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Annuities the Next 401k SNAFU? Advisers Offer 6 Reasons Why

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After a series of Congressional comments, regulators move to take action. There’s a hot, new investment product making lots of positive headlines in the financial press. Washington, succumbing to its own version of the behavioral psychology 756634_86560097_Venus_Fly_Trap_stock_xchng_royalty_free_300phenomenon known as “recency,” formally adopts this product as a panacea to investor woes. There is much rejoicing among every 401k fiduciary as these new guidelines hold the promise of reducing fiduciary liability.

Fast forward two years. A market turnaround exposes the flaws of this neophyte product. Investors grumble. Congress holds hearings. Nothing gets done, but, again, regulators maneuver to take action. The world of the 401k fiduciaries waits. Have they unknowingly taken on more fiduciary liability than they have bargained for?

Sound familiar? Are we rehashing the past and present of the 401k Target-Date Fund SNAFU? Or are we seeing the present and future of the coming 401k Annuity SNAFU?

Pension & Investments reports, “In a joint agency RFI published in today’s Federal Register, the Treasury and Labor departments expressed concern that defined contribution plans generally make only lump-sum payments available to plan retirees” (“Government wants input on DC plan annuity payouts,” February 2, 2010). The report goes on to quote Robert Reynolds, president and CEO of Putnam Investments, who, according to a company press release, “endorsed requiring retirement plan sponsors to offer federally backed annuity.” In addition to its mutual funds, Putnam sells annuities via Hartford and All State.

Now, the government is looking for your ideas on the pluses and minuses of requiring the inclusion of annuities as an option in 401k plans (“Treasury, Labor Dept. seek info on using annuities in 401(k)s,” Investment News, February 1, 2010). According to the periodical, the Treasury and Labor Department “also seek an explanation why most retirees, when faced with a choice of a lifetime income option or a lump-sum distribution, choose the lump-sum option.”

FiduciaryNews asked several prominent independent investment advisers what they felt about this initiative. They revealed six major concerns every 401k fiduciary must consider regarding annuities.

1)      Annuity-based products have minimal fee transparency – In an era when 401k fees have become almost an obsession, one might feel the last thing the DOL wants to do is to require plans include a product where it is notoriously hard to determine the product’s underlying fees. “In my experience, it has been extremely difficult figuring out fees in 401k annuity products. This is one of the reasons I stay away from them as a fiduciary,” says Maria Fitzpatrick, AIF, Independent Fiduciary at Piedmont Investment Fiduciaries. She prefers open architecture platforms because she can easily “obtain administration and record keeping costs and, if there is revenue sharing involved, see it broken out for each fund.” She also likes the ability to see an illustration “showing how much revenue is being generated from Sub-TA and 12b-1 fees and how that revenue offsets the costs of the plan.” Her warning for plan fiduciaries: “I have yet to see an illustration like this on any annuity-based 401(k) product.”

2)      Plan participants might have difficulty understanding annuities as opposed to mutual funds – More than fees, Scott Holsopple, President, Smart401k focuses on the process a plan sponsor/fiduciary would go through to prudently select an annuity option(s) for their plan. “This process,” says Holsopple, “needs to address not only fees, but other things such as the insurer’s stability, payout to the participant, restrictions (portability, surrender charges, etc…) and how a participant will be educated on the option.  If direction regarding the evaluation process isn’t provided by the government and providers don’t greatly simplify their product (fees, restrictions, etc), annuities may only add to the confusion that many participants and plan sponsors feel regarding 401k plans.”

3)      Annuities may encourage bad investing behavior – Chad Griffeth, AIF, Co-Founder, BeManaged sees a much more subtle – and potentially more devastating – concern. “In our interactions with participants, we have found that few participants understand risk and how much exists in their portfolios. If the market were to suffer another correction, the fear would be the participants would overcompensate and commit too much money into an annuity during a down turn, dramatically affecting their retirement income. Hence, the investor’s attempt to mitigate risk could in fact cost them significant income during retirement. This ‘income lock-in risk’ needs to be considered, as the behavioral impact of investors’ decisions is well documented, as well as the true impact of education, which is minimal.” Griffeth is quick to add he doesn’t think “annuities for participants are a bad idea, but the risks involved are complicated, and thus I believe one of the distinct reasons why employers have been slow to embrace them as an investment option.”

