For 30 years employers have steadily moved away from offering retiring workers lifetime income through a defined benefit program, attempting to escape the perceived disadvantages of traditional pension plans including high costs, volatile and unpredictable cash contributions, and responsibility for unpredictable obligations. Its no wonder that 401(k) and other defined contribution plans have become the dominant form of retirement benefit.
As a result, employees now bear the risk of market volatility, while rising longevity has increased the likelihood that they will outlive their savings. This has sparked interest in a lifetime income option for defined contribution plans both at the U.S. Department of Labor and among some employers. So far, however, there has not been a rush by companies to offer employees this option.
But one company has been leading the way. Hartford, Connecticutbased United Technologies Corp. broke new ground in retirement-plan design by incorporating a lifetime income feature into its 401(k) savings plan in 2010. The maker of Pratt & Whitney engines and Otis elevators offers new hires the option to receive a guaranteed monthly income for their entire life borrowing one of the most appealing features from the pension plan. The lifetime income option also offers a degree of flexibility that is not available with a traditional annuity, explains Robin Diamonte, chief investment officer for United Technologies. Retirees can withdraw any amount above the scheduled monthly payments at any time but in return for this flexibility, will receive a lower monthly payment afterward.
Since the launch of the new 401(k) feature, Diamonte says her company is pleased with employee response to what it calls the lifetime income strategy. United Technologies has become a strong and even passionate advocate in the employer community for similar offerings. Diamonte, who oversees $42.7 billion in defined contribution and defined benefit assets, recently spoke with Institutional Investor Contributor Robert Stowe England at the United Technologies office in Hartford about the strategic decision to offer the lifetime income strategy, the details about how it works and the way it fits in with the companys traditional defined benefit plan.
Institutional Investor: How did you come up with the idea to offer defined contribution participants a lifetime income option?
Diamonte: We actually had a meeting in 2007 with Prudential [Financial]. They have a lifetime income strategy called IncomeFlex. We have a big relationship with Prudential, and they alerted me to the whole notion of having retirement income in a defined contribution plan. So we put that concept on our wish list of things to look at in the future and started discussions at a low priority level with other firms in thinking about other ways we can do it. And then [the credit crisis of] 2008 happened, and we had other priorities.
And then what we saw slowly was this trend happening quickly in our peers: large corporations freezing pension plans. And we thought if that happens [at United Technologies], were going to have to give our employees another option for retirement income. And thats when we started to prioritize even higher the concept of lifetime income. So it really started in 2007, but not in earnest until 2009. And at that point we went and talked with many investment managers, insurance companies and recordkeepers to really try to understand how we would make it work.
As you investigated this concept and how it might be implemented, did you seek to tailor it to your own workforce?
We worked closely with AllianceBernstein. They have a similar off-the-shelf product that they were offering. They had done a lot of work for us when we created custom target-date funds. They are the glide-path provider for those target-date funds. So they took a lot of demographic information, and they really understood our population. So we worked with them to try to design the lifetime income option. We bounced ideas off them.
Right now our default option for new hires is lifetime income in a target-date fund. But we also continue to have target-date funds without lifetime income. Even though we closed our pension funds to new hires, were still accruing for previous employees. So we still have a large population of UTC employees who still have ongoing pension benefits. We wanted to make sure we had options to be flexible and accommodate all employees. So you have already a defined benefit plan that is accruing. Or, you could have a lot of different financial circumstances where you dont need an annuity, but you still want a target-date fund; we want to provide that option. So you can think about it as a target-date portfolio with or without lifetime income.
Have new hires stayed with the default option since it was introduced in 2010?
Yes. As a matter of fact, we have a very small opt-out rate. People tend to stay in the option that you put them in. I dont know if thats a benefit of lifetime income or thats just inertia. So we already have a growing population there; we already have over 17,000 participants. We have over $630 million in this option.
How many options do you have in the plan?
We have ten options. We have target-date funds, with or without lifetime income. And we have core options, so people can mix and monitor their asset allocation. And those are the major asset classes. These are all passively managed index funds with low fees. So theres a stable value option, which is common in 401(k) funds. We have a government credit bond option, large-cap equity, small-cap equity and emerging-markets equity. What we have are the building blocks of a retirement investment portfolio. And we also have a mutual fund window. Right now, we still have less than 1 percent of assets in the mutual fund window. So I think people are happy with our core options.
For employees enrolled in the lifetime income strategy, does the monthly benefit they receive change or stay constant? And is it costly to annuitize the strategy?
Before age 48 youre in a traditional target-date portfolio. And then, from 48 to 60, youre taking the principal and the money you are contributing in, and, in chunks, you are buying protection on that underlying portfolio. By the time youre 60, your entire income base is protected or has an income stream associated with it. Every quarter you put money in, and based upon what the current rates are now and your age, youll get a withdrawal rate. When youre 48, your withdrawal rate is going to be higher than when youre 65. [The quarterly withdrawal rate is multiplied by the account balance receiving a guarantee to yield the amount of income one can withdraw for life at retirement. United Technologies purchases insurance for this program from Nationwide and Lincoln Financial as well as Prudential Financial.]
The reason we have multiple insurance companies is that they have to bid every quarter and compete against that business. For example, one will give us 5 percent and one will give us 5.25 percent and another will give us 5.2 percent. The company that gave us 5.25 percent will actually get a little bit more business. We still want to diversify, so well give a little bit to all three. So the [company] with the highest rate will get the most business, and that helps to keep competitiveness up.
