The growing demand for retirement income solutions: Options for the plan sponsor

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1 Institutional Retirement and Trust The growing demand for retirement income solutions: Options for the plan sponsor The need for retirement income solutions has become more evident each year. Today, fewer retirees are walking out the door with a pension check in hand. More likely, the retiree takes a lump sum 401(k) distribution into retirement with little idea how that balance translates into monthly retirement income. In addition, retirees face a good news/bad news situation regarding longevity. The good news is people are healthier and more active later in life than ever before. The bad news: How are they going to ensure their money lasts as long as they do? While a participant may feel like they can make their money last to their projected life expectancy, should they plan for a longer life span? If they don t, they run the risk of running out of money. But if they plan for a long life, they may be over-saving during their working years or under-spending in their retirement years, which will adversely impact their lifestyle. With an increasing number of baby boomers getting ready to retire, plan sponsors should address these challenges now. You should consider participant needs and weigh them against plan and fiduciary considerations, explore current solutions in the marketplace, review the legislative environment, and assess where the industry is headed. This paper serves as a practical guide to help you evaluate potential retirement income solutions. Use it as a tool to work with your retirement committee and plan advisors to help define your goals and narrow the choices for your plan. The sooner you get started, the better positioned you will be to make sure your fiduciary decisions are in line with the best interests of your plan and participants. 50% of middle-class Americans surveyed agreed they would pay a premium to insure their future retirement savings. Source: 2014 Wells Fargo Retirement Study More than 22% of plan sponsors surveyed indicated that they have an in-plan retirement income product in place or are considering adding a retirement income product to their plan. Source: Evolution of the Retirement Investor, Cerulli 2015 Planning for longer life expectancy Today, a man who is age 65 has an average life expectancy of 84 years. A 65-year-old woman has a life expectancy of 86 years. One in four adults who are age 65 will live to be at least age 90, and one in ten will live past age 95. Source: Social Security Administration, Life Expectancy Calculator, 2014

2 What do participants want? Participants who have spent all or a large part of their careers saving for retirement through a defined contribution plan might feel good about the balance they see on their account statement each quarter. In many cases, it is the largest asset they hold and the lump sum amount can seem like a lot of money. As retirement approaches, however, more relevant questions arise: Do I have enough? How should I invest after retirement? What if the markets go down? How much can I withdraw each month? What will inflation do to my purchasing power? What if I live to be 90 or 100? Will I need long-term care? Issues for plan sponsor consideration Since retirees are having a difficult time planning for their retirement income needs, plan sponsors may decide to play a greater role in offering assistance. How much or how little help you provide is an important consideration for each plan sponsor. Level of involvement As a plan sponsor, how involved do you want to be with helping your participants decide what to do with their retirement account balance? Consider the following spectrum: What level of involvement do you want? Participants want an easy way to convert their account balance into a monthly payment that when combined with Social Security and a pension (if they have one) provides a lifelong retirement paycheck. They want to protect their money from market dips as they approach retirement and while they are in retirement. They may also want to leave money to their beneficiaries. You will provide education on the topic to help participants consider their options. You will provide help with the transition, possibly providing access to advice/ guidance or tools for making out-ofplan comparisons. You want to offer a retirement income option within the plan. Participants want control and flexibility too, which often runs counter to a predictable income stream. Participants like to have access to their money in case their needs change. That s why, historically, most retirees choose the lump sum rollover option when requesting a distribution from their 401(k) plan. Most of all, participants want simplicity. Watching the behavioral habits of the retirement plan participant during the accumulation phase, we ve learned they are likely to take the easiest option available. That s why automatic enrollment is more effective than sending an enrollment book and waiting for a person to complete and return the enrollment form. And why defaulting a participant into a target date fund can be more effective at creating a diversified portfolio than asking every employee to choose investments from a wide array of funds. Participants want many things when it comes to planning for their retirement years and no one solution is going to fulfill all of those needs. However, there are many viable retirement income solutions that may help a participant better prepare for retirement including helping them determine their actual retirement date. It s up to you to decide the appropriate path for your plan now and in the future. At one end of the spectrum, a sponsor may view their role as getting participants to retirement and then their involvement ends. While active, a participant has access to resources such as pre-retirement workshops and website information on retirement planning. Then at retirement, the participant should take a distribution from the retirement plan and move forward in whatever direction they choose. Sponsors in the middle of the spectrum want to help employees transition to retirement but don t want to provide an in-plan solution. These sponsors may provide an advice or guidance resource to help retirees decide what to do with their distribution, or they may offer a third-party investment comparison tool. At the other end of the spectrum, some sponsors want to provide a seamless way for participants to move from building an account balance to receiving a monthly retirement paycheck. They offer solutions that help a participant incrementally acquire retirement income. This provides more certainty for the participant and improves their ability to plan for retirement. These solutions also keep assets in the plan, which may lower pricing for all participants and reduce costs for the sponsor. 2

