Targeting Income. Retirement Income for Today s DC Plans. By Chip Castille

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1 Targeting Income Retirement Income for Today s DC Plans By Chip Castille

2 Editor Tony Mastrogiorgio phone About the author Chip Castille Mr. Castille is head of BlackRock s US & Canada Defined Contribution Group. In 2007, he rejoined Barclays Global Investors (BGI) as head of US Defined Contribution Product Development prior to its acquisition by BlackRock. During his previous tenure with BGI from 1993 to 1999, Mr. Castille was a research officer in BGI s Advanced Strategies and Research Group and part of the team that developed LifePath, the industry s first target-date strategy. From 1999 to 2007, Mr. Castille was managing director of Wilshire Associates and Chief Investment Officer for Wilshire Funds Management. Along with John Pirone, M. Barton Waring, and Duane Whitney, Mr. Castille co-authored Optimizing Manager Structure and Budgeting Manager Risk, which was published in the Journal of Portfolio Management, and received the Bernstein Fabozzi/Jacobs Levy award for outstanding article in He holds an MBA from Loyola University and a BA in journalism from Louisiana State University.

3 BlackRock 3 Table of contents Executive summary What happened to lifetime income? Why DC plans need new investment solutions Diving into the mortality pool Building a DC annuity pool Can managed annuities improve target date strategies? Managed annuities and fixed income Comprehensive retirement solution Sponsor and participant benefits: QDIA eligibility and institutional pricing Conclusion: The next evolution?

4 4 Targeting Income Executive summary Traditional sources of retirement income have either declined in availability or come under threat just as the first wave of the baby boom generation approached retirement. At the same time, defined contribution (DC) plans have increased in importance and are ideally placed to partially offset the loss of income from traditional sources. Unfortunately, DC plans have historically focused on lump sum accumulation and paid scant attention to the challenge of delivering lifetime retirement income. This paper explores a new type of DC investment strategy that will partially replace income from traditional sources by incorporating pooled, unallocated deferred annuities. Providing benefits similar to defined benefit (DB) plans and social security, pooled, deferred annuities are one of the most powerful tools for providing lifetime income. They also offer the potential to overcome some of the challenges preventing the adoption of individual annuities, which can be expensive, complicated, are often misunderstood and have proven difficult to incorporate into DC plans. Further, by combining the annuity pool into a target date fund structure, it may be possible to mitigate the point-in-time risk associated with individual annuity purchases by accumulating annuity income over time as the target date glidepath becomes more conservative. Equally intriguing are characteristics of the annuity pool itself, including the possibility that it can extend the asset allocation and inflation risk management capabilities of target date funds. The prospect of using a target date fund structure introduces additional potential benefits. By tying the annuity allocation to the glidepath, the investment manager suggests an optimal annuitization level. Since unallocated annuities are not individually owned by participants, there would be no transaction costs for participantdirected activity. Finally, such a strategy can also benefit plan sponsors by providing a cost-efficient DC income solution that is qualified default investment alternative (QDIA) eligible.

