Art by Alex Eben Meyer
According to recent research from American Century Investments, “73% of workers want an investment that protects against losses, and a majority would prefer to have their account balance’s ability to generate guaranteed income automatically protected.”
Findings like this have been spurring defined contribution plan sponsors’ interest in retirement income options, including the use of in-plan annuities. Such demand has also led to the growth of in-plan products, including target-date funds that default participants into fixed-income annuities.
So far, however, adoption has been limited. PGIM Inc.’s survey of DC plan sponsors, DC Solutions: The Evolving Landscape April 2023, found that only 5% of plans currently offer in-plan annuities, but 34% are considering them. Meanwhile, only 14% of sponsors reported “a significant amount of participant interest in adding in-plan annuities.”
Retail annuity sales, however, continue to break records amid high interest rates and a rocky market ride in 2022. So how can an adviser recommend an in-plan annuity option today?
The guaranteed lifetime withdrawal benefit is, at the moment, the most popular option for plan sponsors, often via a managed account program, which have seen the biggest growth in 2023, according to Larry McQuaid, vice president and head of business development for SS&C Technologies’ retirement solutions division. GLWBs come in several varieties, according to McQuaid, such as target dates with insurance guarantees, or moderate risk funds with an allocation in guaranteed income.
In the future, McQuaid sees innovations such as TDFs with an annuity sleeve taking off “once plans become comfortable with making them plan default options.” But for now, the GLWB is the predominant use case to offer participants in-plan retirement income.
Contract (or account) value vs. income benefit base
Unlike traditional investments that have a single value in a participant’s account, plans with a GLWB calculate both a participant’s account value and a hypothetical income benefit base value. The benefit base is used solely for calculating withdrawals—this money cannot be rolled over to an IRA as a lump sum, for instance. While account values fluctuate with investment returns and can experience negative returns, the participant’s benefit base does not decline with market performance (although it can increase). Contributions to the account also increase the benefit base.
FIAs are linked, not invested
A fixed-indexed annuity’s account performance is linked to an investment index like the S&P 500, but the account funds are not invested directly in the index. Instead, the participant’s account value will track the index through a credited interest rate based on the index’s capital gains or losses. Dividends are not included in the return calculation, and a fixed-rate option is usually available as well.
Formulas for crediting index-linked interest vary, but a typical arrangement uses three scenarios. First, if the index has a loss for the calculated period—one year, for instance—the credited interest rate for the next period will drop to zero (the rate “floor”), but the income base value will not decline.
Second, if the index’s price return is between 0 and 10%, the credited interest rate for the next year will match that gain, although some FIAs use a participation rate that limits increases to a percentage of the linked index’s gain.
Finally, the tradeoff for the downside protection is a cap on the upside return. Should the tracked index generate a return of, say, 20%, the benefit base might be limited to a 10% maximum credited interest rate for the next period. The range of floors and caps varies among FIAs, but the use of a predetermined returns’ spread is standard.
Rolls-ups, step-ups can increase the benefit base
The benefit base can increase over time from “roll-up” and “step-up” provisions, in addition to investment returns and contributions. A roll-up feature provides an automatic percentage increase in the benefit base during the accumulation period. For example, the Allianz Lifetime Income+ plan offers a 2% annual additional return on a plan’s benefit base, even if the credited interest rate for the period is zero.
Wade Pfau, the Dallas-based co-founder of RISA LLC and the author of “Retirement Planning Guidebook,” notes that automatic increases to the benefit base are not the same as investment returns.
“Sometimes people say, ‘I’m getting a 6% guaranteed return on my annuity,’” Pfau explains. “What they really mean is: ‘My benefit base is growing at 6% a year,’ which is not a number you have access to. It’s just a hypothetical number used to calculate the subsequent guaranteed income amount.”
If the plan’s investments have performed well and its account value on the evaluation date exceeds the benefit base, the benefit base is reset—stepped up—and locked in at the higher account value, known as the “high water mark,” which in turn will increase the guaranteed income distribution. A benefit base increase is generally the higher of the roll-up or the step-up amount.
Withdrawal amount calculations
A participant’s guaranteed income is usually determined by the benefit base value and the participant’s age at the time of the first withdrawal. For instance, the guaranteed annual withdrawal rate at age 65 could be 5%, escalating to 6.5% for withdrawals starting at age 80. Provided the participant does not withdraw more than the guaranteed amount, under most GLWB options, the initial withdrawal rate will hold for life, even if the account value goes to zero. Some plans have variations on the withdrawal rate in that scenario, though. Nationwide’s NCIT American Funds Lifetime Income Builder Target Date Series provides a 6% withdrawal rate against the income base that drops to 4.5% if the account value reaches zero.
Excess withdrawals
The guaranteed withdrawals reduce the account value, but that does not change the participant’s withdrawal amount, which is calculated using the income base. Also, withdrawals with a GLWB provision do not require participants to annuitize their account balances. GLWBs provide additional liquidity above the regular withdrawal amount by allowing participants to take excess withdrawals from their account balance. These excess withdrawals reduce the account value and the benefit base and consequently reduce future guaranteed withdrawal amounts. Some insurers adjust the benefit base using a dollar-for-dollar method; others use a proportional method.
Cost of GLWB features
The lifetime income guarantee poses a risk to insurers who must continue making payments, even if the participant’s account value cannot support the withdrawal amount. According to the Institutional Retirement Income Council, the average annual cost charged against participants’ accounts to insure against that risk averages about 80 basis points. These fees generally start when the participant begins to allocate funds to the GLWB option, or within 10 years of the target date in a TDF structure.
One point to keep in mind is that withdrawals up to the account value are a return of the participant’s own funds, even though the product issuer is charging the insurance fee during those withdrawals. According to Spencer Look, associate director of retirement studies at the Morningstar Center for Retirement & Policy Studies, the firm’s research found that in “the vast majority of our simulations, the plan participants ended up just withdrawing their own money until their projected death. The value of the insurance only came through in the rare cases where the plan participant lived a very long time and experienced very poor market returns.”
Death Benefit
Currently, the standard arrangement is that a participant’s beneficiary receives any remaining account balance, but that could change. Morningstar’s “The Retirement Plan Lifetime Income Strategies Assessment” report noted that death benefit riders that can provide a larger benefit than the remaining account balance are common in out-of-plan variable annuities and could be offered in plans in the future if there is demand.