3 As you determine what level of involvement you want to take, you should address the following: Fiduciary standards One of the main considerations is your fiduciary responsibilities. Here are just a few things you need to consider: If you decide to offer a retirement income option, whether in-plan or out-of-plan, you need to document the evaluation and selection process. If you offer a guaranteed retirement income product, you must conduct a due diligence review to choose a qualified insurance carrier that you expect will deliver on its promises. You will also need to follow structured ongoing practices for monitoring your provider. With an in-plan solution, you may be limiting your ability to change recordkeepers (plan portability). If you later want or need to remove a carrier, what options will you have if participants have accrued higher income payments than the current market value supports? Is the retirement income option you offer fairly priced? For example, fixed annuities do not carry an expense ratio and may offer many features and options for payments so it can be difficult to make an apples-to-apples comparison. Education and plan design When 401(k) plans were introduced, the industry assumed that with appropriate information, employees would investigate their choices and make educated decisions about saving and investing for retirement. Now 30 years later, we know it takes repeated effort to communicate and educate employees about retirement needs before the messages are effective. One method an enrollment book, a group meeting, or a website is not going to be enough on its own. Much of what we have learned as an industry about participant behavior in the accumulation phase can also be applied to the decumulation phase. A plan sponsor that wants to address the retirement income issue commits to ongoing communication and education about the options available to participants. Experience has taught us that successful retirement income programs are fully integrated into the messaging and design of the plan. As in the accumulation phase, in some cases, you may need to take additional steps to promote participant action. There is a lot to consider before offering a retirement income solution. The following pages provide an overview of the advantages and disadvantages of a variety of retirement income programs. You should consider this information before deciding which direction you want to take. You may not be familiar with these types of decisions so care needs to be taken to fulfill the fiduciary role. Beyond fiduciary responsibilities, plan sponsors also need to address: Financial considerations. Keeping retiree assets in the plan may help you maintain your plan pricing. The largest balances often belong to those nearing retirement. With baby boomers rapidly approaching retirement in great numbers, significant assets may roll out of your plan in the coming years if you do not have an in-plan solution. Administrative duties. If you offer a solution that keeps the money in your plan, you may continue to have a connection to retirees long after they stop working for your company. You will need to keep track of addresses and perhaps respond to retiree questions for many years after they have retired. 3

4 Types of retirement income solutions Based on what you have learned about participant needs and the issues for plan sponsor consideration, you can begin to look at what types of solutions might make sense for your plan. To simplify your analysis, consider the following two questions: 1. Do you want to offer a solution that leaves assets in your plan or that rolls assets out of the plan? Keeping assets in the plan can help you maintain pricing and offer economies of scale. Fiduciary risk and ongoing administrative costs are also major decision factors. 2. Do you want to offer guaranteed solutions or nonguaranteed solutions? With guaranteed solutions, participants are able to transfer some of their investment and longevity risk to an insurance company (for a price). Whereas, with nonguaranteed solutions, participants bear the investment and longevity risk on their own. Based on these two questions, retirement income solutions can be categorized into four broad types (shown on the grid below). This grid is a helpful place to start your analysis of the current environment. Keep in mind, based on the increasing interest and demand for retirement income solutions, new products and names for products are being announced on a routine basis. These solutions are not mutually exclusive. You may choose to offer more than one which would allow participants to use them in combination. For example: A participant could use a portion of their balance to purchase an immediate annuity through the Institutional Supermarket program while starting a Systematic Withdrawal Plan with the remainder. Another participant could initiate Managed Account Distributions and at the same time purchase a deferred annuity that would start making payments at age 85, when the managed account is exhausted. Nonguaranteed Guaranteed Out-of-plan In-plan Managed Payout Fund Income Replacement Fund Systematic/Partial Withdrawal Plan Managed Account Distributions Retail Annuities Institutional Annuity Supermarket programs Guaranteed Minimum Withdrawal Benefit (GMWB) Annuities Deferred Fixed Annuities 4