5 BlackRock 5 What happened to lifetime income? The decline of defined benefit plan pensions, growing uncertainty about social security, and the rise of defined contribution plans with an emphasis on lump sum accumulation have combined to make lifetime income an increasingly scarce commodity for American workers on the verge of retirement. If not quite extinct, DB plans and their promise of lifetime income no longer play a significant role in retirement preparedness for today s workers and for younger workers, they play almost no role at all. The trend is unmistakable. According to the 2010 Deloitte US Consulting 401(k) Benchmarking Survey, only 23% of US employers offer an active, qualified DB plan, while 74% offer a qualified DC plan. Another of the traditional pillars of retirement income for most Americans, social security, is also under stress. Projections from the Social Security and Medicare Board of Trustees suggest that projected Old Age, Survivors, and Disability Insurance (OASDI) tax revenue will begin to fall short of outlays within a few years, and that the trust fund balance could be exhausted within a few decades. It remains to be seen if the political willpower exists to increase OASDI taxes in order to bring the programs into actuarial balance or to maintain the current expected benefit levels. In light of such uncertainty, any prudent retirement plan should include reduced expectations of projected social security income. The pressure on retirement income comes at a time when millions of Baby Boomers are preparing to enter retirement. Almost by default, they find DC plans have become the centerpiece of their retirement planning. Unfortunately, the investment strategies DC plans rely on have failed to mature into a complete retirement solution, most notably when it comes to the transition from decades of savings to decades of spending. Increasingly, Baby Boomers and participants have recognized this shortfall. A study conducted by BlackRock and the Boston Research Group in March 2009 found that nine in ten participants are interested in seeing a retirement income option added to their plan. The question is, can DC plans deliver income efficiently? Why DC plans need new investment solutions The defined contribution plan is no longer a supplemental savings plan; it is a retirement plan that is the primary source of retirement wealth for many participants. While participants have come to appreciate the flexibility and portability of DC plans, they come at a price: decisions about managing investments and planning retirement spending fall squarely onto participants shoulders. Considering that few participants are capable of the decades of investment decision-making necessary to manage their savings, DC plans should include investment options that manage the three most significant risks participants face during their working years and in retirement: Asset allocation risk. Can participants build an investment portfolio that reflects suitable risk/return characteristics for their age and time horizon, and adjust the allocation as they age and their circumstances evolve? Inflation risk. Will their savings outpace inflation during accumulation and retain purchasing power throughout retirement? Longevity risk. Will participants outlive their savings? DC investment options have evolved sufficiently to capably manage the first two risks, asset allocation and inflation, particularly through target date fund strategies. Since BlackRock introduced them in 1993, target date funds have proven popular with both plan sponsors and participants. The appeal is obvious. For plan sponsors, they represent a professionally managed, well-diversified option suitable for most investors for participants, a single, straightforward investment choice manages asset allocation risk across decades. Also, a welldesigned target date fund that includes real assets, such as real estate investment trusts (REITs), and inflation protection options, such as Treasury Inflation-Protected Securities (TIPS), should also provide inflation protection. Additionally, a prudent exposure to equities during retirement may also help preserve purchasing power. With the passage of the Pension Protection Act (PPA) of 2006 and the Department of Labor s corresponding qualified default investment alternatives (QDIA) regulations, target date fund assets have become the predominant default choice for plan sponsors. But an important shortcoming remains for today s target date funds and by extension the DC plans that offer them: their inability to manage longevity risk.

6 6 Targeting Income Longevity risk, defined simply as the risk of outliving one s savings, is one of the most significant challenges facing participants and one of the most difficult for individuals to manage efficiently. If participants are ill-prepared to manage decades of investment decisions during accumulation, they are even less prepared to manage decades of decumulation, when mistakes may have even more dire consequences. Individuals are left to accurately estimate their own mortality, which is nearly impossible to do in a way that is meaningful to retirement planning, and find cash flows of sufficient maturities to fund retirement in a simple, transparent, and cost-effective way. (This task becomes problematic for very long-dated cash flows with maturities beyond 30 years.) Most individuals attempt to protect themselves from longevity risk through the use of market securities. But more often than not, they inefficiently over-insure by holding larger-than necessary account balances, therefore spending less than they were able and enduring a diminished quality of retirement life. Or they overestimate market returns (or invest unsuccessfully) and exhaust their savings prematurely. One practical way to manage longevity risk is to gain access to a security that pools longevity risk, thereby relieving the participant from the challenge of estimating their life expectancy. For most workers, access to such a security pool can be obtained only through a traditional insurance product, typically an annuity. Unfortunately, existing insurance products and annuities are poorly understood, seldom used effectively, and have not previously been seamlessly incorporated into DC plans. But before we can explore the possibility of incorporating annuities efficiently into a DC investment solution, it is necessary to understand the strengths and challenges of today s insurance-based products. Diving into the mortality pool Today s most popular insurance-based income products, variable annuities, attempt to replicate the tax advantages of DC plans while providing a DB-like benefit in terms of income. The annuities most individuals buy are developed, marketed, and priced for the retail marketplace. Individual buyers typically pay a sizable commission, face expenses ranging from 100 to over 200 basis points (bps) annually (depending on the type of investment focus), and face charges for redeeming a policy prematurely that can range from 4 to 8%. To further complicate matters, retail insurance products usually include a complex set of benefits that have a large degree of embedded optionality, such as period certain, survivor benefits, and income based on high-water mark account values. Yet despite their cost and complexity, annuity products have features that not only make them fascinating financial instruments, but also offer the potential to be extremely beneficial to DC participants seeking to manage longevity risk. Armed with a sufficient understanding of how annuities work, it may be possible to adapt them to the needs of DC plans and participants. The first benefit is that annuities are backed by a mortality pool, which is formed by organizing individuals into a collection about which statistical expectations can be made with a high degree of confidence. Not surprisingly, the most relevant statistic is the life expectancy of the pool itself. With a large enough unbiased sample from the population and an accurate estimate of the life expectancy of the population from which the pool is drawn, one can be sure that the realized life span of the pool will converge closely with that of the population. Why is the mortality pool a benefit? It allows insurance companies to provide lifetime income to each individual in the pool with near certainty that they will actually pay out only those cash flows necessary to fund the average life expectancy of the pool. In other words, the insurance company can expect to pay out the value of exactly 20 years of cash flows if the life expectancy of the pool at the age of 65 is 85.

