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TOPICS IN RETIREMENT INCOME SIMPLICITY IS SOPHISTICATION WHEN CONTEMPLATING RETIREMENT INCOME The tides are shifting in the defined contribution (DC) plan arena. Plan sponsors are beginning to recognize that a DC plan can – and must – play a more significant role in helping employees create guaranteed lifetime income. With the growing realization that many workers will spend as much time living off retirement assets as they spent accumulating them, DC plan sponsors have begun to reframe the goals of their retirement programs beyond the notion of a savings-only vehicle. MetLife’s 2016 Lifetime Income Poll found that a large majority of plan sponsors (85%) agree that the core purpose of a DC plan should be to serve as an income source during retirement.1 This represents a sea change from a 2012 MetLife study when only 9% of plan sponsors believed that generating retirement income was their plan’s primary focus.2 In September 2016, the Government Accountability Office (GAO) recommended to the Department of Labor (DOL) seven steps for improving retirement income options for DC plan participants. These recommendations were based on the agency’s survey of plan sponsors and a range of industry stakeholders. Yet, even before the GAO released its report, plan sponsors had begun thinking about, or implementing, strategies for recasting their DC plans from savings vehicles to income generators, according to MetLife’s survey. For DC plans governed by the Employee Retirement Income Security Act of 1974 (ERISA), nearly three-quarters of DC-only plan sponsors (70%) have already taken important preparatory steps for the future addition of an income annuity.3 The core purpose of a DC plan should be to serve as an income source during retirement, according to 85% of plan sponsors who responded to MetLife’s 2016 Lifetime Income Poll. In fact, one industry professional has suggested that, “If the vehicle doesn’t have a lifetime income option, it doesn’t look like a retirement plan.”4 In this paper we examine the various retirement income products available in the marketplace and, importantly, how plan sponsors can decide which solution or combination of solutions is best suited for their DC plan participants. Guaranteed lifetime income has become an essential metric for accurately evaluating one’s true “retirement readiness.” But the extent to which workers have access to guaranteed retirement income solutions through a DC plan, either as an accumulation option during their working years or as a distribution option at the point of retirement, or both, depends largely on the commitment by DC plan sponsors to make these solutions available. DC plans that don’t allow participants to convert all or a portion of their savings to guaranteed lifetime income are incomplete. Perhaps that’s why most retiring employees opt to take their retirement savings as a lump sum. But rationing their savings over three or more decades may be a bumpy ride for those who take the lump sum or attempt to manage a drawdown strategy, as academic research shows that as many as 57% could run out of money in today’s economic climate.5 SIMPLICITY: THE ESSENTIAL ELEMENT IN STRUCTURING A RETIREMENT INCOME SOLUTION When determining how best to design a retirement income solution for DC plan participants, in words often attributed to Leonardo da Vinci, “Simplicity is the ultimate sophistication.” Plan sponsors appear to agree with this thinking. A majority of plan sponsors (90%) believes that “it is in the best interests of plan participants to keep plan design changes simple, since complexity, such as too many choices and features, often leads to participant inertia.”6 For this reason, beginning with a “back-to-basics” approach when considering retirement income plan design changes may be the most constructive – and sophisticated – strategy for plan sponsors to employ. Plan sponsors generally must decide whether to structure their retirement income approach as an accumulation option alongside the plan’s investment options or as a distribution option at the point of retirement. Sponsors will also want to determine whether to offer a fixed or variable product. In order to select the option that is most appropriate for the plan, sponsors should take into account the financial acumen of the participants, the ease by which the offering can be communicated and the cost of the guarantees, among other considerations. Additionally, they should adopt education tools that make the most sense for their participants. By offering retirement income options as a component of – or a complement to – their DC