4)      The real issue isn’t annuities, it’s a lack of retirement savings – Griffeth’s concern about bad behavior really emphasizes the greater issue of investors not saving enough to begin with. Paul G Escobar, Managing Director, Retirement Planning, US Wealth Management says, “Annuities don’t actually address the issue – namely that most baby boomers don’t have enough saved. This is a combination of factors from not having had a 401k plan to not having participated at all or not having participated enough.” In addition, Escobar cites “withdrawals for loans, hardships and cash outs at job changes” as other reasons for participants not having sufficient savings to retire.

5)      Annuities are really tax-advantaged insurance products, not retirement vehicles – Historically, insurance companies offered annuities to people seeking both to defer taxes and simultaneously obtain life insurance. Since 401k plans already offer a tax sheltering benefit, any costs (both direct and indirect) associated with maintaining an annuity’s tax-advantaged status are paid by 401k investors without providing any value. In addition, the additional cost of the life insurance may also not add value. “The death benefit was triggered in only 1% of all policies from 2002-2004, according to Limra International, an insurance-industry research group,” says Aaron Skloff, AIF, CFA, MBA, Chief Executive Officer, Skloff Financial Group. He adds, “The actual amount paid out may not justify the cost of the benefit.  If you think you will fall into that 1%, a life insurance policy to cover a $10,000 or $50,000 shortfall might make more sense.” This actuarial reality may address the question as to why most people – and why most professional advisers recommend – roll over their retirement savings in a lump-sum rather than take an annuity option.

6)      Using annuities in 401k plans suffers from too many practical obstacles – Roger Wohlner, a financial advisor with Asset Strategy Consultants in Arlington Heights, Illinois, feels, “The idea of introducing annuities has some appeal on a conceptual level.” He says this is because “401k participants have seen wide fluctuations in their account values due to the huge market swings of the past couple of years.” But, he cautions, “The practical application of this idea is not so simple. Among the issues to consider are the often high and less than transparent fees that many commercial annuity products carry. Additionally, what criteria will be set to determine which insurers are eligible to have their products included; will there be a standard payout scale or formula for participants of a given age; will the government stand behind the fiscal health of the insurers; will there be limits on the expenses a company can imbed in the annuities included in 401(k) plans? There are certainly many other questions to be answered and details to be nailed down if the Administration is determined to go down this path.” Wohlner spells out his ideas in more detail in his February 11, 2010 blog “Annuities in 401(k) Plans-My Questions and Concerns.”

Interestingly, on the heels of an Investment News story on questionable sales practices (“California couple sues VALIC over its annuity sales practices,” Investment News, January 17, 2010), none of the above advisers mentioned the very practical concern of the marketing of annuities. Currently, unlike a mere Blue Sky filing like mutual funds (where the Securities and Exchange Commission administers the Investment Company Act of 1940 to regulate all mutual funds) insurance companies must obtain approval from each individual state before offering a specific insurance product, including annuities. Some of the most attractive – and some feel controversial – annuities today are offered in states (like Florida) but cannot be offered in other states (like New York). If a company operates in multiple states, how does it handle its choice of annuities?

It would seem the idea to mandate the presence of annuities in 401k plans may have originated from last year’s significant drop in the values of 401k plans. As we’ve earlier reported (“Readers Select Top Fiduciary Stories of 2009: #5 401k Plans Recover Significantly by Year-End,” February 11, 2010) time may have cured that particular issue.

If you’d like to officially register your comments with the Department of Labor, they have provided this link to review for your convenience: http://www.regulations.gov/search/Regs/home.html#documentDetail?R=0900006480a898af A spokesman for the suggested to FiduciaryNews.com this part of the document that will help you most (FiduciaryNews.com is grateful for the help provided by the Department of Labor in providing the following information):

SUMMARY: The Department of Labor and the Department of the Treasury (the “Agencies”) are currently reviewing the rules under the Employee Retirement Income Security Act (ERISA) and the plan qualification rules under the Internal Revenue Code (Code) to determine whether, and, if so, how, the Agencies could or should enhance, by regulation or otherwise, the retirement security of participants in employer-sponsored retirement plans and in individual retirement arrangements (IRAs) by facilitating access to, and use of, lifetime income or other arrangements designed to provide a lifetime stream of income after retirement. The purpose of this request for information is to solicit views, suggestions and comments from plan participants, employers and other plan sponsors, plan service providers, and members of the financial community, as well as the general public, on this important issue.

DATES: Comments must be submitted on or before May 3, 2010.

ADDRESSES: You may submit written comments to any of the addresses specified below. Any comment that is submitted to either Agency will be shared with the other Agency. Please do not submit duplicates.

Department of Labor. Comments to the Department of Labor, identified by RIN 1210-AB33, by one of the following methods:

Federal eRulemaking Portal: http://www.regulations.gov. Follow the instructions for submitting comments.

