THE CASE FOR GUARANTEED ANNUITIES IN DEFINED CONTRIBUTION PLANS

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1 OCTOBER 2010 THE CASE FOR GUARANTEED ANNUITIES IN DEFINED CONTRIBUTION PLANS HELPING PLAN FIDUCIARIES CLOSE THE RETIREMENT INCOME GAP Executive Summary Millions of Americans rely on defined contribution (DC) plans as their primary source of retirement security. For many workers, a typical DC plan, even when combined with Social Security, won t provide enough income to meet living expenses in retirement. DC plan sponsors can help by offering a low-cost, guaranteed fixed annuity as a plan investment option. Providing both asset accumulation and lifetime income, fixed annuities are ideally suited to serve as the foundation of a complete retirement plan. Their unique combination of benefits includes: Safety and stability. Participants enjoy guaranteed income and upside return potential, with no downside risk. 1 Diversification. Due to very low correlations with other asset classes, fixed annuities can help reduce overall volatility and enhance long-term return potential in a diversified portfolio. 2 Potentially higher retirement income. Employees may receive larger monthly income payments in retirement by contributing to the annuity over time, rather than waiting until they retire to purchase the annuity. Increased readiness for retirement. When they retire, employees are more likely to annuitize, face a smoother transition to retirement and may incur lower costs. Reassurance for plan sponsors. Consistent with fiduciary duty and safe harbor regulations, offering a lifetime income option increases confidence that employees can afford to retire. Plan sponsors must exercise due diligence in selecting an annuity provider, evaluating the insurer s strength and stability, track record, costs, transparency and participant education capabilities. The chosen provider should be a trusted financial partner who shares the plan sponsor s goal: to seek a safe and secure retirement for their employees.

2 A proactive employer can significantly improve the likelihood that employees will achieve secure retirement income, and simultaneously improve the employer s ability to manage their work force without increasing costs. Institutional Retirement Income Solutions: A Call to Action, Institutional Retirement Income Research Council, 11/2008 THE CHALLENGE: IMPROVING RETIREMENT SECURITY FOR EMPLOYEES America s workers face an uncertain future in retirement. Savings rates are low, the long-term solvency of Social Security remains in doubt, and traditional defined benefit (DB) plans which a majority of employees used to rely on for guaranteed retirement income are no longer common. As a result, millions of people are looking to their employer-sponsored defined contribution (DC) plans to help build sufficient savings and provide retirement income that s guaranteed to last a lifetime. 3 For many, a typical DC plan, even when combined with Social Security, won t be enough. According to McKinsey & Company, the average U.S. household faces a retirement savings shortfall of $250, And the Employee Benefits Research Institute (EBRI) reports that nearly half (47.2%) of Americans approaching retirement are at risk of running out of money. 5 How big a shortfall? Most Americans haven t saved enough in their retirement plans to bridge the gap between the monthly income they ll receive from Social Security and how much they ll need to meet living expenses. Average Spending vs. Average Social Security Income $3,070 Average monthly spending for people over 65 * $1,169 Average monthly Social Security payment for retired workers ** * Based on average annual of $36,844. Source: U.S. Bureau of Labor Statistics 2008 Consumer Expenditure Survey. ** As of May Source: U.S. Social Security Administration Office of Retirement and Disability Policy, Monthly Statistical Snapshot. As proposals to fix the U.S. retirement system are debated in Washington, plan sponsors can take action now to enhance retirement security for their employees. Offering a low-cost, fixed annuity as a plan investment option can be part of the solution. These annuities provide a guaranteed level of monthly income that cannot be outlived, much like a traditional DB plan. Some retirement experts refer to these offerings as personal pensions that help bridge the retirement income gap. 6 WHY LOW-COST, GUARANTEED ANNUITIES ARE PART OF THE SOLUTION Fixed annuities provide both asset accumulation and lifetime income. This makes them particularly well-suited to serve as the foundation of a complete retirement plan, offering benefits for plan sponsors and participants alike, including: Safety and Stability A fixed annuity guarantees safety of principal and a specified interest rate. 7 Unlike stocks, bonds and other variable investments, the annuity provides upside return potential with no downside risk. As a result, a participant s annuity account balance never declines even during periods of extreme market volatility and negative returns for other asset classes. U.S stocks plummeted nearly 45% between December 2007, when the Great Recession began, and March 9, 2009, the recent bottom for most equity markets. 8 A fixed annuity, however, would have held its value and increased by the amount of guaranteed interest paid under the terms of the annuity contract. The advantage of no downside risk has held true over the long term, not just during periods of extreme market volatility. Exhibit 1 shows annualized 20-year returns for the average investor in equity and fixed-income mutual funds. These returns are lower than those provided by many fixed annuities and have been accompanied by much higher volatility. 2 The Case for Guaranteed Annuities in Defined Contribution Plans

