The SECURE Act made it much easier for employer 401(k) and other plans to offer guaranteed lifetime income investment options provided by life insurance companies. It remains to be seen whether employers will now offer them, and if they do whether employees will choose them.
SECURE Act and Lifetime Income
One of Congress’s main concerns when passing the bipartisan Setting Every Community Up for Retirement Enhancement (SECURE) Act in late 2019 was making retirement assets last through a retiree’s lifetime. Changes that worked towards that goal included delaying required minimum distributions until age 72, taking the age limit off IRA contributions, and making plans disclose an employee’s lifetime income estimates in plan statements.
A somewhat controversial part of this project was making it easier for employer plans to offer individual lifetime income annuities provided by life insurance companies. The problem is that many investors have only a dim understanding of what annuities are, so it is unclear how your average 401(k) participant would be able to choose. Plans would have to offer a lot of education.
Whatever the overall concerns about life insurance products, Congress addressed two of the main objections employers have to annuities:
- the risk of fiduciary liability for selecting a bad annuity provider, and
- the difficulty of dealing with an individual employee’s annuity if the employer wants to discontinue that investment option.
What are Annuities?
Guaranteed annuities are contracts issued and sold by state licensed insurance companies. Annuities are usually bought by individuals, though employer plans sometime buy contracts from insurers to help fund pensions.
Immediate income annuities provide monthly income starting right away. These are often bought at retirement if an employee cashes out a 401(k). They can be viewed as do-it-yourself pensions. Some people prefer having at least some of their assets generating predictable income, month-in, month-out, until death.
Deferred income annuities can also be bought as a savings or investment vehicle. An individual can set up regular contributions during their working years. Or it might be provided through an employer retirement plan. The owner “annuitizes” the contract by electing to take monthly payments.
Publicly Traded Financial Assets and Annuities Compared
Publicly traded financial assets have the following features:
- they provide the exact same benefits in terms of growth and dividends no matter who owns them;
- they are normally easy to liquidate at fair market value at any time for distribution or other purposes;
- they are easy to buy again with distributed or transferred cash, if that is what one wants; and
- these kinds of assets are expected to come and go in one’s retirement account through one’s life.
Annuities are not like that. They are tailored to the individual purchaser’s age when making payments to the insurer, and the individual’s age when payments begin. Plus, different companies offer different rates and benefits for different annuity products.
Annuities are not really designed to stop until death. They generally have a cash-out feature with an accompanying fee or penalty. But the owner cannot simply take the cash across the street and buy a similar annuity because that person has aged.
It is like buying whole life insurance when you are 50, cashing it out when your 60, and then going shopping for the same deal. Entering a contract for a new life insurance coverage at age 60 is a lot more expensive than it is for a 50-year old. So are lifetime income annuities.
On the plus side, basic annuities are not touched by stock market volatility. Also, the owner and surviving spouse will not run out of money as long as they live (though payments will diminish in value over time due to inflation).
Employer Plans and Annuities
Employer defined contribution plans (including Code Sec. 401(k), 403(b), and 457(b) plans) are funded with elective salary deferrals and employer contributions. Both kinds of contributions are excluded from income. Assets grow tax-free until withdrawn. Distributions are taxed at ordinary rates at retirement.
Employer 401(k) plans have historically focused on publicly traded financial assets rather than annuities. These kinds of assets are easy to cash out when necessary and easy to swap out if the employer wants to change the plan’s mix of investment options.
Nothing has prevented employers from offering annuities in their 401(k), 403(b) or 457 plans. The IRS as long recognized Qualified Plan Distributed Annuities (QPDAs) that can be distributed in-kind directly to employees at retirement. The IRS encourages employers to offer Qualified Lifetime Annuity Contracts (QLACs), which are not subject to RMD rules until age 85.
The Portability Problem
In practice, however, 401(k) plans generally do not include lifetime annuity options. One reason is “portability.” As discussed above, annuities are tailored to each individual. An employer that wants to discontinue offering a particular annuity would have to cash it out. Because time has elapsed, however, the employee would have to start all over again.
One option might be to just distribute the annuity in-kind to the employee. Another would be to let the employee roll it over into an IRA. The problem, however, is that employer plans such as 401(k)s are generally prohibited from distributing benefits while the employee is still working for the employer.
SECURE Act and Portability
The SECURE Act allows distributions of “lifetime income investments” out of the plan to employees even if they are still working for the employer. The employer and employee have up to 90 days prior to the date the investment is discontinued to transfer the annuity. This portability rule applies to “qualified distributions” from or to the following plans:
- 401(k) plans;
- tax sheltered annuity 403(b) plans;
- custodial accounts (including IRAs);
- eligible deferred compensation 457(b) plans.
A “lifetime income investment” is an investment option designed to provide an employee with election rights:
- which are not uniformly available with respect to other investment options under the plan, and
- which are to a lifetime income feature available through a contract or other arrangement offered under the plan (or under another eligible retirement plan, if paid by means of a direct trustee-to-trustee transfer to such other eligible retirement plan).