plans, employers are giving their retiring workers access to programs that are institutionally-priced, and therefore, generally more competitive than those available in the retail annuity marketplace. As such, they have the potential to deliver outcomes that are 10% to 20% higher.7 SOME RETIREMENT INCOME PRODUCTS ARE MORE CONFUSING THAN OTHERS Institutional retirement income options available today offer benefits that range from maximum income flexibility to maximum income guarantees. A systematic withdrawal plan (SWiP) is at one end of the spectrum, offering full flexibility but few guarantees — thereby exposing retirees to market volatility and longevity risk. At the other end of the spectrum is a fixed income annuity that offers maximum guaranteed income for life. Along the middle of the spectrum are variable deferred annuities offered to participants during the accumulation phase, such as guaranteed lifetime withdrawal benefits (GLWBs), guaranteed minimum income benefits (GMIBs) and guaranteed minimum withdrawal benefits (GMWBs). These products, which provide income flexibility and guarantees at an additional expense, include features that are designed to overcome a number of objections that participants have to annuities 2 (e.g., lack of liquidity, an inability to benefit from investment gains, etc.). Because these products are typically embedded in the plan’s target-date default option into which employees who make no elections are automatically enrolled, some sponsors believe they serve the dual purpose of providing opportunities to participate in the investment markets while at the same time delivering income guarantees for participants who might otherwise be biased against annuities. Although the sheer number of DC plans offering these income products may – on its face – seem impressive, experience has shown that there is a fairly low take-up rate on these products – most likely because they are too complicated for the majority of plan participants to understand and too complicated for sponsors to successfully communicate. While many participants and sponsors may find the “concept” of guarantees attractive, nearly six in ten plan sponsors (58%) do not believe that withdrawal solutions with minimum guarantees are easy to understand for the average DC plan participant. Certain Approaches That Involve Variable Annuities, Particularly Those That Try To Address Every Need, Can Be Complicated For Participants During Their Saving Years In a GMIB approach, participants buy into a fund that provides a minimum income benefit with the potential for upside appreciation. The upside appreciation comes from the investment performance of the fund that is associated with the annuity; typically, this is a balanced fund. The minimum (or floor) income benefit is determined by using conservative annuity purchase rates. Upon retirement, the participant will receive the higher of the minimum income guarantee (the floor) or the income generated by the current annuity purchase rates applied to the market value of the account. Once the annuity is purchased, generally there is no liquidity. The participant may choose not to annuitize and withdraw the market value of his or her account in a lump sum. The GLWB (also known as the GMWB) approach combines systematic withdrawals with a potential income guarantee. These products are often structured as a DC plan investment (i.e., target-date or risk fund) that can guarantee a fixed withdrawal amount regardless of a participant’s actual account balance at retirement. At a specified age the assets are moved into a guaranteed fund component and “wrapped” with a guaranteed percentage withdrawal amount, say 4% or 5% of the asset base. Each year, positive investment performance will result in a reset or “step-up” of the asset base to the increased current value of the assets; however, the asset base is kept unchanged at the prior level in the event of a market decline. Upon retirement, the participant is eligible to withdraw the guaranteed withdrawal amount, while leaving the remaining assets in the market. However, excess withdrawals over a stated amount and other participant actions may trigger penalties and/or reduce the guaranteed withdrawal amount. FIXED-INCOME ANNUITIES AS DISTRIBUTION OPTIONS: 401(K) “COMPLETERS” Offering fixed income annuities as a plan distribution option allows retiring participants to use all or a portion of their plan assets to purchase a guaranteed fixed income stream for life. Sometimes referred to as 401(k) “completers” because they round out or “complete” the retirement readiness process, the most common of these are immediate fixed income