3 EXHIBIT 1. Annualized returns for the average mutual fund investor 20 years ended Equity Fixed income 12/31/ % 0.77% 12/31/ % 1.02% Past performance cannot guarantee future results. Average stock and bond fund investor performance results are calculated using data supplied by the Investment Company Institute. Investor returns are represented by the change in total mutual fund assets after excluding sales, redemptions and exchanges. This method of calculation captures realized and unrealized capital gains, dividends, interest, trading costs, sales charges, fees, expenses and any other costs. After calculating investor returns in dollar terms, two percentages are calculated for the period examined: Total investor return rate and annualized investor return rate. Total return rate is determined by calculating the investor return dollars as a percentage of the net of the sales, redemptions and exchanges for each period. Source: DALBAR, Inc. For the 20 years ending in 2008, average annual returns did not keep pace with inflation. 9 However, safety guarantees and attractive risk-adjusted returns come with some tradeoffs. For example, unlike mutual funds, annuities often have liquidity restrictions and mortality and expense (M&E) risk charges. Diversification Guaranteed assets are excellent portfolio diversifiers because, as shown in Exhibit 2, their returns historically have had very low correlations with those of other asset classes, such as stocks and bonds. Diversification can help lower overall volatility and enhance long-term return potential, which may make it easier for employees to maintain an appropriate asset allocation during periods of market volatility. 10 Potentially Higher Retirement Income Contributing to a low-cost, fixed annuity over the course of a working career and converting the accumulated savings into a guaranteed stream of lifetime income offers the potential for higher monthly income payments, compared with purchasing a separate annuity with the same amount of savings at retirement. There are two reasons for this: During the accumulation phase, some annuities pay additional amounts of interest above the minimum guaranteed rate. This can result in initial monthly income payments that are larger than those received by noncontributing employees who delay purchasing the annuity until retirement. 11 Delaying the annuity purchase can result in a lower level of guaranteed income, depending on interest-rate levels at the time of purchase. For example, the current low-rate environment could translate into lower income payments compared with purchasing the annuity in a higher-rate environment. 12 Increased Readiness for Retirement Research has found compelling evidence that employees who contribute to a fixed annuity within their DC plan are better prepared for retirement. These employees: Are more likely to annuitize. A recent study by the TIAA-CREF Institute found that contributing to annuities during the accumulation phase increases the likelihood that individuals will annuitize their retirement savings and receive retirement income in the form of lifetime annuity payments. According to the study, retirees who have annuitized are more than twice as likely to have saved through an annuity in a DC plan while working, compared with retirees who have not annuitized. 13 3

