As a 401(k) plan sponsor, your sole goal is to make sure that your employees, especially those nearing retirement, have enough money saved and are well-prepared for retirement. You usually do that by auto-enrolling employees in the plan, making matching contributions, and then auto-escalating employees’ contributions on an annual basis until a threshold of about 15% of their annual pay is reached. However, despite all these extremely important “tricks,” sometimes they are not enough. You may want to take it one step further and make sure that a retiring employee doesn’t do anything wrong or irreversible.
For example, it is not uncommon for an employee to have an improper asset allocation just before retirement. Many 401(k) plan participants nearing retirement instead of being conservatively invested more in fixed-income products, remain heavily invested in equities. This mistake alone can put their retirement under jeopardy as they won’t have enough time to recover should the market tank. To prevent this from happening and protect your employees’ hard-earned money you can conduct educational sessions for retirees on asset allocation and retirement income strategies. Or you may even consider offering a one-on-one meeting with a financial adviser which could create a specific plan of action.
Another possible way of addressing this issue and protecting employees’ financial future could be incorporating annuities into their overall retirement income strategy.
In a very simple form, an annuity is a contract with an insurance company that guarantees a future payout, whether monthly, annually, or in a lump sum. Annuities can take many forms and aren't always the easiest or most transparent instruments to comprehend. But there are two types that we believe could be beneficial for your retirees that are looking to minimize investment risk and generate an ongoing stream of income for life. These are fixed annuities and variable annuities with a guaranteed lifetime withdrawal benefit (GLWB) rider.
Fixed annuities are the most common and easiest to understand. When an employee approaches retirement he or she can purchase an immediate fixed annuity using the money in his or her 401(k) account. Usually the payment is in the form of a lump sum and once made, your employee can expect to receive a fixed monthly payment for life. The investment risk is then transferred to the insurance company and no matter what happens with the market, the payment is guaranteed (as long as the insurance company itself remains solvent). This makes fixed annuities an extremely reliable source of retirement income. The longer your employee waits to annuitize it the higher the monthly payment is going to be.
Variable Annuities with a GLWB Rider
Variable annuities with a GLWB rider work differently than fixed annuities. During the accumulation phase an employee nearing retirement can begin to relocate the money from traditional asset classes like stocks and bonds into the annuity. Then inside the annuity the employee will be presented an option to move the money into investments offered by the insurance company. It is extremely important to know in advance what investment options are available as some funds could be very expensive and have complex investment strategies behind them. However, index equity and bonds funds are usually available. Be aware that the asset allocation can be decided by the insurance company so that the employees don't take too much risk.
This limitation comes a with an important benefit though: the GLWB rider protects the account against negative market dynamics. Every year the insurance company looks at the value of the account and adjusts the benefit base upwards if the value has gone up. If the next year the value of the account has gone down due to a bad market, the benefit base will never go down. For example, let’s assume that an employee invested $50,000 into a variable annuity with a GWLB rider and the value went up to $100,000 in year one. This $100,000 value becomes new benefit base and even if the account value drops to $50,000, for instance, in year two, the benefit base will remain $100,000.
Once the employee retires, the decumulation phase begins. The employee annuitizes and is offered a payout rate based on the interest rate, age, and a certain percentage of the benefit base. This payout is promised to be paid for life. As with fixed annuity the longer the employee waits, the higher the payout is going to be.
For years investment professionals enthusiastically sold annuities to be part of 401(k) plans. But many plan sponsors are wary of annuities and do not add them readily. And no wonder why. Annuities can be very expensive, usually lack transparency, and it is hard to assess the insurer’s solvency. This exposes the 401(k) plan sponsor to fiduciary risk because employees can sue them for offering expensive investments that no one fully understands. Nevertheless, a change is needed.
Making Annuities More Appealing
To improve this situation, earlier this year Congress passed a bill to boost the presence of annuities in 401(k) plans. The bill, called the Retirement Enhancement and Savings Act of 2018, would amend annuity rules around portability, disclosure, and fiduciary responsibility. If passed, the bill can seriously change the investment landscape within 401(k) plans and add additional sources of retirement income.
Despite all the negatives that are associated with annuities, there are clearly some very important benefits for the employees that can’t be ignored. Annuities provide peace of mind when it is needed the most. With an insurance company guaranteeing payments for life, your employees will feel assured that they will never run out of money.
But before you go ahead and consider offering annuities, wait and see if the legislation goes through. Fiduciary risks are way too high right now. If the bill becomes law, do some extensive homework and preparation. Look through prospectuses very thoroughly and compare each insurance product you are considering offering to employees, making sure you’re comparing apples to apples. Look at the cost and fees, check the payout rates, make sure the benefits are the same, and -- last but not least -- review the insurance company for solvency. The latter is easier said than done but checking company’s current credit rating could be a good start. Finally, educate employees and explain who should consider annuities, when to consider them, and how much to invest.