Turning Target Date Funds into a Lifetime Income Stream

According to the Social Security Administration Annual Performance Plan for Fiscal Year 2012¹, nearly 80 million baby boomers will file for retirement benefits over the next 20 years – an average of 10,000 per day.  At the same time, according to the 2013 Retirement Confidence Survey² published by the Employee Benefit Research Institute and Mathew Greenwald & Associates, 48% of the survey respondents estimate that they need to save $500,000 or more for a comfortable retirement.  For those respondents who have performed a retirement needs analysis, they are “twice as likely as those who have not to expect they will need to accumulate at least $1 million before retiring.” However, according to the Federal Reserve Bulletin Volume 100, No 4³ published in September 2014, “[t]he conditional median⁴ value of retirement accounts rose 25 percent from $47,200 in 2010 to $59,000 in 2013; and the mean⁵ value rose 10 percent,from $183,400 in 2010 to $201,300 in 2013. This growth is likely explained by a combination of resurgent stock markets and increased contributions by those who participated in retirement plans.” The truth is that we are still not saving enough for retirement.

According to the Bureau of Labor Statistics⁶ December 2012 article – The last private industry pension plans – by William J. Wiatrowski,

“[h]aving sufficient income during retirement years is a concern for many Americans.  In years past, many employers provided a pension plan – formally a defined benefit plan – that ensured periodic payments for the life of the retiree and his or her spouse.  Such plans are becoming rare for workers in private industry.  In 2011, only 10 percent of all private sector establishments provided defined benefit plans, covering 18 percent of private industry employees.”

The Pension Protection Act of 2006 (PPA) recognized the shift from defined benefit (DB) to defined contribution (DC) plan as the primary retirement savings plan for American workers and introduced the Qualified Default Investment Alternative (QDIA) as a fiduciary safe harbor to professionally invest their contributions. Since then, the retirement industry began to change the dialog from investment performance to outcome performance.  By emphasizing automatic enrollment and contribution escalation, in conjunction with defaulting participants into target date funds (TDFs) as the QDIA, the new paradigm is to enhance and improve the likelihood that the desired income replacement ratio at retirement for the average participant will be attained at retirement date.  Thus, the natural progression for the next step is to create retirement income distribution solutions that will convert all or a portion of the plan assets at retirement into a predictable stream of post retirement income for life.

Fiduciary Safe Harbor – Selection of annuity providers

On October 7, 2008, the DOL issued final regulation 29 CFR 2550.404a-4⁷ to establish a safe harbor for the selection of annuity providers for the purpose of benefit distributions from ERISA covered, individual account, defined contribution plans.

The selection of an annuity provider satisfies the requirements of section 404(a)(1)(B) of ERISA if the fiduciary:

1. Engages in an objective, thorough and analytical search for the purpose of identifying and selecting providers from which to purchase annuities;
2. Appropriately considers information sufficient to assess the ability of the annuity provider to make all future payments under the annuity contract;
3. Appropriately considers the cost(including fees and commissions) of the annuity contract in relation to the benefits and administrative services to be provided under such contract;
4. Appropriately concludes that, at the time of the selection, the annuity provider is financially able to make all future payments under the annuity contract and the cost of the annuity contract is reasonable in relation to the benefits and services to be provided under the contract; and
5. If necessary, consults with an appropriate expert or experts for purposes of compliance with the above provisions.

Further, the ”time of selection” may be either:

1. The time that the annuity provider and contract are selected for distribution of benefits to a specific participant or beneficiary; as in the case of an immediate annuity; or
2. The time that the annuity provider is selected to provide annuity contracts at future dates to participants or beneficiaries, as in the case of a deferred annuity, provided that the selecting fiduciary periodically reviews the continuing appropriateness of the conclusion. A fiduciary is not required to review the appropriateness of this conclusion with respect to any annuity contract purchased for any specific participant or beneficiary.

Annuity as an investment allocation in TDFs

On October 24, 2014, the IRS issued Notice 2014-66⁸ (Notice) that offers a special rule that enables DC plans to provide a lifetime income by offering a series of TDFs that include deferred annuities among their assets and to meet the nondiscrimination requirements. The Notice uses an example to illustrate the eligibility for relief.

1. The TDF series must satisfy the conditions to be considered a QDIA within the meaning and definition of DOL regulations § 2550.404c-5(e)(4)(i)⁹.
2. The ERISA Section 3(38)¹⁰ glide path manager of a series of TDFs makes asset allocation decisions based on a consistent investment strategy but cannot hold employer securities that are not readily tradable on an established securities market.
3. Based on generally accepted investment theory (such as the body of knowledge collectively referred to as the Modern Portfolio science), the glide path manager allocates among equity and fixed income assets to achieve a progressively more conservative portfolio as participants get closer to age 65.
4. Each TDF will only be available to those participants with the corresponding birth year where their retirement year will fall narrowly around the target date.
5. TDFs within 10 years from target date will hold unallocated deferred annuity contracts in lieu of a portion of the TDF’s fixed income allocation.  This means TDFs available to participants younger than 55 will not have allocation to unallocated deferred annuity contracts.
6. The annuity contracts are issued by an insurance company that is independent from the investment manager.
7. The TDFs do not provide a guaranteed lifetime withdrawal benefit (GLWB) or guaranteed minimum withdrawal benefit (GMWB) feature¹¹.
8. Each TDF is dissolved and distributed at its target date unlike the current TDF series. The TDF at target date will not be folded into a final risk base fund.
9. Participants in the TDF. upon reaching the target date, will receive an annuity contract certificate representing the pro rata portion of the participant’s interest in the annuity contract held at the TDF.  The contract offers an immediate or deferred annuity payments in accordance with the terms of the annuity contract and the plan.  The remaining portion of the interest in the dissolved TDF is reinvested in other investment options available under the plan.
10. Fees and administrative expenses among the TDFs are determined by the investment manager in a consistent manner regardless if such expenses are paid for by the employer or plan assets.