4 An important feature of life annuities is that, for any given level of guaranteed monthly income for life, the annuity provides this income at lower cost than any other product. Jeffrey R. Brown, Ph.D. Director, Center for Business and Public Policy at the University of Illinois College of Business Why is this important? Academic research has shown that many retirees would be better off annuitizing a large share of their retirement portfolios. 14 In fact, annuitizing is the only way to guarantee a consistent income stream in retirement that cannot be outlived. 15 (See Exhibit 3, Lifetime Annuity Payments: Ensuring That Retirees Don t Outlive Their Income. ) Face a smoother transition to retirement. The transition from building savings to receiving income can be complicated for participants unfamiliar with annuities. They risk choosing products or income options that have not been screened for suitability and may not meet their needs through retirement. Employees choosing a fixed annuity through a DC plan are more likely to receive continuing education about its appropriate use in a long-term retirement portfolio. They can also be confident in their choice because plan sponsors have a fiduciary duty to ensure the suitability of investment options. As noted by the Institutional Retirement Income Research Council (IRIRC), employers should encourage their retirees to consider retirement income solutions that have been vetted through a strong fiduciary process. 16 Additionally, employees benefit from a seamless transition to receiving income when they retire there s no need to redeem shares (as with a mutual fund) or shop for an annuity outside the plan. May incur lower costs. According to the TIAA-CREF Institute, An important feature of life annuities is that, for any given level of guaranteed monthly income for life, the annuity provides this income at lower cost than any other product. 17 Moreover, employees choosing an annuity through a DC plan generally enjoy more favorable pricing and lower M&E charges than individuals who buy annuities in the retail market. 18 They also avoid having to pay commissions that might be incurred by rolling over their accumulated savings to an outside annuity provider. 19 EXHIBIT 2. Low correlations = strong diversification benefits Average correlation of monthly returns, Guaranteed assets Guaranteed assets 1.00 Large-cap U.S. stocks Large-cap U.S. stocks Investmentgrade U.S. bonds 60% Large-cap U.S. stocks/ 40% Investmentgrade U.S. bonds Investment-grade U.S. bonds % Large-cap U.S. stocks/ % Investment-grade U.S. bonds Correlation measures the relationship among returns of different asset classes, showing how similarly or differently they tend to perform. Correlations range between -1.0 and A correlation of +1.0 implies that the two assets perform in lockstep; a correlation of -1.0 indicates that their returns move in opposite directions; and a correlation near 0 suggests that their returns have little to no relationship. A well-diversified portfolio includes a mix of asset classes with low correlations to one another. This table is not intended to represent the investment performance of any product. Rather, it shows the historical correlation of returns among different kinds of assets, or combination of assets, over a 30-year period. There are substantial differences between stocks, bonds and fixed annuities, including differing investment objectives, costs and expenses, liquidity, safety, guarantees or insurance, and fluctuation of principal or return. Large-cap stocks are represented by the Russell 1000 Index; investment-grade U.S. bonds by the Barclays Capital U.S. Aggregate Bond Index; and guaranteed assets by TIAA Traditional Annuity (Retirement Annuity contract). Specific features of guaranteed assets, including interest rates, liquidity and income payout options, vary by product and may not be identical to those of TIAA Traditional. You cannot invest directly in any index. Source: TIAA-CREF calculations. 4 The Case for Guaranteed Annuities in Defined Contribution Plans

5 REASSURANCE FOR PLAN SPONSORS Recent surveys indicate significant employee demand for retirement income solutions. According to the 2010 Retirement Confidence Survey, nearly half (46%) of U.S. workers say they are very or somewhat likely to choose a retirement plan option that pays monthly guaranteed income for life. 20 Another survey found that almost three-quarters (73%) of respondents would like a fixed annuity option in their DC plan. 21 Many plan fiduciaries recognize the value of offering lifetime income options. In a 2009 Towers Watson study, one-third of plan sponsors offering annuities and nearly half (46%) of those considering doing so rated themselves highly on helping participants at retirement. 22 Among plan sponsors that do not offer annuities, only 20% gave themselves high marks on this measure. Fixed annuities can meet participant demand for safety and stability while enabling plan sponsors to offer a holistic retirement plan emphasizing both asset accumulation and lifetime income. Plan sponsors should also be encouraged by the U.S. Department of Labor s safe harbor provision, designed to give employers fiduciary confidence in selecting annuity providers for benefit distributions from their plans. Final DOL regulations issued in October 2008 clarify the plan sponsor s role in choosing these providers and allow flexibility in specific evaluation criteria to satisfy fiduciary requirements. Furthermore, the DOL is currently seeking ways to expand availability of guaranteed income options for all Americans a goal well served by including annuities in DC plans. Our goal is to increase public awareness of the need for annuities and encourage employers to offer annuities as an option. Hilda Solis, Secretary, U.S. Department of Labor 12/2009 EXHIBIT 3. LIFETIME ANNUITY PAYMENTS: ENSURING RETIREES DON T OUTLIVE THEIR INCOME In this hypothetical example, a 65-year-old with $1 million in accumulated savings wants her income to last 30 years. Assuming a 4% interest rate, if she takes her income in the form of a single life annuity, she ll receive $66,671 per year, guaranteed for as long as she lives. However, if she decides not to annuitize and instead withdraws her money in regular installments, she would have to limit her withdrawal amount to $55,606 per year to receive income for 30 years about $11,000 less per year. And if she lives longer than 30 years, she risks depleting her savings completely. Research by the TIAA-CREF Institute concludes there is a greater than 50% chance retirees will run out of money if they take systematic withdrawals equal to the income payments received from a life annuity. * * Applies only to plans that pay out income over a life expectancy. Source: Benjamin Goodman and Michael Heller, Annuities: Now, Later, Never?, Trends and Issues, TIAA-CREF Institute, October Hypothetical Single Life Annuity vs. Systematic Withdrawals $80,000 $60,000 $40,000 $20,000 $0 65 Annuity Payment Withdrawal AGE Assumptions: Age when income begins: 65. Annuity option: Single Life Annuity. Initial accumulation: $1,000,000. Annuity payments: 4% interest, mortality based on A2000 with a 3.25 year set back. Earnings rate for systematic withdrawal: 4% per year. Life expectancy using A2000 with a 3.25-year set back is years. Both accounts were funded with pretax dollars and therefore payments will be taxed at ordinary income tax rates at the time they are paid. The impact of taxes and certain investment expenses, which would reduce the amount of income received, are not reflected in this illustration. The rates of return used in this example are hypothetical and are intended for illustrative purposes only. They do not represent and cannot predict or project the performance of any specific insurance or investment products. Actual results will vary. Lifetime income guarantees are backed by the claims-paying ability of the issuer. 5

