The Rise of Lifetime Income Options

Traditional pensions, known as defined benefit plans, have been on the decline since their heyday in the 1960s. Guaranteed lifetime income was a key feature of traditional pension plans. Benefits under a plan would be paid monthly to individuals after retirement until their death. There also was the possibility of spousal benefits being paid for the life of the participant’s spouse. Defined benefit plans insulated participants from longevity risk and market risk.

For plan sponsors, it is a little different: Defined benefit plans are an accounting liability to a sponsoring corporation. Expenses that defined benefit plan sponsors pay are high due to Pension Benefit Guaranty Corp. premiums, administrative costs, and because a specific amount of a benefit is owed regardless of market conditions. The plan sponsor bears all the market risk. Still, lifetime income was a core aspect of traditional pensions.

Because of the financial burdens associated with a defined benefit plan, defined contribution plans have become the primary retirement vehicle for workers. Defined contribution plans put market risk on participants instead of the sponsor; most also are self-directed to minimize plan sponsor fiduciary liability. Longevity risk is a real issue for participants in the defined contribution world. Lifetime income options enable participants to insure against longevity risk. Thus, lifetime income options in defined contribution plans are on the rise. In many ways, lifetime income options in defined contribution plans are the best of both the defined benefit and defined contribution plan worlds.

Without lifetime income, retirees, sometimes justifiably, may worry about overspending and outliving their funds. The average 401(k) balance, as of the date of this writing, for 55- to 59-year-olds is estimated to be around $250,000, with the median far lower. The life expectancy post-retirement for this same group ranges from 21.83 years to 24.94 years for males, and 24.95 to 28.34 for females. Although everyone is advised on how to save, not many individuals are advised on how to spend. As such, retirement drawdown can be a Gordian knot for many individuals. A guaranteed lifetime withdrawal benefit (GLWB) helps take this stress off the table, since a participant knows that a specific dollar amount of funds will be paid at least annually until death if certain conditions of the GLWB are satisfied.

President Trump has been very supportive of lifetime income options. In Executive Order 14330, “Democratizing Access to Alternative Assets for 401(k) Investors,” he urged the U.S. Department of Labor (DOL) to clarify its position on alternative assets, including “lifetime income investment strategies.” A little more than a month after the executive order, the DOL issued an advisory opinion allowing a program that offered a lifetime income option as a qualified default investment alternative (QDIA). It can take months, if not years, to get a response to an application for an advisory opinion, so this request was likely made before the executive order. However, the executive order likely pushed it forward, and thus the advisory opinion explicitly approved a lifetime income option as a QDIA.

QDIAs are meant to be used as a default investment when participants are given a choice of investments when they are auto enrolled or enroll in a plan without choosing investments. QDIAs have become ubiquitous in the defined contribution world, with mandatory auto-enrollment for new plans having been a centerpiece of the Setting Every Community Up for Retirement Enhancement (SECURE) Act 2.0. In the future, universal auto-enrollment and periodic reenrollments are likely to become mandatory, in which case QDIAs will become even more important in the defined contribution world.

Prior to the advisory opinion, some plan sponsors may have been concerned whether lifetime income options within a managed account could be used as a QDIA. An investment must meet the requirements of ERISA and associated regulations to be considered a QDIA. These requirements include that the investment:

• Must be diversified to avoid the risk of large losses.
• Must be transferable to other investment options or withdrawn without imposition of restrictions, fees, or expenses during the first 90 days after the participant is defaulted into the investment.
• Must be managed by an RIA or otherwise qualified investment manager.
• Cannot contain employer securities.
• Must be a lifecycle (or target-date) fund, balanced fund, or professionally managed account.

The DOL opined that a lifetime income product could qualify as a QDIA if it satisfies the transferability requirements and other provisions of the regulation.

The lifetime income solution discussed in the advisory opinion was a managed account program that had the option for a GLWB, whereby a participant is guaranteed the ability to withdraw a specific amount of the account balance each year for life, subject to certain restrictions on excess withdrawals. Lifetime income options make sense for defined contribution plan participants for many reasons.

A managed account arrangement with a GLWB strategy guaranteed by an insurance company is one of many models for structuring lifetime income options. While a managed account is designed for a single plan or related plans, lifetime income collective investment trusts (CITs) maintained by banks are available as investment options in the marketplace. A CIT is a pooled investment fund that permits unrelated plans to pool their assets for investment purposes, provided that the CIT meets certain IRS requirements. The guarantee is backed through an annuity contract, which may be issued to the CIT trustee or plan.  Some designs include a rollover IRA to provide GLWB payments upon retirement, while in others the trustee makes payments to the plan or participant, and the annuity contract provides the guaranteed payment once the account balance is exhausted.

In addition, because some lifetime income options may be complex products, many plan fiduciaries have been hesitant to adopt them. When a plan is self-directed under ERISA section 404(c) and complies with the QDIA regulation, plan fiduciaries remain responsible for the selection and monitoring of the QDIA, although the fiduciaries are not liable for any investment loss that may occur from an investment in the QDIA. In the advisory opinion, the DOL outlines the two safe harbors available to fiduciaries when selecting annuity providers for defined contribution plans: 29 C.F.R. § 2550.404a-4 and 29 U.S.C. § 1104(e) (ERISA § 404(e)). The regulatory option speaks directly to choosing a lifetime income provider. The statutory option is less specific. According to the advisory opinion, if a fiduciary complies with the requirement of one of these safe harbors in selecting (and monitoring) the insurers selected to provide lifetime income options, it will satisfy its fiduciary obligations under ERISA.

Perhaps the advisory opinion, which calls out the safe harbors and signals an explicit acceptance of a lifetime income option as a QDIA, will be the push plan sponsors need to include lifetime income options.