7 BlackRock 7 For the buyer, not only is he relieved of the need to accurately estimate his own life span, he can also buy lifetime income at a rate that is discounted by time and also by the probability of being alive when the cash flow is due. This leads to a much cheaper access to true lifetime income than self-insuring. (See the sidebar, Mortality Discounts.) Of course the lunch is not completely free. Once the buyer exercises the annuity and begins receiving payments, he cannot easily get a return of his capital. He can only get the promised annuity payments. Therefore, if the buyer dies before average life expectancy, he overpaid for the annuity. If our buyer cannot overcome his hesitation about potentially overpaying for the annuity, he can elect to take a (relatively) small reduction in the monthly annuity payment in order to designate the annuity period certain. For example, a ten-year period certain means that the annuity will continue to pay out for ten years to the designated beneficiary should the annuitant die before the period ends. For period certain annuities, the cash flows would be approximately priced as a zero coupon bond over the period, and the mortality discounts begin for those cash flows due beyond it. The buyer can also buy a joint survivorship annuity, which provides lifetime income to both the buyer and another person, such as a spouse. Each of these choices will impact the amount and cost of inflation-adjusted monthly income. In any event, mortality discounting will always provide some reduced cost for buying future cash flows since the probability of actually living into the future will always be less than 100%. Can we bring the benefits of an efficiently managed mortality pool into DC plans to provide lifetime income options for participants? The answer depends on what features the annuities should have and how they can be most efficiently managed within the DC context. Mortality discounts Contemplating the mortality pool may seem morbid, but it does provide a here-and-now benefit: a discount on future income. Consider a 65-year-old investor who wants to buy a single $2,000 monthly payment to begin delivery 20 years into the future. If he buys a zero coupon bond, his cost is a straightforward calculation based on the interest rate and time. If he has access to a security backed by a mortality pool, his cost is discounted by the probability of the issuer having to make the payment. The mortality discount for this single payment is 46%. Cost of $2,000 Payment $2,000 $1,500 $1,000 $500 $0 $ Zero Coupon Bond $ Deferred Annuity Cost, Age 65 Payment, Age 85 This example assumes a 4.5% interest rate and calculates the probability of a 65-year-old surviving to age 85 as 46%. The zero coupon bond payment will be made regardless of whether or not he is alive to receive it. The mortality-discounted payment will be made only if he survives. Calculations: $2,000/(1.045) ^ 20 = $ and $ = $

