401(k) annuity options growing despite concerns
Roberta Rafaloff is a vice president of MetLife and head of the insurer’s institutional income annuities business. She recently shared with EBN her perspectives on the potential that annuities hold for 401(k) participants, and current developments on the annuity regulatory front. Highlights of that conversation follow.
Employee Benefit News: Many defined contribution plan sponsors are reluctant to give participants an annuity distribution option out of fiduciary liability considerations. What’s the status of efforts to raise sponsors’ comfort level in that regard?
Rafaloff: First, there is an annuity selection safe harbor for defined contribution plans that was promulgated by the Department of Labor back in 2008 as a result of the Pension Protection Act. However, a lot of sponsors don’t think it’s specific enough to give them the reassurance they need. It requires sponsors to conclude that the annuity provider is financially strong enough to make all future annuity payments under the annuity contract.
EBN: What has happened since then?
Rafaloff: In 2013 the American Council of Life Insurers put forward a proposal to the Department of Labor on how it could make the safe harbor rule more meaningful to DC plan sponsors. It would allow the DC plan fiduciary to rely on the certification by its chosen insurer that it has met very specific standards with respect to state insurance commissioner review.
EBN: What are those standards?
Rafaloff: For example, the insurance carrier would have to certify that it is licensed in at least 26 states, has a clean certificate of authority from its home insurance commissioner, has audited financial statements showing it has reserves that satisfy the reserve requirements of all the states that it does business in, and could not have operated under an order of supervision, rehabilitation, or liquidation. Finally, the carrier would have to undergo a financial examination by the insurance commissioner of the state in which it’s domiciled, at least every five years. We support this proposal, we think this is a very solid outline and we hope to see some more come out of it.
EBN: That was three years ago. Is the Department of Labor going to accept any of those recommendations?
Rafaloff: In July of 2015, the department did publish a Field Assistance Bulletin, also known as a FAB, that was meant to provide further clarification on the safe harbor. It said that a plan sponsor’s fiduciary duty to monitor an insurance company’s solvency generally ends when the plan no longer offers the annuity as a distribution option, not when the insurer finishes making all promised payments. That was helpful, but there still is more clarification that’s needed.
EBN: That seems like it would provide a lot of reassurance, but you’re saying it’s not enough?
Rafaloff: The Department has recognized that questions continue to be raised about how to reconcile the selection standard in the safe harbor rule based on information that’s available at the time, with ongoing monitoring requirements under ERISA. From what we understand, the Department is considering issuing additional guidance around the annuity selection safe harbor, and we hope to see that.
EBN: If and when that happens, do you expect to see a major uptick in incorporation of annuity options in DC plans?
Rafaloff: Yes. Fewer than one in 10 plan sponsors say that their 401(k) plan includes a guaranteed income option, but a poll we recently released found that almost two-thirds of plan sponsors whose plans don’t currently include an annuity option, say that they would be at least somewhat likely to make income annuities available when the DOL completes work on an updated safe harbor rule. I also think there’s an opportunity for plan sponsors to start reframing their plans and changing how participants view annuities that are offered to them in order to increase adoption.
EBN: When plan participants do have an annuity option, how can they assess the price they are paying for the lifetime income guarantee, i.e. the insurance component as opposed to the investment part of it?
Rafaloff: Plan participants really do need help to understand how their savings are going to translate into income during retirement. Offering a robust education program on retirement income topics is critical to the success of any income annuity program. They need to understand that income annuities let them shift longevity risk, interest rate risk and market risk to an insurance company. An insurance company is the only company positioned to manage these risks, because it does so in a pooled environment. So the efficiencies that become available to participants when they’re offered these types of programs they can’t get anywhere else.
EBN: But how to educate them about the cost?
Rafaloff: When you’re looking at costs, you can talk about the differences between an institutional product and a retail product. The primary difference between the two is distribution costs, costs attributable to paying the agent. You don’t have that inside of a 401(k) plan because there is no agent, it’s part of the institutional offering. That’s really where your cost benefit is going to come in.
