It’s the year 2035, and you’re retiring at age 70. Unfortunately, your company closed its defined benefit (DB) pension plan to new employees years before you were hired, and Social Security hasn’t been providing a cost-of- living adjustment since 2025, when the first wave of Baby Boomers became too great a strain on the government’s so-called retirement safety net. Thank goodness, you were smart enough always to join your employer’s 401(k) and contribute the maximum. Now, you have a substantial nest egg, but you are faced with the one question no one can answer: How long will you live?
As the retirement system braces for the graduation of a generational bulge into old age, plan sponsors are starting to worry whether they are doing enough–now that an increasing number no longer offer DB plans–to prepare employees for a potentially long retirement with fewer safety nets. Yes, they have been providing education on savings and more investment options in their defined contribution (DC) plans, but do their participants have the knowledge to make their savings stretch over an indeterminate life span?
Plan sponsors suspect not, and many are beginning to investigate vehicles that will assist their employees with the challenge. The most popular is one that has faced serious bad-mouthing in the not so distant past–annuities.
“The theory is that in the future, people will need options to guarantee a lifetime income,” says Robert Nestor, principal of retiree services at The Vanguard Group Inc. “Annuities are unique in that they are the only [product] that provides a guarantee against outliving your money.”
While annuities come in all shapes and sizes, the basic idea is that in exchange for a lump sum, an insurer promises regular payments for the rest of one’s life. And with the increase in U.S. life expectancy, that could translate into decades. “As life spans increase, many individuals face the real possibility of outliving their assets once they stop working,” says Kathleen Rion, director of global retirement benefits at IBM Corp. In recognition of that possibility, IBM gave its 401(k) plan participants access to annuities this year, one of the many signs that annuities are gaining favor. A number of measures have also been introduced on Capitol Hill to provide some sort of tax relief for retirees who use 401(k) assets to buy an annuity. What’s more, insurance companies are chiming in with new variations on annuities for the baby boom generation as it nervously eyes the health of Social Security and Medicare.
While Social Security provides workers with a lifetime income, it currently replaces just 41% of the pay of a worker with medium earnings, and in the future that replacement rate is expected to move lower. Annuities can be used to fill in the gap between what Social Security provides and the amount of monthly income retirees need.
Annuities can also offset a lack of financial planning, which can trip up even retirees with ample savings. The Employee Benefit Research Institute (EBRI) recently looked at data on people born between 1931 and 1941 and found that in the 10 years ending in 2002, 15% lost 50% or more of their total wealth and about 30% lost 50% or more of their financial wealth. Craig Copeland, an EBRI senior research associate, says that plenty of those who lost substantial amounts of wealth had decent incomes and weren’t in poor health. Nor did the stock market sell-off cause their losses, given their asset allocations. “They have to have done it by spending the wealth in an accelerated manner,” Copeland says. He concludes that retirees would benefit from options in DC plans and IRAs that allow them to turn some of their savings into an annuity or make regular withdrawals.
STILL UNDISCOVERED TERRITORY
Despite the buzz about annuities, however, fewer and fewer DC plans make them available. In 2004, just 23.5% of DC plans offered annuities as a distribution option, down from 37.5% in 1998, according to statistics from the ProfitSharing/401(k) Council of America (PSCA). David Wray, the PSCA’s president, says plan sponsors were scared away from annuities by 1995 Department of Labor guidance requiring plan sponsors to chose the “safest” annuity, which raised concerns about fiduciary liability. The move away from annuities was aided by legislation in 2001 that made it easier for plans to axe annuities and other distribution options.
Of course, the decline in availability might just reflect the lack of demand. Hewitt’s 2005 401(k) survey shows that on average, just 6% of plan participants chose an annuity last year. Retirement experts say there are lots of reasons that annuities aren’t big sellers. Many people still remember the early 1980s, when skyrocketing U.S. inflation wreaked havoc on the purchasing power of fixed annuities. Annuities are also perceived as expensive, and no wonder: Interest rates are the biggest determinant of the cost of annuities and U.S. rates are still close to 40-year lows. And the PSCA’s Wray says the way that DC plans provide annuities often isn’t ideal for employees. Plans tend to offer annuities from a single provider, rather than offering a choice. They also give participants the option of annuitizing all their accumulated assets or none at all, rather than allowing them to use part of their savings.
