401(k)s 'Not Suitable' Retirement Income Vehicles

“Structural restrictions and limited adoption of in-plan income products prevent defined contribution plans from being a suitable vehicle for income,” states Bing Waldert, Managing Director, U.S. Research at Cerulli.

“The Cerulli Edge – U.S. Edition, June 2016 Issue” notes that recent policy activity includes Notice 2014–66, issued in October 2014 by the Internal Revenue Service (IRS) and the Department of Labor (DOL), clarifying that a defined contribution (DC) plan sponsor would not be held responsible for selecting the annuity provider that was incorporated into a target-date fund, but only partially addressed the annuity purchase safe harbor regulations.

Beyond the issue of safe harbor, several issues need to be resolved before plan sponsors will feel comfortable offering an in-plan retirement income product, Cerulli says. The report notes that fee levels need to decline because they are generally perceived as too high.

Plan sponsors are also reluctant to be among the first movers in this space. Large plan sponsors are painfully aware that they will not be rewarded as an early adopter—rather, they are more focused on minimizing risk of litigation.

Improved portability is a significant stumbling block because it remains to be seen whether middleware products will successfully address the portability problems of retirement income products. There are also concerns regarding education, which is always a challenge in the DC space, particularly with more complex products.

Cerulli strongly agrees with the intentions of the DOL’s Conflict of Interest rule designed to create awareness of consumer protections and raise the standard for financial advice. Cerulli says it also believes that the terms of the rule will not impede the vast majority of rollovers. However, raising the standard for the rollover decision may prevent assets from flowing from DC plans to IRAs when, in fact, the IRA is a more flexible platform. Cerulli believes concerns that the additional regulation would create a barrier to lower-balance participants getting advice are largely overblown. But, the decisions surrounding drawing income from a portfolio and the trade-offs among guarantees, liquidity, and future appreciation are challenging. It is likely that 401(k) plan design will evolve over time to make the platform more flexible, Cerulli says. In the meantime, the industry must find solutions to deliver nuanced advice around retirement income to low-balance investors.

According to the Cerulli report, low interest rates have made variable annuity products less attractive. The industry is in the early stages of a transition from guarantee-rich variable annuities (which it is struggling to sell) to a more diverse and more sustainable product set. This transition includes the introduction and reintroduction of fixed products designed explicitly for income purposes, most notability single premium immediate annuities and deferred income annuities (DIAs). With DIAs, investors turn over a lump sum to the insurance company with a guarantee of future income later.

Because investors make a trade-off of limited to no liquidity, the insurance company can invest the general account assets more aggressively, leading to a higher income stream. Income-oriented fixed annuities also present the advantage of not being subject to the enhanced disclosure requirements associated with the DOL’s Conflict of Interest rule, the report says.

Cerulli believes technology will ultimately play a role in income planning, particularly for lower-balance investors. While digital advice or “robo-advisers” came to the market purporting to disrupt traditional wealth management, their business models have quickly evolved. Cerulli finds that the vast majority of digital advice providers have a human component, in which an investor may speak with an adviser when opening an account. Still others have begun offering their technology to traditional wealth management firms as a way to serve clients in a scalable fashion. While these tools have largely been accumulation-oriented to date, it seems likely that they will ultimately develop income planning models, Cerulli predicts.

Wealth management firms that assist lower-balance investors with income planning could build a program that incorporates existing income planning tools, technology for scalable implementation, and telephonically based advisers to help with the necessary trade-offs in income planning, Cerulli says. Banks and insurance companies would be strong candidates for this type of service because they already serve numerous client relationships through multiple channels. Insurance companies in particular, who see their traditional broker/dealer business threatened by the DOL regulation, could use technology to evolve their consumer advice offering.

The Cerulli report also notes that despite a reputation for being less modern than its corporate counterpart, the 403(b) plan is significantly more advanced in one important way—its emphasis on creating a stream of income in retirement, in particular the use of annuity products. The significant presence of annuities within the 403(b) market is further underscored by the 56% of providers that make annuities available both within and outside of an employer-sponsored plan, and the 51% of 403(b) assets held in life insurance company products.

While the 401(k) industry has spent the past two decades training American savers to focus on asset accumulation, the 403(b) market was created with an eye toward providing a stream of income in retirement. Only in recent years have the 401(k) industry and related regulatory bodies begun to realize that there is a crucial “second act” to the 401(k) savings arc—specifically, “decumulation” or, in more plain terms, how to turn the proverbial pile of money an employee saves across a career into a sustainable paycheck in retirement, Cerulli notes.