5 Out-of-plan > Nonguaranteed Managed payout or income replacement funds Retirement income solutions in this category offer an option for the retiree to take a 401(k) distribution and invest it in a product designed to deliver a retirement paycheck. There are many variations in the marketplace but most can be categorized into managed payout funds or income replacement funds. Income replacement funds are designed to be exhausted by the stated end date of the fund, sort of a target date fund in reverse. They invest in stock and bond funds and have changing allocations to become more conservative as the end date nears. They do not ensure any principal will be left for beneficiaries. Managed payout funds offer payouts of various amounts such as 3%, 5%, or 7% without touching the principal. To meet these returns, the fund manager must take on some risks (i.e., invest in equities). These funds are also called endowment-style funds because the principal can be preserved for your beneficiaries. Pros Cons Portability: Investors can withdraw all or part of their investment at any time. Flexibility: An initial investment can be made at any time and additional contributions are possible. Endowment opportunities: Any balance that s left when the investor dies (regardless of age) goes to the beneficiaries. Less fiduciary risk: Less risk for the plan sponsor since money has left the plan. Pre-retiree market risk: Prior to retirement, participants are exposed to market volatility. Variable income stream: There s no guarantee the fund manager will successfully execute the strategy. Investor bears the market risk: In down markets, the fund may need to return principal to meet payout goals. 5

6 Out-of-plan > Guaranteed Rollover annuities An annuity is a contract between the purchaser and an insurance company in which the purchaser pays a premium and the company offers a guaranteed monthly income for life, or a specific term, regardless of economic conditions. For a retiree with a 401(k) balance, the most common type of annuity would be a single premium immediate annuity, although many types and variations are available. Most annuities will pay income for the rest of the annuitant s life, with the option to have payments continue to a spouse or another beneficiary after death. This feature plus others such as inflation protection and period certain payments will reduce the quoted income. Annuities come in many shapes and sizes with a broad range of retail products and a variety of structures. To assist the participant, a plan sponsor can choose to offer a third-party platform to provide a real-time comparison of institutionallypriced annuity options. Think of this tool as the annuity version of websites that offer mortgage or bank rate comparisons using a simple search format. Pros Cons Longevity protection: Income continues for as long as the investor is alive. Pooling Accounts: An investor withdrawing money from a non-guaranteed portfolio needs to use a conservative payout rate to reduce the risk of running out of money. By pooling the accounts of numerous investors, an insurance company can use overall mortality statistics in its calculations, which may result in a larger monthly income. Insurance company bears the market risk: The investor transfers the risk of potential market downturns to the insurance company. Certainty: Annuity purchaser knows what the payment will be regardless of market performance. Less fiduciary risk: Less risk for the plan sponsor since money has left the plan. Complexity: Many products are available in the market and it s not always easy for a retiree to determine which is the best fit. Cost: Retail annuities can be very expensive some charge as much as 3-4% annually. However, this can be mitigated in institutionally-priced annuity programs. Loss of control: In many products, the retiree no longer has control over the account balance for access or investment choices. Lack of flexibility: Many products involve irrevocable decisions which limits a participant s options if their needs change. Pre-retiree market risk: Prior to retirement, participants are exposed to market volatility. Point-in-time risk: Lower interest rates at time of purchase lead to lower income for life of annuity. Loss of principal: An early death can mean the full potential of the retirement savings was not realized (if payment option to a beneficiary was not chosen). Insurance company risk: the guarantee is subject to the financial strength and claims-paying ability of the insurance company. 6

7 In-plan > Nonguaranteed Systematic/partial withdrawal plan A systematic withdrawal plan provides a somewhat more defined approach to spending down a retirement account balance as opposed to taking random withdrawals whenever needed. If permitted as a distribution option, the retirement provider typically offers this service as a distribution option for plan sponsors to consider. The systematic withdrawal plan allows a retiree to choose a specific payout amount at predetermined intervals, such as monthly, quarterly, semiannually, or annually. Some retirement providers offer participants access to managed account programs which guide the investment of the participant s assets based on data provided by the participant and their account information. Some managed account programs include a managed distribution module to help participants move seamlessly from the accumulation to the decumulation phase with the assistance of a trusted advisor.. Retirement providers may also allow for partial withdrawals which allow participants to withdraw portions of their account upon request. Pros Cons Flexibility and control: Participant maintains control over the income stream and the investments (within plan limitations). Asset retention: By keeping more assets in the plan, it helps maintain scale and preferred pricing. No outside investments: Program uses plan investments for which the plan sponsor has fiduciary oversight. No additional investment due diligence work is required of the plan sponsor. Lack of long-term planning: Chosen income stream may not match income needed or life expectancy; participants often overestimate the amount they can withdraw and run the risk of outliving their money. Investment risk: If the participant is self-directing, they may not be appropriately allocated and may not change their allocation over time. 7