8 8 Targeting Income Building a DC annuity pool Designing an annuity that meets the retirement income needs of DC participants is straightforward. To manage longevity risk we need an annuity with only two components: lifetime income and inflation protection. The lifetime income feature provides long-dated cash flows. The inflation protection ensures that future cash flows have relevant purchasing power. If the annuity is purchased during the accumulation phase, the annuity would be deferred, which means that the income provided begins at some date in the future. The picture becomes more complicated as we consider management of the annuity pool. Any DC plan that includes some form of annuity to either pay or guarantee income must be tied to the individual participant. Can this be accomplished while still taking advantage of the collective nature of a DC plan? We believe the answer is yes. Annuities can be purchased in two different forms: allocated and unallocated. Allocated annuities require the provider to administer the annuity on an individual basis. In practical terms, that means the insurance company must maintain personal information on each individual holding the annuity and the plan sponsor must track the income levels and/or annuity units accrued by the individual. (See the sidebar, The Record Keeper Challenge.) Unallocated annuities are written on behalf of a group and the insurance company does not need to have or maintain any personal information on individuals in the group. (The annuity provider may know or estimate important characteristics of the group, such as age and sex, for actuarial purposes.) Units of unallocated annuities are largely fungible between members of the same group, making adjusting their allocation more efficient. They are also easier to administer, reducing costs to the participants. This type of annuity, which we will refer to as a managed annuity, is institutionally designed, less expensive than an individual annuity, and allows participants to transact more efficiently because they can move into or out of the managed annuity without commissions or redemption fees. Both allocated and managed annuities can potentially play a role in providing DC participants lifetime income. In fact, several insurance companies offer allocated annuities to DC plans. Perhaps not surprisingly, the uptake for individual annuities among DC participants has not been significant, possibly because participants are overwhelmed by the complexity of annuity products in addition to being wary of the expense. The record keeper challenge As DC plans have evolved, technology and operational support have frequently had to scramble to keep up. Today s record keeper platforms efficiently perform the task of tracking mutual fund units and updating prices. Tracking and pricing annuities, reporting projected future income back to participants, and managing the transition to an individual annuity at retirement are all beyond the scope of current record keeper platforms. One possible solution, as opposed to requiring expensive technology builds for every record keeper interested in supporting income solutions, is to leverage the approach used by DC plans with self-directed brokerage accounts. Such plans have a brokerage window in which a third party tracks participant activity and reports back current values to the record keeper. All that is required on the record keeper s part is a relatively simple connection between the brokerage window and their platform. BlackRock and SunGard, a leading technology company specializing in financial services, developed the income window leveraging this approach utilizing SunGard s existing brokerage window technology. The income window reduces the need for a record keeper build and is sufficiently flexible and customizable to support a wide range of income solutions. A more successful annuity-related income product that has gained some traction in IRA asset management programs, and to a lesser extent in DC plans, is called a guaranteed minimum withdrawal benefit (GMWB). These offer an annuity wrapper that guarantees a minimum level of income typically based on a percentage of the portfolio s high-water mark. Should the portfolio become exhausted during the distribution phase (and assuming all the conditions are met), the annuity provides income for the remainder of the participant s life. In effect, the participant in a GMWB pays insurance against market risk. The attraction of GMWBs for participants is that they provide the security of lifetime income. They are expensive, however often with charges of over 100 bps per year. In addition, they frequently have restrictions that reduce the income guarantee if a withdrawal exceeds the agreed upon maximum. Further, the guaranteed withdrawal amount

