What is the most important characteristic of a lifetime income solution for DC plans?
There are many considerations in selecting an in-plan lifetime income solution. They include longevity risk, tax implications, total accumulation value, guaranteed income vs. non-guaranteed, etc. But the crucial question is: will it help the majority of plan participants? In other words, can you default participants into it?
We already know that when plan sponsors offer lifetime income as a menu item, participants simply do not choose it. If we are going to have an impact on employees' retirement readiness, we have to use default solutions. Otherwise, we will fail.
So, whether a solution is appropriate for default is the most important consideration in the selection of a lifetime income solution.
This consideration is not limited to whether the product is technically "QDIA-eligible" (qualified default investment alternative). QDIA-eligible simply means the product meets the minimum legal criteria to be permissibly used as a default. The real question is whether a solution is QDIA-appropriate.
The test of whether a solution is appropriate as a default can be summed up in four questions:
- Is it simple for the participant?
- Does the participant avoid paying fees for a solution she doesn't use?
- Do the participant's assets have the same opportunity to grow that they would without the lifetime income solution?
- Is it fully liquid, without penalty, even when it is in pay status?
If the answer to each of these questions is yes, then the solution is appropriate as a default.
Simplicity
The focus on simplicity in DC plans in recent years has been on "auto." First it was auto-enroll. Then auto-escalate. Now it is time for auto-income.
The beauty of target-date funds is that they are simple and appropriate for default. They are ideal starting places for all the employees who take no action or who expressly prefer a "do-it-for-me" solution. Unless the participant opts out, she is automatically enrolled in a TDF series that suits her age. Thanks to the passage of the Pension Protection Act in 2006, TDFs can be used as defaults.
Similarly, thanks to the passage of SECURE 2.0, as her salary increases, her DC plan contribution can automatically escalate.
Income should be just as simple. But in most income products, it is not.
Some products require significant decision-making by the participant. The participant has to decide when she should begin to allocate to a guaranteed product and how much of her account she wants to commit to the guaranteed product — even though that product may not begin to pay any guaranteed income for more than 10 years from when she makes the decision. And once the annuity begins to pay that guaranteed income, the decision will be irrevocable and illiquid.
How can a typical DC plan participant address these questions? Perhaps in a plan serving college professors or engineers, that kind of opt-in approach makes sense. Opting-in is not a bad thing. But we already know from experience that, when plan participants are offered complicated lifetime income products on a DC plan menu, they do not choose them in any significant number.
Fees for something the participant does not use
Nobody wants to default a participant into a product that has fees for a feature of the product that the participant might not use.
For example, some products "wrap" the entire portfolio with a guarantee. This can cost a full percentage point or more annually. One could argue that the fee is worth it because the participant has the option or availability of guaranteed income. But that is cold comfort to the participant who, for whatever reason, does not want or need it.
Sacrificing growth during accumulation
Plan sponsors fear that if they default participants into a lifetime income solution, they will sacrifice growth of the participant's account value during the years of accumulation. This is a very important concern. It can occur when there is a wrap fee on the entire portfolio, as discussed above. That wrap fee is a significant drag on the growth of the portfolio. So, when a payout of a particular percentage on the total account value is promised, say 5%, that payout will be based on a smaller account value due to this fee drag.
Additionally, some products require that the participant allocate a certain percentage of his account to an annuitized vehicle. This may be perceived as safe, but it puts a constraint on growth.
These hindrances on growth do not inherently make these products a bad choice. Sacrificing growth in exchange for a degree of safety can be a good trade-off, but how can a plan sponsor default participants into these solutions that come with the actual expectation that the participant will give up growth?
Liquidity
"How can I default someone into a vehicle that she can't get out of?" a plan sponsor asks. Another says: "I don't want some 78-year-old coming to me and saying, 'What do you mean I can't get out of it?'"
Irrevocability can be part of a fair deal with the insurance company: In exchange for a guarantee, I know that the insurance carrier can keep my money. But this is not the kind of product a plan sponsor can use as a default. Some products wait until the participant is in his 60's and then ask him to choose how much of this balance and future contributions should be annuitized. Besides the difficulty of making this decision, the decision is permanent. That means that when the participant was defaulted into this product, let's say, 15 years earlier, he was defaulted into a product that would only meet its goal of guaranteed income if he would be willing to give up control or access to a significant portion of his account permanently. That does not work for a default.
If a plan sponsor wants to default participants into a lifetime income solution, it should be fully liquid, up to and through retirement, even when it is in pay status.
So, if you really want to make an impact on your employees' readiness for retirement, you should choose a solution that is appropriate for default. Such a solution must:
- Be simple.
- Not pay fees for features a participant might not use.
- Not sacrifice growth.
- Be fully liquid for life.
If you want to "check the box" and say you offer a lifetime income solution, then go ahead and make it opt-in. If you want to help the majority of your participants have a secure income in retirement, make it the default.
Charles E.F. Millard is the former director of the U.S. Pension Benefit Guaranty Corporation and is a senior adviser for ARS, a developer of lifetime income solutions. He is based in New York. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.
