Annuities struggle to gain foothold in 401(k) plans

Sponsors of 403(b) plans are light-years ahead of their 401(k) peers when it comes to offering annuities within their plans.

More than half of 403(b) plan sponsors (53.5%) offer annuities as a retirement distribution option, whereas only 17.2% of 401(k) plan sponsors provide them, according to the Plan Sponsor Council of America's recent survey of 379 organizations that have 403(b) plans.

Why the threefold greater adoption of annuities by 403(b) plan sponsors? It's not that 403(b) plan sponsors are bolder or any less worried about lawsuits than their counterparts in the 401(k) world, experts say.

The plans have simply been around much longer than 401(k)s and have had the benefit of time on their side. 403(b) plans first appeared in 1958, arriving when insurance companies were the primary service providers to retirement plan sponsors in the non-profit sector. The 401(k) plan, in contrast, didn't debut until 1978.

"It's really a legacy of the 403(b) record-keeping industry," said Michael Volo, a principal at CAPTRUST Financial Advisors in Boston, explaining that the early providers to 403(b) plans were insurance companies that typically offered what he called traditional "fixed accounts."

These fixed accounts were in essence fixed annuity products that offered a minimum rate of return and were conservatively invested in the general accounts of the insurance companies offering the annuities, Mr. Volo said.

To this day, traditional fixed accounts "are still pretty prevalent in 403(b) plans as well as some 401(k) plans," he said.

Without doubt, insurance companies have left an indelible mark on 403(b) plans. Today, eight of the top 10 record keepers to the 403(b) market are insurance companies, including market leader TIAA-CREF, which as of Sept. 30, 2020, had $464.5 billion in 403(b) assets, according to Pensions & Investments' data.

The primary reason that 403(b) plans are more likely to offer annuities than 401(k) plans is that "insurance companies dominate the 403(b) space more so than mutual fund companies and pure record keepers," said Michelle Richter, executive director of Institutional Retirement Income Council in New York.

Other industry observers attribute the greater use of annuities by 403(b) plans to the fact that the plans were designed from the start to mimic traditional pensions with a guaranteed income stream, unlike 401(k) plans that were designed to supplement pensions.

"403(b)s were designed to be core pension plans, and that's why they had annuities," said Tim Walsh, Boston-based senior managing director at TIAA-CREF.

When Congress added section 403(b) to the Internal Revenue Code in 1958, the addition "identified 403(b) plans as tax-sheltered annuities that created pensions for public school and university employees, many of whom didn't have a pension or a defined benefit plan that corporate employees had," Mr. Walsh said.

Until 1974, 403(b) plans offered only annuities as they weren't allowed to offer mutual funds, a fact that gave 403(b) plan sponsors a big lead over their 401(k) counterparts in the adoption of annuities, Mr. Walsh said.

More than half of 403(b) plan sponsors offer annuities and others that don't are considering them. Mohammad "Mo" Raihan, assistant vice president of HR retirement services at the New York City Health and Hospitals Corp., for example, is looking to add an annuity option to his organization's $3.5 billion 403(b) plan.

"We are looking into it aggressively," he said, adding that he's shooting to have an option in place by next year.

While the large public health-care system offers employees pension benefits and financial wellness programs, it strives to emphasize to employees that their pensions — even when combined with Social Security — may not be enough for their retirement, Mr. Raihan said.

Having some form of guaranteed retirement income is "a really great opportunity for employees to keep them secure," he said.

Mr. Raihan pointed to the market downturn following the 2008 financial crisis and more recently the market drop triggered by the pandemic last year.

"I don't think people were in a very good place to retire, but had this income option been available, they would still have been able to retire because they would have had that fixed stream of income with the annuity option," he said.

NYC Health and Hospitals is evaluating the "products that the industry is slowly rolling out in the area of annuities," said Frank Picarelli, a senior vice president in Segal Marco Advisors' New York office and the investment adviser to the health-care system's 403(b) plan.

The organization is looking to introduce a series of target-date funds into the plan and is also evaluating different investment managers that are now rolling out target-date funds with "an annuity type of insurance feature to guarantee lifetime income," Mr. Picarelli said.

"Let's get a good target-date fund in, and if it's a target-date fund that has an annuity and we're eligible for it, we'll look at it," he said.

In addition to target-date funds, NYC Health & Hospitals is considering in-plan annuities as well, Mr. Picarelli said.

Mr. Raihan started thinking about adding an annuity option to the plan investment menu in 2020 after the pandemic hit but was also partly motivated by the SECURE Act, legislation passed in December 2019 that created a fiduciary safe harbor for plan sponsors offering annuity options.

"The SECURE Act was one of the factors that really got me into having more discussions around the annuity option in the retirement plan," Mr. Raihan said.

The SECURE Act provides a safe harbor for defined contribution plan sponsors provided they meet minimum fiduciary requirements in choosing an annuity provider, thereby limiting sponsors' liability — and risk of being sued — should the annuity provider go out of business.

Proposed legislation introduced in the House in May — The Securing a Strong Retirement Act, also referred to as SECURE Act 2.0 — would open new possibilities for 403(b) plan sponsors in particular. The legislation would allow 403(b) plan sponsors to offer collective investment trusts in their plan lineups, giving them the opportunity to expand beyond the annuities and mutual funds to which they are now limited.

Whether the SECURE Act will help close the gap between 403(b) plans and 401(k) plans in offering annuities is an open question.

"It's not likely," said Robyn Credico, Willis Towers Watson PLC's Las Vegas-based defined contribution consulting leader.

Ms. Credico noted that the safe harbor under the SECURE Act is limited.

"Having some level of fiduciary protection is fine, but not every annuity falls into that safe harbor," she said.

Ms. Credico also said that the administrative requirements of offering an annuity option are challenging, creating an impediment for plan sponsors.

Other obstacles include educating employees about the complicated products and issues that arise when changing record keepers, she said.

CAPTRUST's Mr. Volo was more optimistic in his views. "I do think we'll see greater adoption in the 401(k) space," he said, citing the SECURE Act.

Still, he said, there are "hurdles to overcome," including simplifying the products and enhancing participant understanding of those products.

"We now have the safe harbor, but we haven't seen an explosion in the adoption of annuity products, and so it will still be a little bit of a slow roll," he said, adding that he sees momentum picking up among 401(k) sponsors over the next two to three years.