With pensions gradually being phased out, 401k plans emerged as the premier retirement savings tool. But within these plans, participants have often been unsure about participating, deciding what percentage to defer, and largely uneducated on what to invest in.
Fortunately, over the past 15 years many of these challenges have been addressed with improved plan design solutions offering more help for participants. Features like auto-enrollment, auto-escalation and target-date funds all added great value to the industry. Yet all of those features merely addressed the accumulation phase of the retirement journey. The lack of the ability to “pensionize” defined contribution retirement has been a void discussed, debated and legislated greatly in the past several years.
To meet these needs, the industry has lobbied for protections to be codified allowing solutions to be manufactured based on established guidelines which has led to product innovation. The SECURE Act helped fill this void, allowing the issue of retirement preparedness to come to the forefront. Despite the impact of fee compression, this new frontier allowed recordkeepers, fund companies, and advisors to potentially fulfill participant needs while potentially generating new revenue sources. As a result, industry players worked, and are working, to make needed product solutions while allowing them to replace some of their lost margin and profitability.
Innovation has led business cycles for several hundreds of years. If successful, these innovators are rewarded with strong returns, and then enter the next stage of the business cycle, where they begin defending their business from competitors entering the market. Competitive options typically flood the market many years after a business model is proven, leading to commoditization and fee compression. As margins shrink, consolidation follows and many businesses fail as they can no longer compete at the lower margins. Guaranteed income is clearly in the very early stage of innovation.
Many companies are innovating, yet more are simply repackaging fixed annuities and immediate annuities as “new” solutions and hoping that no one notices.
Yet it is important to delineate innovation from repackaging. Companies thinking short-term who choose to skip innovating and simply repackage old solutions, trying to retrofit them to meet today’s needs, do so in an effort to get to market quickly. The retirement industry is experiencing this today with guaranteed income solutions. Many companies are innovating, yet more are simply repackaging fixed annuities and immediate annuities as “new” solutions and hoping that no one notices. In the case of merging fixed and immediate annuities into retirement plans, companies are repackaging solutions that have been around for over 50 years.
In retirement, the biggest fear most people have is outliving their money. The fear of having to depend on their children for help when their purchasing power declines to unsustainable levels, and losing their independence is very real. The knock for decades on these versions of annuities is that they would lose purchasing power over time, and the investor forfeits his principal the very day they take income. In the 1980s when the average age of death in our country was in the low 60s, these were questionable products at best. Today, with the average age of death being in the mid to late 80s, these products simply are not viable, as the longevity risk has increased dramatically.
For example, suppose you retired last year in 2021, chose a repackaged immediate or fixed annuity solution, gave up your principal and began living on annuity income for the rest of your life. In one year, due to inflation, you would have lost over 9% of your buying power. Imagine compounding just 4% inflation rate for four more years, and you will have lost over 27% of your purchasing power in the first five years of retirement. Are these the solutions that are going to solve the needs of tens of millions of retirees in this country? Innovation is needed.
It is not solely the availability of products causing challenges, but rather the lack of education that poses the greatest challenge. Participants need to be educated on the pros and cons of various guaranteed income vehicles. A focus must be placed on how all products make their money, what they charge, and what the real cost is for investors. The industry reverts if it believes offering proprietary products with hidden fees (to make up for margins lost during this fee-compression cycle) is the answer. How does recommending 100% proprietary solutions that show zero costs to their investors help participants, plan sponsors and consultants?
The industry spent years trying to get away from proprietary fund lineups with embedded sub-ta and 12b-1 fees that investors didn’t understand. There was at least some disclosure about 12b-1 fees in mutual funds. Fixed annuities operate implicitly in a world of fees, which investors and plan sponsors mistake for free solutions. The net-yield margins on the insurer’s general accounts are many times higher than the “high-cost” mutual funds were vilified for.
Advisor capacity
While many challenges exist, the one rarely mentioned is the strain on consultants and advisors caused by this new trend. Since fee compression, these professionals have had to do more work, offer more services, and face more competition. Essentially doing more for less money.
In a world of new solutions, professionals are now expected to be experts and evaluate the marketplace. Professionals are not all created equal. Some have made this a priority and are self-educating themselves. Yet, many exceptional advisors who simply don’t have the resources and unfortunately, the interest to do so.