Vanguard’s Nestor sees the unfavorable tax treatment as another factor working against annuities in DC plans. If retirees decide to annuitize a portion of their 401(k) balance, even if the annuity payments exceed the minimum distribution required by IRS rules, they still must meet the minimum distribution rules on the unannuitized balance in the plan, he says. And from that point, they have to pay taxes on both the annuity payments and the required minimum distributions from the plan. “So it accelerates taxes,” Nestor says.
Still, there’s a sense that demand for annuities will grow as more workers enter retirement without the security of a company pension. In anticipation of that demand, two insurers have launched annuity products that work inside 401(k) plans as an investment option. Metlife Retirement & Savings introduced MetLife Personal Pension Builder, which lets plan participants buy the promise of a certain amount of income once they retire; basically, they’re investing in a deferred fixed annuity. Putting money into Personal Pension Builder over time alleviates the risk that annuities are very expensive at the point that an employee decides to buy one, says Keith Hylind, a vice president at MetLife. Merrill Lynch is making Personal Pension Builder available to the 401(k) plans it administers.
A FEW NEW BELLS AND WHISTLES
Genworth Financial Inc. came out with a deferred variable annuity product for 401(k) plans called ClearCourse. Participants buy future promises of retirement income, and may see that income rise if the balanced fund in which their money is invested performs well. Fred Conley, president and CEO of Genworth’s institutional retirement group, notes that the balanced fund holds stocks and bonds. “A lot of products tend to push people toward lower and lower allocations to equities as they get nearer to retirement,” Conley says. “The [income] floor gives people comfort in staying in a balanced fund and that gives them a hedge against inflation.” As yet, no DC plans or recordkeepers are offering ClearCourse, which was launched earlier this year, but Conley says he expects to announce some deals this fall.
When IBM decided to offer an annuity option, it thought it would have to negotiate with a number of insurers and also line up a vendor to administer the option, Rion says. But the recordkeeper for its 401(k) plan, Hewitt Associates, showed IBM a simpler method: IncomeSolutions.com, an online platform where plan participants can get institutional pricing on annuities from up to eight competing insurers.
Hueler Companies Inc., a stable value consulting and data research company in Minneapolis, launched IncomeSolutions in 1994. So far, it is available only through Hewitt, which now provides it to 54 DC plans with 803,000 participants. Participants access IncomeSolutions via Hewitt’s online Personal Finance Center. “The way we’ve structured the platform, it allows the employer to offer access, as opposed to offering it in the plan,” says Stacy Schaus, personal finance leader at Hewitt. That’s key because it means plan sponsors don’t worry about selecting and monitoring an annuity provider and the fiduciary liability involved, she says.
If a participant buys an annuity on IncomeSolutions, the money to purchase it is rolled out of the 401(k) into an IRA. Hueler charges a 1% fee and Hewitt charges 1.5%, but Schaus says the combined fee is “well below” what would be charged retail. And Hewitt’s pricing studies show that the annuities that participants purchase on IncomeSolutions provide payouts that are 3% to 9% higher than anything available in the retail marketplace.
Kelli Hueler, president of Hueler Cos., argues that to get a good deal, employees need not only institutional pricing on an annuity, but the ability to compare the offers of a few different insurers. Hueler’s data on transactions on the platform shows that the spread between the high and low institutional bids on an annuity range from 4% to 12%. Hueler says that reflects the very fluid pricing that’s characteristic of good insurance companies, which constantly assess factors like the value of their portfolio and the matching of their assets and liabilities to determine what type of business they should be doing. As a result, she says, no single insurance company will always provide the most competitive price.
Annuities also have suffered from bad PR, in part because of their cost and the difficulty retail investors have in figuring out whether they’re getting a good deal. “They’re difficult to understand,” says Ed Moslander, director of pension products at TIAA-CREF, the retirement system for academics. Moslander says plan participants should compare the annuity rate–the annual income that an annuity provides for every $1,000 invested–offered by different companies. They should also check the creditworthiness of the provider, he says.
Vanguard’s Nestor says that for the time being, he expects the low-interest-rate environment and the unfavorable tax treatment to limit 401(k) participants’ interest in annuities. “We’re going to have to see tax changes and rises in rates to make [annuities] attractive,” he says.