E-mail: e-ORI@dol.gov. Include RIN 1210-AB33 in the subject line of the message.

Mail: Office of Regulations and Interpretations, Employee Benefits Security Administration, Room N-5655, U.S. Department of Labor, 200 Constitution Avenue, NW., Washington, DC 20210, Attention: Lifetime Income RFI.

All submissions received must include the agency name and Regulation Identifier Number (RIN) for this rulemaking. Comments received will be posted without change to http://www.regulations.gov and http://www.dol.gov/ebsa, and made available for public inspection at the Public Disclosure Room, N-1513, Employee Benefits Security Administration, 200 Constitution Avenue, NW., Washington, DC 20210, including any personal information provided. Persons submitting comments electronically are encouraged not to submit paper copies.

Internal Revenue Service. Comments to the IRS, identified by REG-148681-09, by one of the following methods:

Mail: CC:PA:LPD:PR (REG-148681-09), Room 5205, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington, DC 20044.

Hand or courier delivery: Monday through Friday between the hours of 8 a.m. and 4 p.m. to: CC:PA:LPD:PR (REG-148681-09), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, NW., Washington, DC 20224.

Federal eRulemaking Portal: http://www.regulations.gov. Follow the instructions for submitting comments (IRS REG-148681-09).

All submissions to the IRS will be open to public inspection and copying in Room 1621, 1111 Constitution Avenue, NW., Washington, DC from 9 a.m. to 4 p.m.

FOR FURTHER INFORMATION CONTACT: Stephanie L. Ward or Luisa Grillo-Chope, Office of Regulations and Interpretations, Employee Benefits Security Administration (EBSA), (202) 693-8500 or Peter J. Marks, Office of Division Counsel/Associate Chief Counsel (Tax Exempt and Government Entities), Internal Revenue Service, Department of the Treasury, at (202) 622-6090. These are not toll-free numbers.

11 responses to “Annuities the Next 401k SNAFU? Advisers Offer 6 Reasons Why”

  1. Irene Diamond, CPA, CPC, AIFA

    Great article! Another concern every 401k fiduciary must consider regarding annuities is the additional paperwork a Plan Sponsor must provide on the distributable assets. The paperwork is lengthy and most individuals don’t understand it. In addition, if the Plan Sponsor forgets to give it to employees, there are DOL consequences.

  2. Adam Pozek

    I agree that this is a knee-jerk reaction that does not provide any real solutions. See my blog post at http://www.pozekonpension.com/pozek-on-pension/2009/12/will-annuities-save-the-planet.html.

  3. Scott Revare

    Excellent summary of the issues Chris. My question is this: The timeframe an annuity is utilized is after a participant stops working and is ready to start taking distributions from their plan. Why is a strategy (and associated burden) to offer an annuity in a plan better than just making participants aware of the option at the time of distribution? By waiting until distribution time, the participant would have any annuity to choose from, instead of only those offered in the plan, and also would have the advantage of knowing how much money they have saved so far.

  4. Ron Gebhardtsbauer

    Hello all:
    I agree there can be problems with high expenses on individually purchased annuities. Fixed Payout Annuities aren’t perfect, but then neither is anything else. If there was a perfect solution, then I can see knocking the annuity, but the alternatives are worse (unless you are fabulously wealthy and can self-insure).

    Some commentators above were concerned about fee disclosure and complexity, but since I’m talking about fixed annuities for retirees, the complexity is gone and one doesn’t need to compare fees. All you need to compare is the fixed monthly check. [I am not talking about the accumulation period of a variable (which I don't call an annuity), where fees can be high, and the policy provisions are complex. I wish people wouldn't confuse the issue, by referring to them and their crazy complex fees, as annuities.]

    I bet many of the above commentators are financial advisors and have a bias. You may feel you can get your clients a better return than the insurer. But higher returns are not the goal in retirement. Lifetime Income is the Goal, and only a lifetime annuity can do that. If a healthy retiree wants to make sure that they do not run out of money ever, then they have to buy an annuity. As fiduciaries, you have to tell your clients that.

    Also, the problem of not having enough money, is helped (not hurt) by the fixed annuity. If someone can’t buy a large enough annuity, then they can’t retire yet. It’s as simple as that. Annuities don’t cause a new problem here. That’s a problem for all people without forsight, and I agree that’s most people, but as I said, fixed annuities help on that. Whenever I have testified before Congress or the ERISA Advisory Board, I have suggested that 401(k)s should not only disclose the account balance. They should also be required to disclose a lifetime income number at the age(s) the participant chooses.