8 In-plan > Guaranteed Annuity option within the retirement plan In an effort to provide pension-like benefits to defined contribution participants, the retirement industry has developed in-plan guaranteed products. In general, these options, which can go by many different names and vary slightly from vendor to vendor, give participants the ability to protect their source of income from market declines by locking into an income base. Active plan participants typically opt-in to this choice approximately 10 to 15 years before their retirement. Flexibility and control remain with the participant. Additional contributions made while an active employee will increase the income base amount. The participant can transfer all or part of their money from the product at any time before retirement and with some products after payments have commenced. Many of the pros and cons listed in the out-of-plan guaranteed section also apply to the in-plan guaranteed solution; however there are some differences worth noting. Pros Helps participants manage risk: Allows participants to incrementally purchase income via payroll contributions, which helps manage pre-retiree market risk and point-in-time risk. Meeting participant demand: Based on a 2010 consumer survey conducted by Prudential Financial, two-thirds of respondents said that a retirement plan solution that provides guaranteed lifetime income, with the ability to opt-out, would be appealing. Income stream certainty: Income in retirement is protected from market downturns, providing certainty to the income stream and allowing participants to better plan for retirement. Pricing: Participant benefits from institutional pricing. Cons Plan sponsor risk: In-plan option carries additional fiduciary considerations, as well as due diligence for choosing a provider. Potential handcuffs: Sponsor may have less flexibility to change recordkeepers if tied to solution. Complexity: Participants have been slow to adopt when offered as a standalone investment. Insurance company risk: The guarantee is subject to the financial strength and claims-paying ability of the insurance company. 8

9 Discussion guide for evaluating your options The following list of questions can serve as a basic guide for evaluating which retirement income solution(s) may be appropriate for your plan and participants. Discuss these questions with your retirement committee members and other advisors to determine a course of action for your organization. Are your plan participants asking for retirement planning assistance? What percentage of your plan participants are going to reach retirement age in the next 5, 10, 15 years? Are you more inclined to want retirees to keep money in the plan, take a distribution, or are you neutral? Could your participants benefit from a guaranteed solution? What have you heard from participants on this topic? Should you follow-up with retirees to see if they have any input? Do you want to offer an in-plan or out-of-plan solution or both? Do you want to take on the fiduciary responsibilities of offering an in-plan solution? Do you want to offer more than one solution? Will the solution impact your ability to change recordkeepers? Are you committed to and do you have time to communicate and educate your audience about retirement income planning realizing individuals may require targeted information at different ages? How will the retirement income information be communicated to participants? How will it appear on the participant s statement and online account? How will you communicate the costs and risk of a retirement income program to your participants? How much control do you want employees to have? Do you want them to be able to opt out of your solution at any time? What happens when a participant leaves the plan? How will the retirement income solution be impacted? Are you willing to take on the additional costs (including administration and communication) of offering a solution? What happens if the carrier you ve chosen for a guaranteed solution is unable to honor the guarantee? Do you understand your fiduciary obligations in making any decision regarding income solutions for your plan? Have you documented your decision process? If you choose to include an income solution vendor, how will you select and monitor your choice? Are the costs for the solution reasonable? What happens if you need to replace a carrier? 9