9 BlackRock 9 in most GMWBs or similar products does not include inflation protection: once the annuity wrapper is activated, the income is set for the life. managed annuities and fixed income share some characteristics that make this change not only feasible, but attractive from a glidepath management perspective. A pool of managed annuities would seem to offer more attractive possibilities for a DC-based solution. Rather than merely insuring against market loss, a managed annuity can be incorporated into a DC investment so that it is part of the participants investment portfolio so that it builds up income over time and delivers a predicable level of income. The question then becomes how to best deliver these benefits to participants. Can managed annuities improve target date strategies? Thus far we have focused on finding an efficient instrument for generating retirement income through a DC investment. We have found managed annuities to offer flexibility that could be leveraged through a variety of investment strategies. But what is the optimal method for participants to invest in the managed annuity pool? As we have already seen, managed annuities address one of the major obstacles preventing individuals from buying an annuity, which is their expense. Another major remaining obstacle is timing. Behavioral finance suggests that participants have difficulty making the decision to move into an annuity. Additionally, there is point-in-time risk in purchasing an annuity based on the current interest rate environment and the market value of the savings available for the purchase. Consider our objective in providing income through a DC plan, which is to finally evolve defined contribution into a complete retirement solution. Next, consider the characteristics of a target date fund that includes growing exposure to managed annuities. The strategy would: Be QDIA eligible, offering safe harbor protection to plan sponsors. Be readily understood by participants who are already familiar with target date strategies. Provide optimal exposure to traditional asset classes as well as the managed annuity. Set risk levels for each stage of the participant s life and adjust the portfolio allocations accordingly to manage asset allocation and inflation risks on the participant s behalf. Purchase the managed annuity in an optimal fashion over a working life. We believe that such a strategy would not only maintain the ability to manage asset allocation, it would also extend it in important ways. To understand how, it is important to understand some characteristics of managed annuities as an asset class. Figure 1: Building income over time The ideal purchase mechanism would address these obstacles by allowing participants to purchase the managed annuity automatically over their working life and convert to an individual annuity (and begin providing income) at retirement. These objectives can be achieved by delivering managed annuities through a target date strategy by replacing the traditional fixed income asset class with a new asset class comprised of managed annuities. Return Age 45 Age 25 Age 35 Annuity Income Fixed Deferred Annuities Growth Allocation As a long-dated, traditional target date fund moves along its glidepath toward its target date, it grows more conservative by decreasing allocations to equities and increasing allocations to fixed income. (See Figure 1.) By substituting managed annuities for fixed income, participants purchase a larger share of the managed annuity pool as they move toward retirement. As we will describe momentarily, Short Age 55 Retirement Time Until Retirement Risk Large Cap US Equity International Equity Small Cap US Equity REITs Long For illustrative purposes only. Not actual allocations.

10 10 Targeting Income Managed annuities and fixed income Annuities and fixed income securities share some essential characteristics. Both offer income. As interest rates change, the market value of that income fluctuates. (A participant s share of the managed annuity can be thought of as a unit. Each unit represents a specific amount of future income. As interest rates rise or fall, the market value of the unit changes, but the amount of income it provides does not.) By responding similarly to interest rate changes, managed annuities as an asset class can provide the equity diversification function currently provided by fixed income. In addition, substituting managed annuities for fixed income may also permit adjustment to the glidepath. The glidepath is constructed to provide optimal risk adjusted return exposure for each stage of the participant s lifetime. The promise of guaranteed lifetime income, further enhanced by including a cost-of-living adjustment (COLA) in the income stream to limit inflation risk, should allow an investment manager to provide incrementally greater equity exposure without increasing overall risk in comparison to a traditional target date strategy. Finally, the managed annuity allocation may be a better hedge to equity risk than fixed income, which would also permit increased equity exposure without increasing risk. In fact, BlackRock s own solution, LifePath Retirement Income, the first strategy to incorporate managed annuities into a target date structure, does have a higher equity allocation and a greater equity landing point than the traditional LifePath strategy. Let s take a more detailed look at how the proposed strategy can manage risk and then consider additional benefits to plan sponsors from combining a managed annuity class inside a target date strategy. Comprehensive retirement solution Earlier in this paper we stated that the complete DC investment solution would help manage asset allocation, inflation, and longevity risk throughout a participant s lifetime. How well would our proposed target date strategy with a managed annuity allocation manage these tasks relative to the traditional approach? We ll begin with asset allocation risk, which has the largest influence on the distribution of outcomes. Asset allocation For the DC participant, managing asset allocation risk becomes increasingly complicated because as a participant ages, his investment horizon steadily decreases. As a result, he needs to manage risk in two dimensions. First, we must ensure that at each point in time, the participant s portfolio is mean-variance efficient. In other words, for a targeted level of expected risk, the portfolio must be designed to have the highest expected return. At the same time, we must also ensure that the expected risk target itself is appropriate given the participant s investment horizon. The traditional target date fund, with an allocation to fixed income securities, can manage asset allocation risk along both dimensions, but it s ability to do so may be enhanced with the addition of the managed annuity asset class. To illustrate this point, consider the Monte Carlo simulations in Figure 2, which depict annuitized wealth distributions for a traditional target date fund and target date fund with an allocation to a managed annuity. The left side of the distribution is usually at zero or slightly above, and the right tail extends out much farther, representing those runs of the simulation that produced very high wealth outcomes. Figure 2: Monthly income from full annuitization Probability $500 $3,500 $6,500 Monthly Income LifePath Retirement Income with fixed income LifePath Retirement Income with annuities Source: BlackRock. For illustrative purposes only.