annuities and qualifying longevity annuity contracts or QLACs. Unlike products designed for maximum income flexibility, income annuities do not seek to address all plan participant objections in a single product, but permit the participant to break the retirement income decision down into separate steps that can be as simple 3 or intricate as the participant chooses, and more cost effective. In contrast to GLWB, GMWB and GMIB approaches – where by virtue of the investment management fees associated with these accounts participants are, in effect, paying for access to upside market potential – immediate fixed income annuities and QLACs used in combination with systematic withdrawal payments (a SWiP approach) afford participants the flexibility to create their preferred amount of guaranteed lifetime income. Income Annuities As Distribution Options: A Plain And Simple Approach Immediate fixed income annuities offered as a distribution option allow participants to use a portion of their retirement savings to purchase an immediate income stream that is guaranteed for as long as they live, while their remaining assets can be more efficiently invested to potentially grow their overall portfolio. Because income annuities produce the highest level of guaranteed income per dollar of assets, an average retiree would need to save about one-third more to replicate the power of the lifetime income annuity. While a retiree trades off a bit of liquidity for the portion of assets put into an annuity, he or she likely will have more income to spend overall. A qualifying longevity annuity contract (QLAC), also known as “longevity insurance,” is a type of deferred fixed income annuity (DIA) where income payments begin at an advanced age – typically 80 or 85. Approved by the U.S. Treasury Department in July 2014 for use as a distribution option in employer-sponsored individual account plans, QLACs can be purchased with the lesser of 25% of a participant’s account balance, or $125,000. Assets allocated to the purchase of a QLAC are not included in the balance used to calculate required minimum distributions (RMDs) for participants beginning at age 70½. By lowering the annual RMDs that participants must take in early retirement, more money can remain in the participant’s DC plan with the potential to grow. Additionally, by delaying payments to a later age, the participant can increase the income amount that is possible when the QLAC’s guaranteed income payments begin. At the time of purchase, features can be added to a QLAC that offer inflation protection and provide for a return of premium (ROP) death benefit payable to designated beneficiaries in the event the participant dies. However, QLACs generate the most amount of income with the fewer options participants elect. RETIREMENT INCOME IN ACTION How an Immediate Income Annuity Compares to a SWiP Approach: Let’s assume a participant has identified the need for $600 of monthly income replacement in retirement. Purchasing an immediate income annuity at age 65 with $100,000 would guarantee this amount to the participant, each month for life. Under the SWiP approach, if the participant at age 65 allocates $100,000 to an investment account at an assumed 4% annual rate of return, withdrawals of $600 each month would deplete the account by the time the participant reaches age 85. Using a portion of savings, this participant could purchase lifelong income to cover fixed costs via an annuity, with the balance of savings left in the plan and available for use as he or she chooses. 4 Immediate Income Annuity Provides $600 per month for Life Provides $600 per month to age 85 Alternative Investment Initial Investment of $100,000 85 +4%/yr This is a hypothetical illustration for illustrative purposes only. The immediate income annuity illustrative payout is based upon the Annuity 2000 Mortality Table D, a 4% interest rate assumption, no expense load and a single life only payout. For the alternative investment, the illustrative funds being withdrawn monthly are based on an annual 4% rate of return assumption. Comparing an Immediate Income Annuity to a GLWB Approach Let’s assume a participant contributes $10,000 to a retirement savings account beginning at age 45, and contributions continue for the next 20 years. Under one scenario, at age 65 the participant uses the funds accumulated in the plan to purchase a single life immediate fixed income annuity using actual MetLife purchase rates as of 1/1/2016 (unisex DC plan rates are applied). Under another scenario, the participant purchases a GLWB contract where the GLWB feature is activated at age 55 at which time a 1% guarantee fee