Annuities Embedded in TDFs: The Way Forward?

Hybrid annuity target-date funds have begun to pick up steam as an investment option in defined contribution plans, but recent Vanguard research suggests that these products still face hurdles around implementation, participant behavior and suitability.  

Brian Miller, senior investment specialist and head of target-date product management at Vanguard, says embedding an annuity into a target-date fund that participants default into can be a strategy to address the retirement income needs of investors who are less engaged or lack the desire or ability to construct their own asset allocations. 

However, Miller says “it remains to be seen” whether embedding annuities into TDFs will become more of a trend going forward.  

“I think you’re certainly seeing some plans that are more willing to adopt this type of strategy, in particular, insurance companies [or] those that previously had a defined benefit plan might be a little bit more used to this type of payment plan,” Miller says. “Those companies have typically been a little bit more at the forefront of adopting this type of strategy.” 

Speakers at this month’s PLANSPONSOR National Conference argued that TDFs with an annuity sleeve that kicks in when a person is further in their career will become standard as a qualified default investment alternative. The speakers were split, however, on whether this will function as an opt-in or opt-out situation.  

Meanwhile, according to research from the Defined Contribution Institutional Investment Association, only 39% of recordkeepers currently offer an annuity with a guaranteed lifetime withdrawal benefit.  A GLWB is the most frequently offered in-plan guaranteed option, especially among recordkeepers who only offer one annuity option. In addition, DCIIA found that there is no clear trend in annuity offerings based on organizational size. 

But for the majority of plans today, Miller says the focus is on selecting the best investments for accumulation, keeping costs low and offering programs and benefits that are straightforward. According to Vanguard’s paper, most hybrid annuity TDFs have three components: 

• A multi-asset allocation to support asset growth 
• An income funding strategy for the guaranteed income product purchase  
• An annuity for guaranteed income 

The investment value of hybrid annuity TDFs, according to Vanguard, is that they remove market risk and longevity risk by providing income from the annuity, but this benefit comes at a cost of reduced accumulated wealth from the annuity purchase.  

“Whether it’s a hybrid annuity target fund or a standard target fund, during the accumulation phase, it’s going to look pretty similar,” Miller says.  

With hybrid annuity TDFs though, Miller says it will start to allocate more toward bonds, which would eventually be used to purchase an annuity. When someone decides to purchase the annuity, they will receive guaranteed income in exchange for some of the potential growth they might have gained with a portfolio that invested more in equities.  

“In essence, you’re taking less risk, or getting that guaranteed income and addressing that longevity risk,” Miller says. “But your ability to grow that asset pool is obviously diminished a little bit because you’re taking that, let’s call it 30%, portion out, and moving that over to the annuity, versus leaving it in the market.” 

Vanguard also recommends that plan sponsors consider many factors when evaluating hybrid annuity TDFs. For example, an annuity component may not be optimal for everyone, and the appropriate type of annuity, timing and amount of the annuity are likely to differ significantly across participants. Vanguard suggests that plan sponsors should include a few personalization options for more engaged participants that can be tailored to their individual needs.  

Portability is also a concern, as participants are unable to transfer annuity benefits as easily as funds. As a result, Vanguard suggests that plan sponsors explore partnerships with annuity providers to enhance portability or introduce portable annuity options.  

When it comes to the cost of these investment vehicles, Vanguard recommended that plan sponsors offer transparent information on costs and charges and reinforce it with the value of the solution, as well as provide financial planning support.  

Miller adds that one of the major hurdles to offering this solution is educating participants about it. While the word “annuity” tends to hold a negative connotation for a lot of people, the idea of guaranteed income is very attractive to employees.  

“I think for plan sponsors, an absolutely big consideration is, what is the educational hurdle?” Miller says. “Do they have the ability to partner with their asset manager [or] recordkeeper to provide that educational material in a very straightforward way to those participants?”