10 Helping participants understand retirement income needs Short of adopting a specific retirement income product, there is also momentum behind other initiatives that could help your participants meet their retirement income needs. Here is a brief summary of what s happening in the industry. Translating account balances into income streams Pension and Social Security statements have always presented their benefits as an income stream a payment amount the retiree can expect to receive on a regular basis (typically monthly). With the shift to DC plans, participants have been conditioned to focus on account balances, with little thought given to how that translates into a monthly income. The true goal of any retirement plan should be sufficient income replacement, not simply amassing a large nest egg. Since no retirement income solution can overcome a lack of retirement savings, consistent communication of income replacement can encourage participants to save more to reach their goals. The retirement industry is starting to include messaging to participants that shows how their account balance translates into retirement income. In addition to voluntary actions taken by sponsors and plan providers, a more formal requirement may be on the horizon. Proposed regulation would require an account balance to be translated into the monthly or annual income equivalent. This information would need to be provided on a statement to participants at least annually. The proposal has received favorable feedback but it has yet to move forward due to more pressing matters facing regulators. Regulatory actions In addition to the proposals mentioned previously, other regulatory action is being discussed that will address retirement income questions. Back in 2010, the Department of Labor issued a Request for Information on lifetime income issues. After follow-up questions and hearings, two main topics emerged: Providing Safe Harbor protection. Extending protection to sponsors who offer guaranteed income products could encourage their use in 401(k) plans. Appealing safe harbors would provide guidelines for plan sponsors on the process to select and monitor a carrier, and offer protection from participant lawsuits if they need to replace a carrier. It would also provide protection for participant education on retirement income products. Income framing. What criteria should be used for income projections? Should it be centralized or left to individual providers? Over the last few years, the Departments of Labor and Treasury have issued several modest rulings aimed to enhance retirement security. These rulings, and the ongoing discussions in Washington, show how retirement income has become a key issue. Advice and guidance With the inherent risk of making a potentially irrevocable decision (retiring, purchasing an annuity, etc.) and the lack of time to make up for any mistakes, decumulation planning can be even more complicated than the accumulation phase. Most participants need some sort of assistance to make an educated choice. A plan sponsor must consider whether offering an advice or guidance service is a viable option for helping plan participants. Once again, plan sponsors have to weigh the benefits against the costs. Plan sponsors need to compare online versus face-to-face advice, in-plan versus out-of-plan guidance, and fiduciary concerns such as costs, objectivity, and potential conflicts of interest. 10

11 What s next for the industry As you can see, there is a growing need for more attention to be paid to the decumulation phase of retirement planning by the industry, the government, plan sponsors, and participants. You re likely to hear additional comments from participants about how to make their money last, and from vendors touting their latest innovations on the product side. Industry groups such as The SPARK Institute created standards enabling assets in retirement income products to move more easily between recordkeepers even when locked into a specific product. The industry has also developed a central clearing house to simplify how recordkeepers and insurance carriers interact, thereby improving plan portability. Both legislators and regulators have recognized the need for clarity and are evaluating solutions at this time. Additional resources A variety of industry websites feature information on Retirement Income products and plan sponsor considerations. Here are some websites that may be helpful to you: Institutional Retirement Income Council iricouncil.org Center for Retirement Research crr.bc.edu Employee Benefit Research Institute ebri.org With all of this activity under development, some recordkeepers and plan sponsors are waiting for the market to evolve. Yet, as we have shown here, there are pros and cons to every solution. As a plan sponsor and fiduciary, you may wish to evaluate the retirement income products available to determine, which ones, if any, are appropriate for your plan. Be sure to document your decisions whether you decide to implement a solution, wait for the next evolution, or not offer a retirement income solution. For more information, please contact Wells Fargo at

12 Recordkeeping, trustee and/or custody services are provided by Wells Fargo Institutional Retirement and Trust, a business unit of Wells Fargo Bank, N.A. Wells Fargo Bank, N.A. is a bank affiliate of Wells Fargo & Company. This information is for educational purposes only and does not constitute investment, financial, tax or legal advice. This information is general in nature and is not intended to be reflective of any specific plan. Neither Wells Fargo, nor any of its representatives, may give legal or tax advice. Please contact your investment, financial, tax or legal advisor regarding your specific needs and situation. Wells Fargo Bank, N.A. and its affiliates, including their employees, agents, and representatives do not act as investment advisors or investment fiduciaries with respect to the selection of participant-directed investment options of any retirement plan. The plan sponsor, plan investment committee, or other plan fiduciary must make an independent decision about which funds to include in the plan. Links to third-party sites are provided for your convenience only. Wells Fargo neither endorses, monitors, nor guarantees the accuracy of information of third-party websites. Third-party websites may not follow the same privacy, security, or accessibility standards as Wells Fargo s website. Wells Fargo is not responsible for the security, content, or availability of third-party websites or any reliance thereon Wells Fargo Bank, N.A. All rights reserved. ECG

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