11 BlackRock 11 Important factors that influence the shape and location of the distribution of outcomes include the savings rate of the participant; the expected returns, risks, and correlations of the fund s underlying asset classes; and the shape of the glidepath. BlackRock research indicates that when savings rates are fixed and a manager is restricted to using asset classes currently available to traditional target date funds, little can be done to reshape the left side of distribution of outcomes, which represent worst-case outcomes. In a traditional target date fund, the only directly-held asset that can help manage the worst-case outcome is cash. However, cash prevents investors from earning real returns and exposes them to significant inflation risk. A managed annuity allocation, however, gives asset managers a new tool with qualities that other asset classes in a traditional target date fund simply don t possess. Unlike cash, the managed annuity has a real return expectation as well as inflation protection. The rightward shifted distribution in Figure 2 indicates that managed annuity allocations enable managers to significantly reshape the worst case outcomes by accumulating a real income floor over the life of the fund and offering participants a significant advance in the ability to manage asset allocation risk. Figure 3: Impact of 2.5% per annum inflation Purchasing Power ($) $1.20 $1.00 $0.80 $0.60 $0.40 $0.20 $ Source: BlackRock. For illustrative purposes only. Years Inflation A target date fund with a managed annuity allocation manages inflation risk differently during working and retirement years to reflect the fact that inflation has a more corrosive impact on purchasing power when one is dependent upon a fixed income stream. To hedge inflation during participants working years, both the traditional and managed annuity target date strategies primarily use equities and real assets, such as REITs, as an efficient and practical inflation hedge during this period because of the long investment horizon. The managed annuity target date strategy, however, provides participants a secure income floor during retirement and can therefore maintain an incrementally larger equity allocation during accumulation while maintaining the same risk profile. Once participants retire, the situation changes. On a fixed income, a participant is more vulnerable to the effects of inflation. For example, consider that just a 2.5% annual rate of inflation will reduce the purchasing power of a retiree by over 50% within 30 years, as illustrated in Figure 3. Traditional target date strategies attempt to manage inflation on behalf of participants by assuming a distribution rate and allocating a generally conservative portfolio that retains a degree of equity exposure. It is understood that a retired participant typically cannot assume an investment horizon or risk tolerance level required to hedge inflation with too large an allocation to equities. (Even so, there is a large disparity of equity allocations in retirement throughout the target date fund universe.) Too large an allocation to TIPS or other inflation-protected securities could lead the participant toward inefficient self-insurance against longevity risk through lower returns. Building inflation protection into the managed annuity by including a cost-of-living adjustment (COLA) more directly addresses inflation risk and insulates the participant against investment risk. The COLA can use fixed estimates of future inflation, or it can be tied to some realized inflation index. Within BlackRock s LifePath Retirement Income fund, for example, the annuity is designed and priced with a fixed 2.5% COLA. Upon receiving the individual annuity at retirement, the plan participant can choose to move the COLA to a higher- or lower-fixed amount at an actuarially equivalent rate, or tie the COLA to a CPI for an additional fee.