Plans can provide either or both of these distribution options:
- trustee-to-trustee transfers of participants’ lifetime income product interests to other eligible plans (including IRAs), or
- distribution to the employee of an employee’s accumulated lifetime income benefit in a qualified plan distribution annuity contract.
The Employer Liability Problem
The other major problem for employer plans is they do not want the responsibility of picking annuity providers or products for their plan participants. These kinds of investments are complicated enough, but there is the added risk that the insurer might become insolvent or might not otherwise perform.
Employer plans have fiduciary responsibility to participants, breach of which can cause serious liability. Employers do not want to become in effect guarantors of insolvent life insurers.
SECURE Act’s Fiduciary Safe Harbor
The SECURE Act provides a fiduciary a safe harbor that relies to a large extent on state-level licensing and oversight of annuity providers. That move outsources a lot of the work to state regulatory agencies. Perhaps more important, it means a plan fiduciary’s duty is satisfied by exercising due diligence at the time of selecting an annuity provider. It does not require a good outcome.
Under the safe harbor, a plan and its fiduciaries must:
- engage in an objective, thorough, and analytical search to identify insurers from which to purchase guaranteed retirement income contracts;
- with respect to each identified insurer consider its financial capability and the cost of the contract (including benefits, features and services); and
- based on such consideration, conclude that at the time of the selection, the insurer is financially capable of satisfying its obligations under the contract, and the relative cost of the selected contract is reasonable.
A fiduciary is deemed to satisfy the financial capability leg of the safe harbor if:
- the fiduciary obtains written representations from the insurer that the insurer is licensed to offer guaranteed retirement income contracts;
- the insurer, at the time of selection and for each of the immediately preceding seven plan years: (i) operates under a certificate of authority from the insurance commissioner of its domiciliary state which has not been revoked or suspended; (ii) has filed audited financial statements in accordance with the laws of its domiciliary state under applicable statutory accounting principles; (iii) maintains (and has maintained) reserves which satisfies all the statutory requirements of all states where the insurer does business; and (iv) is not operating under an order of supervision, rehabilitation, or liquidation;
- the insurer undergoes at least every five years a financial examination by the insurance commissioner of the domiciliary state; and
- the insurer is to notify the fiduciary of any change in circumstances which would preclude the insurer from making such representations at the time of issuance of the guaranteed retirement income contract; and after receiving such representations and as of the time of selection, the fiduciary has not received any notice and is in possession of no other information which would cause the fiduciary to question the representations provided.
Are Annuities a Good Idea?
This still leaves the question unanswered whether annuities are a good idea for retirement savings. Here are some considerations.
Risks. In general, annuities are safe. Companies that provide them are highly regulated and supervised at the state level. States usually have a fund set up to guaranty payments. However, not all annuity providers are equally rated by ratings agencies such as Moody’s and this risk is reflected in higher monthly payments provided by lower rated providers.
Inflation can quickly whittle away at a fixed income annuity. Social Security payments are adjusted each year for changes in the cost-of-living, but not annuities unless you pay for it with lower payments upfront. Of course, inflation can whittle away at any sort of fixed-income investment.
Interest rates. Annuities are generally tied to an interest rate at which the annuity’s value grows or is payable to the beneficiary. The rate is usually close to market rates for very low risk investments.
Comment: The value of an annuity is generally impervious to stock market fluctuations and hence a good way to balance a retiree’s portfolio. Annuity providers also sell contracts that tie payments to stock market movements, but they are more expensive.
Costs. Annuities are well known to have fees, and buyers are warned to pay attention.
Annuities and Taxes
Annuities bought with pre-tax dollars in an IRA or through an employer plan are taxed in their entirety at ordinary rates when distributed. Annuities bought with after-tax dollars are also taxed at ordinary rates when distributed, but solely on earnings. In either case, taxes are deferred until distribution.
Any option to invest pre-tax dollars for retirement plan savings is a good move because they grow tax free until distribution which might be decades away. But for those who have already topped out their IRA or 401(k) contribution limits or who do not have those options, buying an annuity with already taxed dollars might make sense. A bright side is annuities are not subject to the required minimum distribution rules.
How do nonretirement plan annuities compare to other taxed investments? Compared to bonds or other interest-bearing investments which are also taxed at ordinary rates, they have the advantage of tax deferral until distribution.
The comparison is less clear cut for investments in corporate stock. Corporate stock generates current income through dividends and capital gains, so taxes are not deferred. However, this type of income is generally taxed at lower rates and can be offset against losses.
SECURE Act changes remove two roadblocks to employer plans offering individualized lifetime income investment options. If employers go this route, they could promote these investments as a “traditional pension” option providing a reliable base income in addition to Social Security or other government pension. Employees could still hold some traditional assets in their accounts to provide growth if they so choose.
By James Solheim, J.D.