EBN: Still, with an annuity, no matter the what distribution mechanism, there’s a benefit — and associated cost — to shifting longevity, interest rate and market risks the risks to the carrier. How should that be communicated to participants?
Rafaloff: In the education process, you point out that there are tradeoffs any distribution option. So one of the things that we talk about a lot is the benefit of partial annuitization. Let’s say someone has $100,000 in their 401(k) plan. We’re not suggesting that people go out and annuitize that whole $100,000. You take some piece of that, annuitize it, and that becomes your guaranteed stream of income. So the rest of your assets can remain in the plan, remain fully invested, hopefully have growth opportunities in the markets. And I think that’s where people have to start becoming more educated around what retirement income means and how you can use the assets that you’ve accumulated in the most cost effective way.
EBN: In your experience, do the 401(k) sponsors that use MetLIfe annuities as a distribution also offer annuities from other carriers?
Rafaloff: We at MetLife primarily work as a sole annuity provider. Whenever there is too much choice or complexity that’s offered in defined contribution plans, participants become confused and inertia sets in, so they just don’t do anything. They toss their hands up and say, “I’m not going to do anything.”
EBN: How much interest have you seen in longevity annuities offered within a DC plan?
Rafaloff: The longevity annuities are definitely exciting. It’s been a little over two years since the regulations came out saying they do not conflict with the minimum distribution rules. To the best of our knowledge, we’re still the only insurer to offer an institutional QLAC [qualified longevity annuity contract], and we are working with many plan sponsors to make QLACs available to their participants.
EBN: In our low interest rate environment, how are fixed-rate annuities faring against variable rate annuities?
Rafaloff: An annuity can serve as an important part of a retirement plan no matter what the interest rate environment is. But it’s also true that income generated by an annuity depends on prevailing interest rates when the annuity is purchased. It gets back to education; the most important component of the income annuity is that it provides a secure and reliable level of income that can’t be outlived. While it may be tempting for plan sponsors to believe that they should alleviate all potential participant objections by offering products with many features like the variable annuities offer, we believe the simplicity has to be a more effective guiding principle for them.
EBN: What about buying a deferred annuity over a period of years; isn’t that a way future retirees can hedge their bets on interest rates?
Rafaloff: With that, you really are buying little pieces of annuity on an ongoing basis. If you go back many, many years, that’s how defined benefit plans were actually funded. So that concept has been adapted for the defined contribution plan market. But quite frankly, there has not been a lot of take-up there. I think they are probably products that are ahead of their time.
EBN: Since the underlying investment earnings on annuities accumulate tax-deferred whether the annuity is held in a retirement plan or separately, is it a waste of a tax deferral opportunity to buy an annuity in a retirement plan, instead of as a supplement to qualified plan savings?
Rafaloff: It’s really up to the individual, if they’ve saved already as much as they can in their qualified plans at work and received all the matching contributions they can, to continue to save outside of the plan. How can anybody say that’s a bad thing, right? But don’t forget that in a qualified plan, taxation of the dollars used to pay premiums for an annuity contract are tax deferred, but they wouldn’t be if the annuity is purchased outside a qualified plan.
EBN: With so much focus now in educating 401(k) participants being around the goal of income replacement instead of simply retirement capital accumulation, should sponsors offer any income replacement ratios as a rule of thumb?
Rafaloff: I don’t know that I would say there is any specific percentage, but I think what we have to look at is that income annuities allow retirees to pay for their basic expenses and to insure their money lasts at least as long as they do. Retirement income sources should be characterized two ways: Those that are guaranteed, like Social Security and any pensions, and those that are investment related — mutual funds, stocks, bonds, et cetera. I think expenses should be classified in a similar manner, essential and discretionary. Essential expenses would include your housing, cars, insurance, and those that are discretionary would be travel, entertainment, gifts, whatever. An annuity should be considered as a means to fill the gap between your other sources of guaranteed income, and essential expenses. Other retirement assets can be for those discretionary expenses.