12 12 Targeting Income Longevity Since annuities directly address longevity risk through guaranteed lifetime income, the question should shift to how much of the portfolio should be invested in the managed annuity. Historically, the annuity purchase decision has been problematic for individuals because there is an implicit trade-off between the income security provided by the annuity and the loss of control over the assets. For example, an individual may be concerned about the potential for an emergency that would demand access to more funds than those provided by the annuity. BlackRock uses a sophisticated consumption model to maximize utility of consumption how much participants can spend in retirement. This maximization considers market growth provided by the investment portfolio and the security offered by the managed annuity. In the case of LifePath Retirement Income, this results in a final allocation of 53% to the managed annuity when the participant reaches 65 years of age. How much income can LifePath Retirement Income provide? The median outcome of Monte Carlo simulations that model the average participant indicates that the managed annuity allocation in the fund could provide a 15% income replacement ratio at retirement. It is widely estimated that individuals need about a 75% income replacement ratio to enjoy the same standard of living postretirement that they enjoyed pre-retirement. That means that LifePath Retirement Income has the potential to provide approximately 20% of an individual s income needs through the annuity allocation. Keep in mind also that at maturity, the annuity only represents 53% of the fund. The remainder is still invested in market securities and can serve to provide flexibility in a retiree s financing needs. Next, we ll take a look at the potential benefits this approach offers DC plan sponsors and investors, particularly in the context of purchasing and managing the annuity. Sponsor and participant benefits: QDIA eligibility and institutional pricing Over 20 years of behavioral finance research indicates that participant inertia is a real and present danger. Communication and education efforts can help, but they re not enough to effect important changes in participant behavior. Plan design and automation have emerged as critical components for achieving the goal of encouraging greater savings. Thankfully, the PPA and resulting DOL regulations include numerous provisions that allow sponsors to default participants into DC investment options that are more likely to lead to good outcomes. Target date funds are eligible as a QDIA under the provisions of the PPA, which provides certain legal protections to plan sponsors who select to deliver guaranteed retirement income through a default for plan participants. In addition to QDIA eligibility, a managed annuity within a target date structure can harness institutional scale and expertise for the purchase of the managed annuity, and includes several benefits: Competitive pricing A competent fund manager will understand how to fairly price the managed annuity and negotiate with insurance companies on an institutional basis to ensure they are paying a fair price for the cash flows represented by the annuity. Also, because the design of the managed annuity calls for an unallocated group contract, the insurance provider can significantly reduce the administrative costs associated with an allocated annuity and pass these savings on to plan participants. This advantage also applies to the day-to-day pricing of the managed annuity and the investment manager s determination as to whether the annuity should be bought or sold at the price currently quoted by the insurance providers. The investment manager, as a fiduciary of the insurance providers, fully understands the fees paid to these providers. Low transactions costs Because an unallocated group contract is used for the managed annuity, plan participants can transact in the income accumulation fund just like other DC options, without paying a charge for changing the allocation to the annuity itself. It is important to note that prior to maturity, the annuities are owned by the target date fund. However, net plan participant transactions are likely to cause the fund to transact in the managed annuity on a regular basis. In a well-designed fund there should be no charge to the fund for these transactions to meet one of the criteria for becoming a QDIA. This is in high contrast to the typical 3 5% load or charge that occurs when individuals buy or sell annuities directly.