6 Given the complexity and urgency of providing secure income during retirement, the necessity of designing the best possible solutions becomes paramount. Institutional Retirement Income Solutions: A Call to Action, Institutional Retirement Income Research Council, 11/2008 CHOOSING A TRUSTED ANNUITY PROVIDER Plan fiduciaries must exercise due diligence in choosing an annuity provider. The following are among the most important criteria in the selection process. Strength and stability. Does the insurer have sufficient capital strength to meet its current and future financial obligations? The financial crisis heightened concerns about the solvency of insurance companies that issue annuity contracts. Plan sponsors should review all publicly available information, including detailed reports issued by independent rating agencies such as Moody s and Standard & Poor s. In a brief on the role of annuities in DC plans, Financial Research Corporation concluded, The financial strength of the underlying guarantor should address concerns over a plan sponsor s fiduciary burden. 23 Track record. Does the insurance company have expertise and experience in providing lifetime income through various market and economic cycles? How long has the company offered annuities through retirement plans? Low costs. Are the company s annuity offerings low-cost, or do they have sales charges, commissions, surrender fees or other expenses that can reduce financial benefits for plan participants? Transparency. Are the company s annuity contracts and income benefits clearly stated and based on reasonable assumptions? Is the annuity option suitable for the company s active and retired work force? Participant education. Does the company offer a robust education program to help participants understand the appropriate use of annuities as a long-term retirement savings vehicle not a source of short-term liquidity? CONCLUSION Offering a low-cost, guaranteed fixed annuity in a defined contribution plan is an effective way to help participants build savings and bridge the retirement income gap. These annuities provide powerful benefits, including: Safety and stability Diversification Potentially higher retirement income Increased readiness for retirement Reassurance for plan sponsors Because of this unique combination of benefits, guaranteed annuities can play an essential role in enhancing retirement security for employees consistent with the plan sponsor s fiduciary obligations. HOW TIAA-CREF CAN HELP TIAA-CREF and the plan sponsors we serve share a common goal: to seek a safe and secure retirement for the individuals who entrust their savings to us. A lowcost, fixed annuity is the foundation of a complete retirement plan offering the advantage of income that participants cannot outlive. TIAA-CREF has provided guaranteed fixed annuities for more than 90 years, helping millions of people plan for and live well in retirement. We also offer: A full range of investment and income solutions Plan designs with proven results Expertise to help plan sponsors meet their fiduciary and compliance obligations Objective advice and financial education for participants Excellent value, combining high quality with low costs 24 6 The Case for Guaranteed Annuities in Defined Contribution Plans

7 TIAA-CREF: A LEADER IN RETIREMENT INCOME SOLUTIONS Our $410 billion in combined assets under management 25 includes nearly $198 billion supporting guaranteed annuity, insurance and financial protection products. 26 TIAA, the insurance company that backs our fixed annuity offerings, holds AAA or the equivalent highest possible financial strength ratings from all four leading independent insurance company rating agencies. 27 As of March 31, 2010, TIAA s capital and contingency reserves which determine our claims-paying ability stood at $24.1 billion, the highest level in the company s history. In a recent survey of 30 companies, TIAA-CREF participants had the highest average retirement account balances. 28 TIAA-CREF is America s largest private retirement system, serving 3.6 million individuals and more than 27,000 retirement plans. WE INVITE YOU TO LEARN MORE Please contact your TIAA-CREF Managing Consultant to: Review your plan menu Learn how lifetime income in retirement can help provide financial security for your employees and their beneficiaries By phone Online 7