and 5% guaranteed income rate are applied. Under both scenarios, the funds are invested 85%/15% in equity fixed at age 45, then move to 50%/50% in equity fixed at age 55, and remain constant thereafter. Fixed income returns are based on historical Barclays U.S. Aggregate Bond Index returns. Equity returns are based on historical S&P 500 returns. The investment period used here runs from calendar year 1996 through calendar year 2015. • Account Balance: Annuities purchased at retirement allow more time for savings to accumulate in the plan. Additionally, fees associated with the GLWB can be significant, resulting in lower accumulated account balances. In this example, at age 65, the balance available to purchase an income annuity would be 8% higher than the balance in the GLWB account ($417,000 vs. $385,000). Income Annuity Versus In-plan Lifetime Withdrawal Benefit (GLWB) Plan Balance at Age 65 $417,000 $385,000 Plan balance to purchase an income annuity GLWB plan balance 5 • Guaranteed Income: Income annuities offer the highest payout when compared to any other annuity option. In this example, the yearly payout from an income annuity would be 44% more than the GLWB yearly payout beginning at age 65. After 20 years in retirement, the total payout from the income annuity would be $556,000 versus $385,000 from the GLWB. Income at Age 65 Provides $27,800/yr Guaranteed Income Provides $19,250/yr Guaranteed Income Income Annuity GLWB Based on plan balance of $417,000 Based on plan balance of $385,000 • Guaranteed Income, plus liquidity and flexibility: Using only a portion of a participant’s account balance to purchase an income annuity at age 65 would provide the same $19,250/year payout as a GLWB – but with an additional $128,000 in liquid funds remaining. With the GLWB, any amount that is taken from the account will reduce the guaranteed benefit. Income & Liquidity at Age 65 Each will provide $19,250/yr Guaranteed Income $128,000 remaining liquid funds Cannot be liquidated without impacting the income guarantee $289,000 for income annuity purchase $385,000 Plan Balance Plan Balance used to purchase Income Annuity Lifetime Withdrawal Benefit (GLWB) Plan Balance For sponsors concerned about the administrative complexities of offering income products, annuities purchased at the point of retirement pose significantly fewer recordkeeping and portability challenges than in-plan solutions. From a communications perspective, annuities as distribution options are simpler and, therefore, easier for participants to understand – involving far less education challenges than income options included in a plan’s investment lineup. 6 Comparison of Retirement Income Options Feature SWiP GLWB Income Annuity Guaranteed Income for Life No Yes1 Yes Guaranteed Payment Amount No Yes1 Yes Provides Liquidity Yes Yes No Variable Investment Options Yes Yes No Eliminates Asset Fees No No Yes Immune to Market Volatility No No Yes Simple Implementation Yes No Yes Easy to Understand Yes No Yes Easy Portability Yes No Yes Inflation Protection No No Yes2 All product guarantees are subject to the financial strength and claims-paying ability of the issuing insurance company. 1 Excess withdrawals may affect guarantee 2 If COLA rider is chosen CONCLUSION When assessing the benefits of adding a retirement income component to a DC plan, it is worthwhile to note that current maximum income flexibility options – designed to offer the potential to both grow savings and guarantee income – have ironically resulted in even greater complexity for participants. If the ultimate goal is to enable the opportunity for guaranteed lifetime income – plain and simple – DC plan sponsors should give careful consideration to plan design options that avoid unnecessary complication. As the benefit of time will likely prove, plan participants can do no better than the guaranteed payout from an income annuity distribution option. 1 2 3 4 5 6 7 M etLife 2016 Lifetime Income Poll M etLife Retirement Income Practices Study, July 2012 M etLife 2014 Qualified Retirement Plan Barometer A lan Glickstein, Watson Wyatt Worldwide Inc., Dallas Witnesses to a Revolution, Pensions & Investments 40th Anniversary Issue October 14, 2013 T he 4 Percent Rule Is Not Safe in a Low-Yield World, Michael Finke, Ph.D., CFP®; Wade D. Pfau, Ph.D., CFA®; and David M. Blanchett, CFP®, CFA® M etLife 2016 Lifetime Income Poll S tanford Center on Longevity, see article A Step Closer to Fixing a Serious 401(k) Flaw 1610-692423 CS L1116483386[exp1117][All States][DC] © 2016 METLIFE, INC. Metropolitan Life Insurance Company 200 Park Avenue New York, NY 10166 www.metlife.com/retirementincome