Promoting appropriate annuity options in 401k and other DC plans is a challenge worth taking on, a new policy brief from the Retirement Security Project at Brookings concludes.
The policy brief summarizes legislative and regulatory changes to encourage 401k and other defined contribution (DC) plan sponsors to offer annuities as retirement income options and to encourage workers to select them.
The July 24 brief, “Reducing regulatory obstacles to annuities in 401k plans,” is authored by J. Mark Iwry, nonresident senior fellow in Economic Studies at Brookings and Visiting Scholar at the Wharton School, along with Brookings’ William Gale, David John, and Victoria Johnson.
Greater use of income annuities, the authors state in the brief’s conclusion, promises to increase retirement security and provide meaningful help in addressing retirees’ decumulation dilemma.
“DC plans could begin to offer lifetime income to tens of millions of participants, with group purchasing, institutional pricing, economies of scale, and behavioral strategies,” the brief states. “To that end, we propose policy reforms to establish an appropriately worker-protective fiduciary safe harbor for the selection of annuity providers, increase annuity portability, and reform the RMD regime. These changes would provide an important start toward restoring the pension to our private pension system.”
It notes that while automatic features have mitigated many concerns for workers during accumulation, they have not done so for decumulation. Retirees face a key dilemma as they consume their retirement resources: how to manage the risk of outliving their savings without unnecessarily sacrificing their standard of living.
Commercial income annuities appear to have significant potential to improve retirees’ well-being, but the market for such products has proven small to date, the authors note. Despite the theoretical advantages of annuities, less than 2% of all U.S. retirement assets are held as fixed annuity reserves.
Why the retirement income annuity market is not larger is a key question for policymakers and researchers. Numerous factors limit annuity participation, including the fact that Americans already own annuitized wealth through Social Security and (effectively) Medicare, that annuities are often expensive (or are perceived as such), and that income annuities generally need to be illiquid.
Behavioral research identifies additional factors that make people hesitant to buy them, and negative press coverage has also impacted consumer perception of annuities.
“While problematic product designs and sales practices for some types of annuities are also a factor, they should not obscure the fact that straightforward and competitively priced commercial income annuities can play an important, pro-consumer role in retirement planning,” the authors state.
Fiduciary Liability
Perhaps the biggest obstacle to greater utilization of annuities to provide retirement income from employer-sponsored plans is sponsors’ fear of long-term fiduciary liability for selecting an insurer that ultimately fails to meet its obligations.
“We recommend mitigating the risk of liability by enacting an appropriate statutory fiduciary safe harbor for DC plan fiduciaries who select annuity providers that are highly qualified (highly rated for financial strength). We also recommend exploring the need for a ‘universal’ independent fiduciary,” the brief says.
Plan sponsors fear potential long-term fiduciary liability for violating the Employee Retirement Income Security Act of 1974 (ERISA)’s high standard of prudence when selecting and retaining annuity providers. These and other considerations have discouraged many 401k plan sponsors from offering annuities.
As an alternative to the vague and confusing Department of Labor steps fiduciaries must take to satisfy ERISA requirements, the authors note a simple, straightforward and objective statutory safe harbor is one of many provisions included in recent legislative proposals like the Retirement Enhancement and Savings Act (RESA) and the SECURE Act.
“The pending legislative version, however, has no financial strength standard. It does not even favor financially stronger providers; instead, it grants the same stamp of approval to virtually any annuity provider that has been licensed to do business for seven years,” the brief states, adding it falls short in protecting retirees, protecting and giving confidence to plan sponsors, and remaining true to the policy underlying ERISA’s high fiduciary standards.
“Our recommended safe harbor would be unambiguously limited to selection of the annuity provider based on its financial strength and stability; it would not apply to fiduciaries’ decisions regarding the type, price, or other terms of annuity contracts,” the authors state, saying those decisions would continue to be subject to ERISA’s regular fiduciary standards.
But the safe harbor would streamline the full fiduciary analysis normally required to prudently select an insurer. It would enable plan fiduciaries to rely on appropriate third-party factual information (though often transmitted through insurer representations) regarding the insurer’s financial capability.
“We recommend that a fiduciary safe harbor include a meaningful quality standard—expressed through simple, objective indicators—relating to insurers’ financial strength.”
ERISA’s fiduciary standards typically look to each plan sponsor to engage its own expert consultant or independent fiduciary to assess each insurer’s long-term financial strength.
“This is unnecessary and inefficient,” the authors say. “As a possible eventual alternative to NRSRO financial strength ratings as a key element of a safe harbor, a strictly independent, expert, non-profit entity might perform this analysis for all plans.”
For example, the DOL could assist in establishing or certifying such an expert entity to serve as a kind of universal independent fiduciary to advise solely on the financial strength of annuity providers for ERISA purposes.
Alternatively, the authors say the responsibility could be delegated to one or more existing government agencies, respected professional organizations, or other non-profit entities, which might set up a panel of independent experts with a dedicated staff.
Annuity Portability
The limited portability of annuities is a second key regulatory concern addressed in the brief.
A plan sponsor that discontinues offering an in-plan annuity in which contributions have been invested interrupts the steady accumulation of annuity benefits. Contributions stop, and employees may be subjected to annuity liquidation or surrender fees, unless they move the annuity to another plan or IRA.
“However, because the law generally prohibits current employees from making such a distribution, we propose a legislative exception to the 401k plan withdrawal restrictions to allow current employees to withdraw and directly rollover an in-plan annuity to an IRA or another employer plan that would accept it,” the brief says.
RMD Rules
The authors take issue with current Required Minimum Distribution rules, noting that they are not designed to serve as guidelines for optimal asset decumulation and do not match most retirees’ needs.
“We propose to completely and permanently exempt from RMDs all retirees with average or below-average retirement balances. The maximum aggregate balance (qualified plans and IRAs) qualifying for the exemption would be $100,000 as of age 70 (phasing out ratably over the next $10,000) with a view to exempting a majority of retirees,” the authors say. “However, this RMD dollar threshold should be adjusted upward (not to exceed $250,000)—or, if necessary, downward—depending on the affordability of the estimated revenue cost.”
The brief proposes to offset the revenue cost of this exemption by closing a sizable gap in the RMD regime. Wealthy retirees can currently defer and reduce taxes by leaving their retirement savings to be paid after their death to young heirs over the heirs’ entire life expectancies (via a “stretch” IRA). “Instead, we would generally require distribution to be completed within five years after the retiree’s death,” the authors say.
Notably, if the SECURE Act becomes law in its current form, eliminating the stretch IRA is one of the ways it would be paid for. As written in the proposed legislation, the entire IRA or retirement plan would have to be distributed within 10 years of the death of the IRA owner.
The brief further recommends regular updating of the RMD life expectancy tables, requiring IRA trustees to automatically calculate RMDs for IRA owners, simplifying and harmonizing Roth and traditional IRA age 70 1⁄2 distribution and contribution rules, and clarifying that the RMD rules do not permit DB sponsors to buy back ongoing DB plan life annuities.
• READ THE POLICY BRIEF AND FULL PAPER HERE