Insurer Selection Safe Harbor

Even though election season has passed, partisan political sparks are still flying in Washington. Yet, during this “lame duck” session, there is an opportunity for both parties to cooperate in passing important retirement-related legislation that has wide support.

In recent decades, the United States has seen the near demise of private-sector defined benefit (DB) pension plans, and the rise of the defined contribution (DC) plan, such as the 401(k). Since 1980, the percentage of workers covered by traditional DB plans has shrunk to less than 25%[1], while the percentage of private-sector workers covered by DC plans is more than double that figure[2]. In this shift, something has been lost—more than a quarter of spending power in retirement.

That loss of spending power is a direct result of the loss of the most powerful feature of defined benefit plans—the pooling of longevity risk. In a DB plan, the substantial risk that you may outlive your savings is mitigated by pooling. Each individual member helps insure the others. The person who will live a long life and the person who won’t are both offered a uniform monthly payout for life, giving them certainty of their spending.

In a DC plan, however, individuals usually face longevity risk alone, since the vast majority of DC plans do not pool it. Going it alone means you must save more or spend less, as though you will live to be 100.

For example, an individual retiring at 65 who wants to spend $50,000 per year (and have 80% certainty that he will not run out of money) would have to have saved over $170,000 more than someone whose longevity risk is properly pooled. Or to put it another way, consider two individuals who retire with the same amount of savings: the one with pooling can spend $50,000 per year, but the other, with the same savings but no pooling, could spend only $39,000.[3]

DB plans, such as those that continue to exist in the public sector, are essentially in the business of providing pooling, as their benefits are typically paid as simple annuities to retirees. The problem here is that the vast majority of employers that offer 401(k) plans do not offer annuities as an option. This is a shame, because the simple annuities that can be offered inside a 401(k) can go a long way toward helping individuals achieve greater security in retirement.  Why don’t they offer them, and can anything be done to change that?

Under the Employee Retirement Investment Security Act (ERISA) an employer that provides a 401(k) takes on fiduciary responsibility. This is a good thing. ERISA requires that, in selecting investments, the plan administrator must act “with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent [person] acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims…”[4].  ERISA imposes on employers a stringent standard of care.  It also affords plan participants an express statutory right of action when that standard is breached.

This standard can cause employers to limit, ex ante, the range of otherwise sound products that they select, for fear of being unfairly second guessed.  For this reason many employers shy away from annuities because of legal uncertainty about how ERISA fiduciary standards would apply to selection of an annuity provider, and the annuity provider’s investment policy.  This unfortunately leaves longevity risk on the shoulders of each individual participant

When it comes to selecting an insurer and offering annuities in a 401(k) plan, the prudent person standard can be met. But only a few very forward-thinking employers, such as United Technologies (a client of AQR), have accepted the challenges, and are providing their employees the option to start pooling their longevity risk. In fact, their approach to offering this option through their DC plan is widely utilized among UTC employees. Over 35,000 employees are participating, including about two out of every three new UTC employees since UTC initiated this option.[5]

Today, beyond the legal uncertainties, employers face other challenges in offering annuities, such as recordkeeping hurdles, but until there is a legislative “safe harbor” for insurer selection, few employers will put in the effort to overcome the obstacles and offer these programs.

Fortunately, there is legislation pending in Washington that creates this safe harbor. It would allow plan sponsors to rely on state insurance commissioners and their regulatory requirements in selecting annuity providers. This legislation has bi-partisan support in both houses. It has already passed the House as part of the September tax legislation. The same reforms exist on the Senate side, in the Retirement Enhancement and Savings Act (RESA), sponsored by retiring Senate Finance Committee Chair Orrin Hatch (Republican-Utah) and Ranking Democrat Ron Wyden (Democrat-Oregon).

Whatever else happens in Washington over the next few weeks, this legislation should be passed. It will give everyone in Congress a rare chance to cooperate, and will finally give more American workers improved prospects for better security in retirement.

Michael Mendelson is a Principal of AQR Capital Management. Charles Millard is former Director of the Pension Benefit Guaranty Corporation and an adviser to AQR.

This feature is to provide general information only, does not constitute legal or tax advice and cannot be substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of Strategic Insight or its affiliates.

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[1] Source: “How many American workers participate in workplace retirement plans?”; http://www.pensionrights.org/publications/statistic/how-many-american-workers-participate-workplace-retirement-plans

[2] Source: “51 percent of private industry workers had access to only defined contribution retirement plans”; https://www.bls.gov/opub/ted/2018/51-percent-of-private-industry-workers-had-access-to-only-defined-contribution-retirement-plans-march-2018.htm

[3] Source: AQR. Based on 1000 simulations of present values of cash flows for a single person and a pool of 1000 people. We assume that people are 65 at retirement and require $50,000 per year for living expenses. We assume the discount rate is 4% which is roughly equivalent to the prevailing yield on investment grade corporate debt. Mortality rates are from the U.S. actuarial tables on the Social Security website (https://www.ssa.gov/oact/STATS/table4c6.html#fn1). This example is illustrative and does not represent the retirement needs of any specific individual.

[4] Source: The Employee Retirement Income Security Act of 1974 (ERISA)

[5] Source: United Technologies Corporation