13 BlackRock 13 Interest rate smoothing Most participants who annuitize a portion of their assets do so at a single point in time: retirement. By doing so they are taking on significant point-in-time risk related to prevailing interest rates, which factor heavily into annuity pricing. A well-designed target date fund should consistently build its managed annuity exposure to the interest risk over the life of the fund. Given the extent to which rates can vary over the 40-year accumulation period, the opportunity to spread exposure to rates offers the potential to significantly reduce risk. Increased credit risk diversification For the sake of simplicity, we have assumed the fund holds managed annuities issued by a single provider. However, a fund manager may purchase managed annuities from multiple providers to diversify credit risk. Furthermore, if each provider manages the assets backing the managed annuity in a bankruptcy-remote separate account, assets in the separate account would continue to be managed by the regulator in the event of a failure by the insurance company and the separate account holder would be the first creditor in line to claim the assets to satisfy the liabilities of the insurer. Participants can watch their income accumulate As discussed above, buying annuities has generally been a complex and anxiety-producing process for most individuals. Because the participant purchases the annuity over the life of the fund, he can potentially witness an increasing income floor develop throughout his working life. Although the benefit of having lifetime income is difficult to quantify, it could have a significant impact upon workers in need of future lifetime income. Conclusion: The next evolution? We began this paper by suggesting that today s DC investment options fall short of reflecting their heightened importance in the current retirement landscape. Most participants lack the necessary tools to overcome asset allocation, inflation, and longevity risks especially when the headwind of inertia is factored into the equation. A well-designed target date fund with a managed annuity allocation can address these challenges by using institutional-quality deferred annuities within the widely accepted target date fund structure. It gives participants flexibility to opt in or out of the program without typical insurance fees and charges, and it enables them to invest in the fund until the fund matures effectively using inertia to their own advantage. As participants focus on other nonretirement life challenges, the fund s mix of securities and annuities continually evolves to ensure diversification throughout participants working and retirement years. In addition, including a managed annuity in a target date framework dramatically extends the traditional target date funds ability to manage asset allocation, inflation, and longevity risks on behalf of DC participants. This development represents the necessary evolution of DC products to meet participants increased dependence on wellbuilt DC investment solutions. For plan sponsors, delivering retirement income through a target date fund may provide the best of both worlds: it can be designed to qualify as a QDIA, which offers important legal protections, and it can give employees access to a secure stream of income and potentially greater financial freedom in retirement.

14 14 Targeting Income

15 BlackRock 15 All statements herein are qualified by, and any offer is made solely pursuant to, a final offering document and investment management agreement. No offer to purchase units in any fund will be accepted prior to receipt by the offeree of these documents and the completion of all appropriate documentation. The strategies referred to in this publication are among various investment strategies that are, or will be, managed by BlackRock as part of its investment management and fiduciary services. The funds are bank collective investment funds maintained and managed by BlackRock Institutional Trust Company, N.A., and are available only to certain qualified employee benefit plans and governmental plans and not offered or available to the general public. Accordingly, prospectuses are not required and prices are not available in local publications. To obtain pricing information, please contact your local service representative. BlackRock Institutional Trust Company, N.A., a national banking association operating as a limited purpose trust company, manages the investment strategies and other fiduciary services referred to in this publication and provides fiduciary and trust services to various institutional investors. Strategies maintained by BlackRock are not insured by the Federal Deposit Insurance Corporation and are not guaranteed by BlackRock or its affiliates. The information included in this publication has been taken from trade and other sources considered reliable. No representation is made that this information is complete and should not be relied upon as such. Any opinions expressed in this publication reflect our judgment at this date and are subject to change. No part of this publication may be reproduced in any manner without the prior written permission of BlackRock. The LifePath Portfolio mutual funds are distributed by BlackRock Investments, LLC, member FINRA. BlackRock Fund Advisors (BFA) serves as investment adviser to the LifePath Portfolio mutual funds, and the Master Portfolios, in which each LifePath Portfolio invests all of its assets, and to the Underlying Funds in which the Master Portfolios invest. BFA is a subsidiary of BlackRock Institutional Trust Company, N.A. The LifePath products are covered by US patents 5,812,987 and 6,336,102. Investing involves risk, including possible loss of principal. Asset allocation models and diversification do not promise any level of performance or guarantee against loss of principal. LifePath Retirement Income is not itself an insurance product. BlackRock is not issuing or selling insurance or promising any financial guarantee or periodic payment. Annuities in which LifePath Retirement Income invests are provided by one or more insurance companies. Income is based on the claims-paying ability of the insurance company and the plan sponsor taking certain steps required to take advantage of the post-retirement income benefit. This publication is not an offer to sell, nor an invitation to apply for any particular product or service. BlackRock is a registered trademark of BlackRock, Inc. LifePath is a registered trademark of BlackRock Institutional Trust Company, N.A. All other trademarks are the property of their respective owners BlackRock, Inc. All Rights Reserved TP-6/11 FOR INSTITUTIONAL OR FINANCIAL PROFESSIONAL USE ONLY Not For public Distribution

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