risk by acquiring units over time. Employer matching contributions often account for a third of an account balance (or slightly less). To many employees, this might be the right amount to devote to lifetime income. Both the QDIA and the employer matching strategies could be structured to complement the trial income strategy summarized earlier.
Longevity Insurance in Qualified Plans. Deferring the start of an annuity until an advanced age such as 85 helps counteract the “wealth illusion” that keeps some employees from converting any of their account balance to periodic income. Many employees are unpleasantly surprised to learn how “small” the monthly payments are relative to a “large” account balance. This “sticker shock” can be countered to some degree by showing employees that they can purchase a meaningful amount of late-in-life longevity insurance in exchange for a portion of their account balance. The employee could retain the account balance to meet economic “shocks” such as medical or long-term care needs. This approach protects against the “tail” of the life span probability distribution – the lower-probability risk that the participant will live to a very advanced age. Facilitating “longevity insurance” will necessitate addressing required minimum distribution rules under the Internal Revenue Code.
Norman Stein, Pension Rights Center
In his opinion, a very strong consensus exists among experts that protecting retirees from longevity risk could provide tremendous benefits. While it is not clear who benefits most from protecting people from longevity risk, it is clear that retirees are one group who would benefit. Mr. Stein suggested we have been conditioned to emphasize conventional annuity products as a solution to dealing with longevity risk. He established a list of reasons why people don’t like annuities.
Individuals often prefer lump sum payments to annuities because they fail to realize that they could outlive their life expectancy. People tend to over-evaluate the spending power of what will be, for many, the largest single sum of money they ever receive. People usually are not given an alternative so they take the money and roll it into an IRA instead of shopping or comparing annuity rates and the associated benefit. Complexity of products in the market simply overwhelms most people. They lack the necessary education to consider all key issues related to annuity products. Another major factor is the financial penalty of death. Most people desire to leave a legacy for children/grandchildren. There are also the dual concerns of company solvency for the employer and the insurer if one was to select an annuity. For employers, lump sums are “cleaner.”
By severing via lump sum, it is suggested that liability is minimized in the future. Mr. Stein suggested that it is important that retirement policy encourage pooling of longevity risks but he cautioned that it may not be entirely clear whether this is something that government policy should pursue. He went on to say that perhaps government’s role should be to encourage a market for annuities and similar products.
Mr. Stein wondered aloud it may not be appropriate to force such behavior to change as a result of manipulation, incentives etc. The first argument that could be raised against taking specific actions would be the creation of the 401(k) itself. Mr. Stein referred to the 401(k) plans as wealth-creation vehicles and that each employee has to make several decisions based upon the individual situation.
Perhaps no single answer is correct in this situation as several have noted this wealth creation model is very attractive compared to the traditional retirement plan and Social Security. Mr. Stein’s position was that for those who believe this, perhaps the best government action is to provide education about annuities and help make an efficient market for annuities. Mr. Stein quoted some well known facts regarding longevity to prove the point that it could create wealth transference between various groups, which he suggested may not be the best approach.
Mr. Stein discussed pre-retirement leakage and noted that it was a greater concern. He went on to the subject of conflicts of interest and felt, in summary, that it was better that people selling and advising not be conflicted.
Inflation bonds came into the discussion as a possible goal. Mr. Stein identified the benefits for both annuity providers and the investment industry in seeing these as a way to structure annuities. Mr. Stein thought the introduction of annuity, when participants are young, made sense and should be considered. He opined that it was premature to introduce a safe harbor as this had not been experimented with in any way.
In closing, Mr. Stein suggested that he thought the following ideas were worthy of consideration for the Council and or the DOL. First, encourage employers to offer a default annuity as a viable offering. Retirement bonds are a good idea as they serve multiple purposes. He suggested defaulting some percentage into an annuity product. He believed that we should offer a paternalistic view to a degree. However, he stopped well short of actionable specifics.
*The Advisory Council's report inadvertently omitted the summary of testimony by Allison Klausner of Honeywell International, who testified on behalf of the American Benefits Council. Anyone interested in obtaining her written or oral statement may contact the Council's executive secretary, Larry Good, at 201.693.8668.