8 NOTES 1 Annuity guarantees are based on the claims-paying ability of the issuer. 2 Diversification is a technique to help reduce risk. There is no absolute guarantee that diversification will protect against a loss of income. 3 Annuity guarantees are based on the claims-paying ability of the issuer. 4 Restoring Americans Retirement Security: A Shared Responsibility, McKinsey & Company, October The EBRI Retirement Readiness Rating: Retirement Income Preparation and Future Prospects, EBRI Issue Brief, No. 344, July Annuities Inside 401(k)s: Providing Guaranteed Income, Life Management Office Association, Information Center Brief, March 2007, and Annuities are Personal Pensions, in Are You a Stock or a Bond? Create Your Own Pension Plan for a Secure Financial Future, Moshe A. Milevsky, Ph.D., FT Press, Annuity guarantees are based on the claims-paying ability of the issuer. 8 Based on returns of the Russell 3000 Index, a broad measure of the U.S. stock market. 9 DALBAR, Inc., 2010 Quantitative Analysis of Investor Behavior, March Diversification is a technique to help reduce risk. There is no absolute guarantee that diversification will protect against a loss of income. 11 TIAA Actuaries, TIAA Traditional Annuity: Adding Safety and Stability to Retirement Portfolios, Spring/Summer TIAA-CREF response to U.S. Department of Labor, Request for Information Regarding Lifetime Income Options for Participants and Beneficiaries in Retirement Plans (RIN 1210-AB33), April Paul J. Yakoboski, Retirees, Annuitization and Defined Contribution Plans, Trends and Issues, TIAA-CREF Institute, April Jeffrey R. Brown, A Paycheck for Life: The Role of Annuities in Your Retirement Portfolio, Trends and Issues, TIAA-CREF Institute, June Yakoboski, April IRIRC, Institutional Retirement Income Solutions: A Call to Action, November Brown, June Statement on Best Practices for the Design of Defined Contribution Plans, Financial Economists Roundtable, October TIAA-CREF response to U.S. Department of Labor, Request for Information Regarding Lifetime Income Options for Participants and Beneficiaries in Retirement Plans (RIN 1210-AB33), April The 2010 Retirement Confidence Survey: Confidence Stabilizing, But Preparations Continue to Erode, EBRI Issue Brief, No. 340, March Most Americans Focused On Basic Financial Needs and Unprepared For Retirement, Ispos, June Managing Defined Contribution Plans in the Current Environment: 2009 Defined Contribution Plan Trends Report, Towers Watson, December Guaranteed Annuities in Defined Contribution Plans: Current Products and Future Prospects. FRC Vision, Financial Research Corporation, Fees for TIAA-CREF variable annuity accounts and mutual funds are generally half the mutual fund industry average. Source: Morningstar Direct (June 2010) based on Morningstar expense comparisons by category. 25 As of June 30, Represents all assets supporting guaranteed annuities used in conjunction with pension, IRA, Keogh and after-tax arrangements during both the accumulation and annuitization phases, as well as TIAA General Account assets supporting insurance and financial protection products. 27 Standard & Poor s (AAA as of 8/10); Moody s Investors Service (Aaa as of 7/10); A.M. Best (A++ as of 12/09); and Fitch (AAA as of 4/10). These ratings don t apply to variable annuities, mutual funds or any other product or service not fully backed by TIAA s claims-paying ability. Ratings are subject to change. There is no guarantee that current ratings will be maintained. 28 Source: LIMRA, Not-for-Profit Market Survey, second-quarter 2010 results. Average assets per participant based on full-service business. You should consider the investment objectives, risks, charges and expenses carefully before investing. Please call or visit tiaa-cref.org for a current prospectus that contains this and other information. Please read the prospectus carefully before investing. TIAA-CREF Individual & Institutional Services, LLC, and Teachers Personal Investors Services, Inc., members FINRA, distribute securities products. Annuity contracts and certificates are issued by Teachers Insurance and Annuity Association (TIAA) and College Retirement Equities Fund (CREF), New York, NY Teachers Insurance and Annuity Association College Retirement Equities Fund (TIAA-CREF), New York, NY C48188 A12439 (10/10)

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