This leads to advisors being drawn to solutions advertising zero fees. That path is understandably attractive to them, as opposed to trying to swim upstream. If advisors are not confident in their relationship with a client, they’ll most likely avoid showing a solution that fully discloses their fees and looks more expensive, despite knowing those that disclose are very likely less expensive than those claiming a zero-fee structure.
A rapidly changing industry faces these dilemmas often. Are you willing to lose a client over showing them fully transparent solutions or use solutions that tout no costs in order to face less scrutiny?
Imagine asking participants today, many of whom still do not understand target date funds, to make an irrevocable decision the day they retire. What will happen when millions of participants realize that they cannot access their money after their annuity payments begin?
It is truly an honor to work with some of the best advisors on this topic, many of whom are competitors. The fact is that the level of knowledge in this space has grown immensely in the last two years.
Our organization believes there are better options: products that clearly disclose fees, products that are multi-managed, multi-insured and portable among recordkeepers, as well as ones that offer fiduciary protection during investment selection. But to a part-time retirement plan consultant or an undiscerning advisor, products like these can “appear” more expensive.
As a result, we embraced this space starting in 2015. We believed the industry would head this way long before SECURE Act 1.0. For over 20 years, our firm has conducted extensive meetings with plan participants. We acknowledge that they want guaranteed income solutions that are simple, easy and most importantly flexible.
Fixed annuity and immediate annuity products, meanwhile, are irrevocable as soon as the income starts. Imagine asking participants today, many of whom still do not understand target date funds, to make an irrevocable decision the day they retire. What will happen when millions of participants realize that they cannot access their money after their annuity payments begin?
Therefore, our approach has been to establish a set of very simple principles:
- The product must be easy for the participant to understand
- It cannot invest 100% of the money into one product manufacturers funds (i.e. no proprietary solutions allowed)
- It must allow participants full access to their funds at all times with no surrender charges
- We require it to be multi-insured (are you prepared to risk every dollar of every investor with one company?)
- It must allow them to fully participate in the market upside (no other path that we are aware of will protect from longevity risk other than outpacing inflation)
- It must provide at very least a minimum guaranteed income that is higher than industry accepted recommended withdrawal rates of 3.8% to 4.5%
These principles lead us to prefer Guaranteed Minimum Income Benefit (GMIB) and Guaranteed Lifetime Withdrawal Benefit (GLWB) solutions of which there are various offerings in the marketplace today.
Impact of economic downturn
The current economic downturn only emphasizes the need for guaranteed income. Industry withdrawal standards typically show, at the high end, no more than 4.5% of their savings in any given year. Therefore, we look for solutions that offer that or higher.
These solutions typically will provide a strong minimum income if the markets face the challenges they do today and a considerable upside if the markets happen to perform well.
Generational reckoning
A whole generation is currently approaching retirement without the pension benefits enjoyed by previous generations. Many face the prospect of retiring with the lack of knowledge to make their money last. With this burden shifted to retirees, above all, we must provide education—to these retirees and equally to plan sponsors.
The vast majority of plan participants and sponsors say yes when asked if they want products that provide guaranteed income in retirement.
Regardless of how we solve this, the tidal wave of retirees coming to decision time presents a major industry challenge. A shortfall of knowledge with millions retiring and missing the opportunity to have a viable guaranteed solution at retirement is going to be tragic for too many.
The path forward
It is when advisors/consultants take the lead that things begin to change. Rather than discussing general trends at conferences, we need to have more focused conversations. As part of this discussion, let us openly discuss specific product types at a high level, as well as create more product-specific study groups and discussions.
I realize these perspectives may not be similar to yours and because of that I want to have an open dialogue and debate with my peers, and we should begin this process sooner rather than later. We should have webinars where advisory groups with different points of view debate actual product types, actual available solutions, respectfully with end-users in mind.
Whenever a problem arises, the best advisors say, “we have to solve that.” The industry clearly recognizes that retirees need guaranteed income solutions. Through the years we have seen the industry transform. Cash and stable value investments were used regularly in the early days of DC plans which were often used as the default holding. Once large-cap funds became more popular, they provided superior returns to cash and stable value offerings. Target-date funds (TDFs) came along and revolutionized the way defined contribution retirement plans operated, once again improving the experience for participants.
There is a real desire on the part of all parties to create solutions to ensure participants are able to secure an income, and with an aging population, could this be the next evolution that improves the outcome of participants? We believe it will.
EDITOR’S NOTE: The preceding op-ed was contributed to 401(k) Specialist by Scott Colangelo, Chairman and Managing Partner of Qualified Plan Advisors.