    In addition, even though a fixed payout annuity is expensive, it can still pay out more than a safe 4% withdrawal, which should be below 3% now, due to low riskless rates. Even an inflation-indexed annuity pays out more than the safe withdrawal. Some healthy people may be concerned about losing their money in case they die early (the ol’ “hit by the bus” problem), but that can be accomodated in tax advantaged ways, by buying insurance. Plus, I really don’t understand a person’s bequest motivations to have an uncertain amount paid at an uncertain time (when they die). Why not give the money away today while you are still alive to see it used by your beneficiary. And if you want it paid at death, why not decide what amount is should be and buy the insurance?

    Also, there were concerns about guarantees. For middle income people, the state guarantee of $300,000 is adequate when you die, and if not, you can diversify across insurers and states.
    Ron Gebhardtsbauer, FSA
    Head of the Actuarial Science Program
    Penn State University

  5. Barnard S. Walsh, CEBS

    Folks,

    It appears there is a lack of understanding within the insurance and financial industries about retirement planning issues, the accumulation stage and the distribution stage.

    Quite sometime ago the primary retirement vehicle was a “deferred vested paid up annuity”. Since that time, mutual funds, CD’s, insurance company separate accounts, and other arrangements have been made available during a “Participant’s” accumulation stage. Now, especially with the gyrations of the stock market and the availability of something called “annuities” (which are suitable for the accumulation stage), individuals are becoming “confused” about ways to receive distributions during the distribution stage.

    “Annuities” are getting an undeserved reputation of being “pricey,” “mysterious”, etc. Let’s be candid, objective and open about this. A true “annuity” is a “series of payments paid over a period of time. In old fashion parlance, a life annuity or a 50% Joint and Survivor were required normal forms of distribution from a pension (“defined benefit” ) plan.

    Let’s revive the concept of an annuity being a “life” annuity (or J&S for those who are married) as a monthly payments guaranteed to be paid for the rest of the Participant’s life. Such are very useful today!

    Look at the volatility of the markets, the manner in which financial institutions are been (or not been regulated by the federal government) and look proudly at those highly rated state regulated insurance companies who offer competitive life annuities. The Participant shops around for the best “deal”, puts her money down and receives a steady (or increasing amount)monthly for the rest of her life! Other assets can be “invested” elsewhere, so that an increase might be purchased at a later date from the same or a different insurance company.

    To ask about “Fees” for such “life annuities” is not applicable. No one asks about “fees” for buying a “cd” or fees for buying a “fixed annuity” during the “accumulation phase.

    For governments to get involved with regulating “so called” “fees” for annuities is just too much regulation. Professionals and other “on-lookers” need to look at the “net return”, the “net income”; “how much does a Participant receive and what are the guarantees?”

    Please note: once a “life annuity” is purchased, the “financial advisor” does not get an opportunity to generate more fees for himself for the management of that money. Perhaps, that is why there are so many criticisms.

  6. Ron Gebhardtsbauer

    Hi Chris,
    It was great to get your reply. Your point that a lack of savings makes moot any talk of annuities, is totally misleading. I would say it makes moot any talk of retiring. Also, as I noted in my words in the earlier email, you can get more from an inflation-indexed annuity than you can get from a safe 3-4% withdrawal.

    You also mentioned the issue is Mandates. Actually, your 5th paragraph only talked about requiring the annuity as an option in the plan. Retirees can always get out of that by electing a lump sum, just like they can elect to not participate in the 401(k), but both would be bad elections in many situations, and that’s why I like it as the default option (and I’d require information on how much annuity the account balance would buy). I might not require it thru the plan, due to unisex issues, but I would require the 401(k) plan to send the money to an organization that provides a lifetime annuity (with the ability to elect out of it, with a signature over a statement whereby the retiree recognizes the risks inherent in either decision -ie, the probablility of outliving ones money if not electing an annuity (maybe high if as you pointed out, many people don’t have enought to retire) vs the state guarantee fund defaulting).

    Also, I see the annuity lock-in as a benefit for healthy retirees (not a problem), since retirees can buy insurance if they want a death benefit to go to their heirs, and I’d never say annuize all your money – just enough to pay for your basic needs.

  7. BPP401k.com Newsletter February 24 - Benefit Plans Plus 401kBenefit Plans Plus 401k

    [...] Annuities the Next 401k SNAFU? Now that the government is looking at the pluses and minuses of requiring the inclusion of annuities as an option in 401k plans, several prominent independent investment advisers revealed six major concerns every 401k fiduciary must consider regarding annuities. Source: Fiduciarynews.com [...]

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