How does the insurance guarantee work?
If your income base [or account balance in the 401(k)] was $1 million, say, and you have a 5 percent withdrawal rate, youre promised $50,000 a year for the rest of your life. If the market value of your portfolio goes down to $900,000, youre still going to get $50,000 for the rest of your life. If it goes down to $800,000, youre still going to get that $50,000. Now, if the market goes back up to $1.1 million, now youre going to have more income. Every time your balance reaches a new high, it has an income stream related to that. It can only go up from there; it cant go down.
As an example, if you were getting ready to retire in 2009 and you started thinking about it in 2007 and 2008, you probably would have lost 20 to 30 percent of your balance because of the credit crisis. But if you were in a lifetime income strategy, your actual annual or monthly income stream would stay identical throughout the entire credit crisis. So if youre relying on that money to retire, you can still retire. Its not going to change that. It wouldnt have gone up during that time, but it wouldnt have gone down.
The great part of this strategy compared to target-date funds is that because it has insurance, we are able to keep the underlying portfolio with a growth aspect to it. It stays at 60 percent equity and 40 percent bonds forever after you retire. For most target-date funds, when you get to age 80, you have it almost all in bonds. Ours stays at 60/40, so it has growth potential so that even in retirement, that balance can go up. So you can be retired and youre not contributing money any more, and have an underlying income stream of $50,000 a year and the market goes up because of your underlying portfolio is 60/40, then your income stream goes up.
The insurance then covers the difference between the guaranteed income level and the ability of the underlying portfolio to provide for that income?
Thats a really good point. Say youre getting $50,000 a year and now you have $800,000 in the bank and you retire. Youre going to be withdrawing your own $50,000 every year. You withdraw, you withdraw and you withdraw. Now, if you are 85 or 90, and theres no money left, or, say theres market volatility change, and the market went down, and now you dont have any money to withdraw from your own balance, thats when the insurance kicks in. So it doesnt kick in until your balance is down to zero.
Does this address the reasons that many retirees are hesitant to go with an annuity?
Absolutely, that helps get a better rate. But let me tell you what I think is the more important design feature. We did a lot of focus groups and studies on plans where people could convert their balance to annuities. We found there wasnt a large uptake. As a matter of fact, when you have an option for a defined benefit plan to take a lump sum or an annuity, a lot of people take the lump sum because it just seems so much more attractive. Youve never had all that money before. They say, Wow, Ive got $1 million in my bank account, or I can have an annuity stream of $50,000. The $1 million just sounds so much better.
What happens if you withdraw more than the insured amount per year?
So if you said, I want to start withdrawing more than my $50,000, in my example, youll get a lower monthly payment. Suppose you said, I want the whole thing and I dont want lifetime income anymore, you could just take that balance. And thats very different [from a traditional annuity purchased at retirement]. So, when we talked about designing this plan, we said that we wanted to provide certainty in retirement or security but also flexibility and control. So the participants have control of the balance because they saved this money for many, many years; they should have control over that money if they need it.
How does this fit in with your defined benefit plan?
The employees hired before January 2010 are still accruing [a defined benefit], so that they have a pension plan. For the new hires, in lieu of the pension plan, were doing a company automatic contribution. The company puts money into the defined contribution savings plan for the employee, regardless of whether an employee puts money in or not. The company, based on the employees age and salary, will contribute money into the plan for that employee. And that money goes into lifetime income unless the employee chose a different place.
So its not like the company said, Youre on your own for retirement. The company said instead, For a whole host of reasons, defined benefit plans I dont want to be in them anymore. So Im going to give you the money and provide a defined contribution plan, and were going to give you a lifetime income strategy to help with retirement because its very much pensionlike in its design. So thats what we did.
Did the 401(k) savings plan exist before January 2010?
Yes, it did exist. As a matter of fact, in January 2010 we completely revamped our savings plan too. So when we closed the defined benefit plan to new entrants, we actually rolled out a new design of our savings plan.
Is there a set formula for how much the company contributes to the plan?
Yes, it ranges anywhere from 3 to 5.5 percent [of salary], depending on the age. If youre in your 20s, you get 3 percent, and if youre older, you get 5.5 percent. The contribution percentage steps in in five-year increments. [The employer contribution rises to 3.5 percent at age 30, 4 percent at age 35, 4.5 percent at age 40, 5 percent and age 45 and 5.5 percent at age 50.] We would expect participants to put money in because the company is also matching employee contributions. The company match is 60 percent of the first 6 percent of compensation that employees contribute on their own.
Another thing we do for new hires is that we automatically enroll them in that 6 percent. So if you start [working for the company], the company is going to be putting money in for you, and youre automatically enrolled in the savings plan and 6 percent of your salary from a payroll deduction is coming out. You can opt out of that right away. But weve found that it helps employees save for the future.
How do you assess the success of the plan so far?
I think its going to take time for that. Were going to be looking at income replacement rates once people start to retire. How much of their last years salary are they able to replace? We are also going to be looking at participation rates, peoples understanding of the product. So were trying to do that now with statistics. But its multidimensional to truly understand how successful it is. But I think its ongoing and way too soon to be able to tell the success rate. I know that its been well received. Im really happy with the participation rate so far, but its going to take many years for us to say, Yes, this is really successful.