Ensuring Retirement Income

Baby boomers surging into retirement or quickly approaching their golden years have few options for turning their nest eggs into a steady stream of retirement income — and lots of reasons for considering every one of those options. Even as their life expectancies lengthen, their 401(k) plans and other investments, battered by the current market maelstrom, no longer seem adequate. Two sources of lifetime payouts — Social Security benefits and defined benefit pensions — have uncertain futures, and the incoming administration of Barack Obama is said to be weighing a series of changes in the defined contribution business.

Faced with low account balances and little help from other sources, participants in defined contribution plans confront a real challenge in trying to draw a steady income from their portfolios. Their woes, however, could represent an opportunity for another group: insurance companies, which are now rushing to offer annuities for the 401(k) channel. Genworth Financial, Hartford Financial Services Group, MetLife and Prudential Retirement are among those that have recently launched annuities targeted at the defined contribution marketplace, and more firms are expected to follow.

There are no precise figures for the size of the market for annuities, but insurers are hoping the product could do for them what target date funds have done for mutual fund companies. Such funds, whose managers automatically adjust the asset allocations to become more conservative over time, are a simple option for savers; they operate on autopilot and potentially tie the fund company to the investor for a lifetime.

First offered in 2000, target date funds now total $185 billion, 90 percent held in retirement accounts. Altogether, Americans had $4.3 trillion in employer-sponsored defined contribution plans as of the first quarter of 2008. Based on recommendations that financial advisers make to investors about how much of their savings they should annuitize, insurers think they could get 20 to 40 percent of that pool.

To do so the insurers are offering a twist on traditional annuities, which are contracts that guarantee a regular payment for life in exchange for a lump sum up front. In some of the new retirement plan annuities, investors put 401(k) contributions into a mutual fund or investment account that in turn is wrapped with an insurance contract that guarantees withdrawals of 5 percent of principal annually starting at age 65.

When 401(k) plans were introduced more than two decades ago, participants often had annuity options, but these were quickly supplanted by mutual funds and other investments as the bull market of the 1980s and 1990s took off and as participants wanted more control over their account balances. Annuities’ tax advantages were also redundant inside 401(k) plans, in which earnings are tax-free until withdrawal.

“Traditional annuities don’t give you flexibility,” notes Brent Walder, director of the institutional income innovations group at Prudential Retirement, which evaluated the market for a couple of years before launching a 401(k) plan annuity in January 2007. “We found that control trumps almost everything else when it comes to participants’ decisions.”

Prudential is offering Prudential IncomeFlex, an annuity wrapped around a target date fund. Investors, who have to be at least 50, own their balances and are guaranteed a minimum withdrawal rate for an annual fee of 95 basis points. Market values of the balance are reset annually on the investor’s birthday, providing a chance to lock in a higher floor value. Seventy plan sponsors have signed on for the annuity, and participants have put in $100 million. Says Walder, “The time is right, but we need to provide flexibility.”

The costs, both administrative and to cover the insurance guarantee, pose a challenge to marketing annuities to plan sponsors, which are under constant pressure to disclose and lower the expenses that participants bear. Prudential and other providers have pared down the costs of 401(k) annuities to below the 1 to 3 percent of principal that is typical in the general annuity marketplace. Many target date funds, including those of Fidelity Investments and Vanguard Group, charge less than 1 percent.

But there are other drawbacks. Unlike 401(k)s, annuities are not easily transferred between plans when employees switch jobs; they are not standardized enough to roll over between providers. And annuities can be difficult to explain to plan participants accustomed to the simple investment portfolio approach of 401(k) plans. “People who have trouble figuring out how to manage the accumulation phase will be clueless during the drawdown phase,” says Warren Cormier, founder and president of consulting firm Boston Research Group in Woburn, Massachusetts.

Michael Heller, a vice president and actuary at New York–based TIAA-CREF, which has been providing traditional and variable annuities to university employees since 1918 and currently offers them with defined contribution plans, says they work the same way that a traditional pension does in guaranteeing lifetime payouts. Investors do not have individual accounts, yet they can count on receiving monthly checks. Although 401(k) plan participants have accounts with balances they can call their own, and with a degree of flexibility lacking in traditional annuities, they have no built-in protection from market declines nor a lifetime guarantee such as an insurer offers.

Heller sees cost as the major barrier to widespread acceptance of the new annuities. Taking advantage of its not-for-profit status, TIAA-CREF charges about 0.5 percent for the guarantee.

Barclays Global Investors works with MetLife to offer an annuity at 0.5 percent. Kristi Mitchem, head of BGI’s U.S. defined contribution group, says that as an institutional buyer, BGI was able to strip away the bells and whistles of typical annuities. Its SponsorMatch wraps an insurer guarantee around a multifund target date portfolio. At retirement the target date fund is structured so that a little more than half of the accumulated balance is switched into the annuity.

Renee West, senior vice president of product development at Allianz Life Insurance Co. in Minneapolis, says that the company is considering entering the market with an offering that is “low-cost, portable and simple.” West notes that it took eight years for target date funds to take hold. It may take that long to see 401(k) annuities catch on.