Annuities in 401(k) Plans

There is a national debate about how to minimize future retiree poverty.  The federal government has been concerned for a long time that many people are no longer covered by defined benefit plans and not saving enough to cover their retirement needs.  As a result, many of today’s employees may find themselves retiring with funds that might not last a lifetime.

In order to encourage the use of annuities (thus ensuring retirees don’t outlive their retirement funds), several rulings were issued recently to make it easier for people to use annuities.

One proposed rule allows employees to earmark part of their funds for “longevity annuities” that won’t be subject to the Required Minimum Distribution rules at age 70 ½.  (A longevity annuity provides a pension after the retiree lives to a certain age, for example age 80, and typically provides nothing if the retiree does not live to that age.)

Another Revenue Ruling makes it easier for defined benefit plans to allow a participant to use his or her 401(k) funds to purchase a supplemental pension.

And another Revenue Ruling clarifies some of the joint-and-surviving spouse rules that apply when 401(k) plans offer annuities.

The purpose of this article is to point out some of the obstacles that plan administrators need to consider when determining if they should add an annuity option to a 401(k) plan.

1. Liabilities:  How will the addition of annuities impact employer liability?  Employers are already concerned about the liability they bear for other investment options.  Could the choice today of a few life insurance companies come back to haunt the employer decades down the road?
2. Sex discrimination:  Employer sponsored qualified plans offering annuities must abide by Equal Employment Opportunity Commission (EEOC) rules, which state that “the employer will be liable for sex discrimination if it provides different coverage to employees of each gender on the basis of gender.”  So, a $100,000 lump sum would have to provide the same monthly pension regardless of the gender of the retiree.  Compared to the annuity market outside of 401(k) plans, a gender neutral annuity within a 401(k) plan would give men too little per month and women too much for the same lump sum conversion.
3. Timing and interest rates:  Does the employer want to be perceived as encouraging the purchase of an annuity if an employee happens to retire when interest rates are historically low – i.e, when annuity costs are historically high?
4. Diversification:  Financial advisors normally encourage people to diversify their long-term savings between equities and fixed income investments by investing in a broad range of stocks and bonds (as with mutual funds).  Would an emphasis on annuities put “too many eggs in one basket” (i.e., one insurance company) and encourage retirees to get out of the stock market, which has, over long periods of time, historically outperformed fixed-income investments?
5. Variable annuities:  To allow participants the option to share in the upside of the market, while still having lifetime guarantees, some advisors encourage the use of more complicated types of annuities – those with “variable annuity” provisions and “guaranteed minimum withdrawal benefit” features.  At the same time, many independent financial advisors suggest that these products are difficult for the layman to understand and often have excessive internal expenses.
6. State guarantees:  State guarantees for failed insurance companies are often only on the first $100,000 invested in an annuity.  What happens when a retiree puts more than this amount into an annuity with a company that fails many years down the road?
7. Administrative complexities:  From the employer’s point of view, there would be additional administrative complexities, as well as joint-and-surviving spouse notifications and elections, although many people feel that the average retiree still won’t purchase an annuity.  So we could end up with a lot of extra administrative expense but few takers.
8. Decision-making process:  Some proponents of annuities want to mandate that at least part of a participant’s lump sum be converted to an annuity.  However, employee decisions need to include other income sources and personal health concerns.  In other words, if a single employee retires early because he was just told he has six months to live, should he be forced to buy a lifetime annuity?
9. Options available outside of the plan:  Will there be more options available outside of a plan than inside?  Unless some of the hurdles described above can be overcome, it is hard to imagine that the participant cannot find more options outside of the plan, where he can invest in IRAs, annuities, and a broader range of investments than most 401(k) plans offer.
10. One size fits all?  Can we find a “one size fits all” set of rules to apply for qualified plans? Given the discussion above, it is hard to imagine how that would work.

We are not discouraging the use of annuities; but before an annuity provision is put into a 401(k) plan, the employer needs to consider and understand all the above considerations.