On October 23, 2014, Assistant Secretary Phyllis Borzi of the DOL issued an Information Letter¹² in response to the IRS’s request for the DOL’s view regarding Notice.  The letter states:

1. The use of unallocated deferred annuity contracts as fixed income investments would not cause the TDFs to fail to meet the requirements of the QDIA regulation.
2. The Plan’s named fiduciary designates an ERISA section 3(38)investment manager to manage the investments of each TDF, including the selection of the provider and the unallocated deferred annuity contracts. The annuity selection safe harbor sets forth an optional means for satisfying the fiduciary responsibilities under ERISA section 404(a)(1)(B) with respect to the selection of an annuity provider or contract for benefit distributions. Consequently, the selection of the provider and the unallocated deferred annuity contracts satisfies the requirements of section 404(a)(1)(B) of ERISA if the designated investment manager satisfies each of the conditions of the annuity selection safe harbor.
3. The plan sponsor, as the appointing fiduciary, must prudently select the investment manager and appropriately monitor the selection at reasonable intervals to assure the prudence of maintaining the appointment. After the investment manager is appointed, however, the investment manager is responsible for the prudent management of the plan’s assets and selection of the unallocated deferred annuity contracts. Assuming the plan sponsor appropriately discharges its duties as the appointing fiduciary, it will not be liable for any acts or omissions of the investment manager, except for any potential co-fiduciary liability under section 405(a) of ERISA.

The Notice offers the retirement industry the first set of functional guidelines and the regulatory framework to build investment solutions that begins to incorporate lifetime income to plan participants.  The Notice also provides plan sponsors with the basic parameters and guidance to replace existing QDIAs with TDFs that addresses post retirement longevity and investment risks. More regulations, guidance, and FAQs are expected as interest grows.

The application of fiduciary standards on investment managers will push these fiduciaries to adhere to the DOL safe harbor rule for selection of annuity providers.  Further, this will systematically place pricing pressure on insurance companies and intermediaries so that the costs and terms of annuity will continue to improve through market competition.

Encouraging retirement savings and guiding employees to prudently invest over their lifetime remains important for the accumulation phase of retirement planning.  But the need to address decumulation and deliver a predictable and safe stream of post retirement income is equally urgent. To manage the retirement asset distribution phase correctly is as important as getting the right sizing for the nest egg.  We need practical and sensible guardrails from regulators, forward thinking plan sponsors who are willing to take action, and fiduciary minded mangers and consultants to innovate and develop solutions that can make the retirement phase of life more secure.

This document is provided as an informational summary regarding the subject matter by Chao & Company, Ltd. and it is intended for general information purposes only and should not be considered or perceived as benefit, legal, tax or regulatory advice. The content is neither an exhaustive discussion nor does it purport to cover all aspects or developments related to the subject matter.  Chao & Company, Ltd. has no obligation to update this document further.  Readers should consult with their legal counsel, tax advisers and benefit consultants to determine how this subject matter may relate to or impact their specifi­c situations. Please refer to the referenced source materials for a more complete description regarding the subject matter.

© 2014 10 27 Chao & Company, Ltd.www.ChaoCo.com

1. SSA-Performance-2012.pdf
2. http://www.ebri.org/files/Final-FS.RCS-13.FS_3.Saving.FINAL.pdf
3. http://www.federalreserve.gov/pubs/bulletin/2014/pdf/scf14.pdf
4. Median is the “middle” number in the list of numbers.  This means there are as many people with a retirement account value less and greater than the medium value of $59,000.
5. Medium is the “average” number among a group of numbers.  This means 50% of the people surveyed has assets below or above the mean value of $201,300.
6. http://www.bls.gov/opub/mlr/2012/12/art1full.pdf
7. http://webapps.dol.gov/FederalRegister/PdfDisplay.aspx?DocId=21588
8. http://www.irs.gov/pub/irs-drop/n-14-66.pdf
9. EBSA-2550.404c-5.pdf
10. http://www.gpo.gov/fdsys/pkg/USCODE-2011-title29/pdf/USCODE-2011-title29-chap18-subchapI-subtitleA-sec1002.pdf
11. Under a contract that provides GLWBs with respect to a participant’s account, the participant is guaranteed to receive a specified lifetime stream of income regardless of the investment performance of the account, while still retaining access to the funds in the account. This GLWB feature permits a participant to withdraw annually a certain percentage (for example, 5 percent) of a contractually specified income or benefit base. In the event that the participant’s account balance (determined without regard to any potential future GLWB payments) is reduced to $0 as a result of these guaranteed annual withdrawal amounts, the insurer will continue to pay the guaranteed withdrawal amount annually for the remainder of the participant’s life. A GMWB feature is similar to a GLWB feature, but a stream of income is guaranteed for a specified period rather than for the lifetime of the contract owner or annuitant. Treasury and the IRS are considering whether or not to provide guidance related to issues arising from the use of GLWB and GMWB features in defined contribution plans.
12. http://www.dol.gov/ebsa/regs/ILs/il102314.html