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New Treasury Guidance Will Encourage Annuities In 401(k) Plans

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Earlier today, the U.S. Treasury Department took an extremely important and welcome step to promote retirement income security.  Treasury issued guidelines to pave the way for employers who sponsor 401(k) and other defined contribution plans to voluntarily allow the contributions of automatically enrolled participants to be placed in deferred annuities.  This could prove to be a watershed event for promoting income security for millions of future retirees.

What is the context for this guidance?

Over the past three-and-a-half decades, the 401(k) plan has emerged as the centerpiece of the private retirement system in the U.S.  The 401(k) plan is based on the concept of “elective deferrals,” meaning that employees can choose to voluntarily defer some of their income by investing it in a 401(k) or other DC plan, where it will grow tax-deferred until it is withdrawn to help support their consumption during retirement.

In an important move, the Pension Protection Act of 2006 encouraged plans to automatically enroll employees in 401(k) plans.  Rather than making people opt in to saving for retirement, firms with automatic enrollment put people in the plan automatically and make the employee opt out if they do not want to participate.  Although an individual is still free to participate or not participate as they see fit, this simple change in the default option has led to substantial increases in 401(k) plan participation (for example, see this academic research and this EBRI paper.)

What happens to the contributions of individuals who are automatically enrolled?

If an employee is automatically enrolled in a 401(k) plan but does not tell the employer how they want their money invested, the employer used to invest the money in safe but low-yielding funds, such as a money market fund.  This all changed in 2007 when the Department of Labor issued regulations that designated certain types of diversified investment products as “Qualified Default Investment Alternatives,” or QDIAs.  Employers were provided assurance that so long as they placed the automatically enrolled participants’ contributions in these specially designated funds (that could include target date funds, lifecycle funds, balanced funds, or managed accounts), the investment allocation would be treated as if it were made by the participant. This provided plan sponsors with the comfort of knowing that they would not be held responsible for market volatility leading to losses in the accounts of automatically enrolled employees.

Since these regulations took effect in late 2007, funds designated as QDIAs have taken off in popularity and are now used as the default investment option for millions of participants across the U.S.

So what is the problem with existing QDIA funds?

QDIAs are investment vehicles.  Properly constructed, they can be a great way to accumulate a large account balance by the time one retires.  But today’s QDIA’s are not well-designed to help people after they retire.  To do this, they need to be designed to help people figure out how to make their money last for as long as they live.

Uncertainty about length-of-life is difficult for people to manage.  If they spend too frugally, they may not be able to maintain the standard of living to which they have become accustomed.  But if they spend too quickly, they may find themselves living to age 90 or 95 with no money left.

Life annuities solve this difficult financial planning problem by trading a lump-sum of wealth for a series of monthly income payments that are guaranteed to last for life.  Unfortunately, only a tiny fraction of 401(k) plans offer an annuity option today.

In 2006, when the Department of Labor was soliciting public input on the design of the QDIAs, I submitted a comment letter in which I stated that the proposed QDIAs were “entirely divorced from considerations related to the payout phase. As such, the regulations may have the effect of unintentionally biasing plan sponsors to focus on issues of asset allocation, instead of on issues that might be of even greater importance to ultimate retirement income security.”  I encouraged the Department of Labor to: “broaden the class of qualified default investment alternatives to include products that are designed to address the retirement income needs of retirees, rather than focusing solely on portfolio allocation issues.”

Unfortunately, the regulatory framework has remained very unclear on this front.

As a result, the enormous growth in the use of automatic enrollment and the use of QDIAs have encouraged saving, but failed to do anything to address the problem of retirement income security.

What changes with today’s guidance from Treasury?

Today’s guidance makes it clear to plan sponsors that they can incorporate annuities into the design of QDIAs.  Specifically, the guidance “makes clear that plan sponsors can include deferred income annuities in target date funds used as a default investment”.

How might this change the future of 401(k) plans?

Today’s guidance is another of several steps taken by the Obama Administration to promote retirement saving and retirement income security.  Other recent steps have included the MyRA proposal unveiled in 2014 State of the Union Address and the July 2014 regulation making it clear that Qualified Longevity Annuity Contracts (QLACs) can be used to provide longevity insurance in qualified retirement plans without violating minimum distribution rules.  It is also expected that the Department of Labor will soon issue final regulations requiring plan sponsors to disclose to participants how much income their 401(k) plan will provide, rather than reporting account balances.  (A sneak preview of what these might look like was provided by DOL’s advance notice of proposed rulemaking on this topic.)

These changes should help to reframe the discussion away from asset accumulation and toward retirement income security.  Academic research suggests that this shift may increase the demand for life annuity products.  Today’s ruling makes it more likely that participants will have easy access to annuities by having them already built-in to their default investment option.

What else is needed? 

Although Treasury should be applauded for taking this and other bold steps, there is still more to be done to increase the availability of lifetime income products in DC plans.  Arguably the most important issue still on the table is making plan sponsors more comfortable with regard to fiduciary concerns in the selection of an annuity provider.

The Treasury announcement notes that In an accompanying letter, the Department of Labor today confirmed that target date funds serving as default investment alternatives may include annuities among their fixed income investments. The letter also describes how ERISA fiduciary standards can be satisfied when a plan sponsor appoints an investment manager that selects the annuity contracts and annuity provider to pay the lifetime income.”  This is an important step, but I suspect it may still be viewed as falling short of the “safe harbor” that many plan sponsors are hoping for.

Overall, today’s announcement is an important one in the ongoing improvement of the defined contribution retirement system.  It is well past time that we remind plan sponsors and participants that retirement income is the outcome upon which retirement plans should focus.