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Gone but not forgotten

Retired Americans represent a growing market for financial services companies, as baby boomers creep toward the end of their careers.

Retired Americans represent a growing market for financial services companies, as baby boomers creep toward the end of their careers.

By Jinny St. Goar
April 2002
Institutional Investor Magazine

For the past 20 years, the 401(k) industry has focused on getting people to save for their retirements. Now it's paying increasing attention to people who are already retired.

Demographics tell the story. The eldest baby boomers turn 56 this year. About 12.6 percent of Americans are now 65 or older, according to the U.S. Census Bureau. By 2030 some 20 percent of the population will be over 65.

These days about $330 billion sits in postretirement savings accounts such as rollover IRAs and annuities, according to SRI Consulting Business Intelligence, a research firm in Princeton, New Jersey. In ten years that figure could exceed the $3.5 trillion that is now held in all defined contribution plans.

"About 6,000 Americans retire every day," says Richard Austin, who retired as president of Templeton Funds Annuity Co. on January 1. Now working part-time as a consultant, Austin points toward the peak of the boomers, retirement cycle , perhaps in 2015 , when Americans will be taking their gold watches at the rate of 10,000 a day. That's "the freight train that,s coming down the track now , the sonic boomers," says Ronald Danilson, a vice president at Principal Financial Group.

Is the financial services industry prepared for this onslaught? "On a scale of 1 to 10, the industry is at about a 5," says Austin. "In these next five years, we,ll see a ramp up in the product line."

With defined benefit plans, of course, retirees received their retirement income in a fixed and predictable stream of payments. But members of the 401(k) generation have more complicated decisions to make. Take a lump-sum distribution and pay ordinary income taxes on the payout? Open a rollover IRA and avoid the tax? Or leave the assets in one's existing 401(k), making only periodic withdrawals?

According to the Employee Benefit Research Institute, close to 90 percent of retirement plan assets go directly into rollover IRAs, in which accumulated returns are tax-deferred. Some individuals are moving their funds into tax-sheltered custodial accounts that invest in a mix of mutual funds and individual securities and are offered by brokerage houses. Only about 3 percent of retiring assets are directed to annuities, but annuities providers are determined to increase their market share. Their central sales pitch: Annuities can easily provide a steady stream of income through retirement.

Annuities offer investors a two-tiered structure , accumulation and then withdrawal. Generally, they come in two forms , fixed rate, which offer a guaranteed rate of return on invested dollars and a guaranteed rate of withdrawal, and variable rate, whose returns rise and fall with the value of an underlying portfolio of stocks and/or bonds. The income earned by the investments underlying the annuity is tax-deferred. To assure that they can effectively deliver on annuities, promises, insurers, who sell most annuities, charge one-time, up-front fees that range up to a hefty 700 basis points.

For a retiree, it's possible to create a custodial account with a brokerage that offers the same tax advantage as an IRA , tax deferral on the investment income. That custodial account can be funded with a mix of mutual funds, stocks, bonds and other investments. For both custodial accounts and IRAs, the retiree determines the timing and the amount of the withdrawals.

Retirees are left to ponder two unknowns: their investment returns and how long they will live. In 1950 normal retirement age was 68, and the average American could expect to live to 72. Now the average retirement age is 62, and the average 65-year-old can expect to live to 80. "Anecdotally, we,re hearing that people are either spending too fast and running out of money, or that they are spending as little as possible, underestimating what they can spend comfortably," says Austin.

Regulators are changing some of the rules to make managing postretirement savings more profitable for IRA providers , a group dominated by mutual fund companies and brokerage houses, with banks and insurers claiming 9 percent and 8 percent, respectively. In early March the Department of Labor announced that IRAs would get some of the latitude that ERISA assets receive. For example, retirement service providers can now invest and trade the securities underlying IRAs in bank collective investment funds or insurance company general accounts. These funds and accounts, like the commingled funds of money managers, do not have to be registered with the Securities and Exchange Commission.

In the defined contribution industry, mutual fund companies and other plan providers have been struggling to keep participants as customers after their retirement. Providers of 401(k)s hold on to only 17 percent of assets when accounts roll over, according to Boston-based Cerulli Associates.

By contrast, the Teachers Insurance and Annuity Association (now part of TIAA-CREF) retains about 98 percent of assets when account holders retire, reports Keith Rauschenbach, a vice president for participant services. The fund traces its roots to 1918, when it was launched to provide annuities for college professors. Close to 20 percent of TIAA-CREF's $270 billion in assets under management , about $54 billion , is now held for retirees. "It will be a few years before the current 80-20 balance [between accumulation and payout assets] tips the other way," notes Rauschenbach.

Postretirement financial products have their own quirky rules. Since 1996, for example, TIAA-CREF has allowed participants to move their money among the variable annuity investment options and from a variable annuity to a fixed annuity product , but not vice versa. Still, only about 2 percent of the funds, retired participants have opted to shift to a fixed annuity.

In July Principal Financial Group will introduce a new product for this market , an investment vehicle that is essentially a wrinkle on an IRA. Principal,s "income IRA" will take the mutual fund investments of a 401(k) plan account and convert them gradually into an annuitylike vehicle where payouts are fixed and guaranteed. For example, in year two of the postretirement installment payments, a portion of the retirement assets , say, 10 percent , would be invested in a fixed-income vehicle. By year 15 , or sooner if the retiree chooses , all of the assets could be safely stowed away in fixed-income investments.

Danilson and his colleagues at Principal decline to specify the annual management fees, but IRAs are occasionally offered at no annual fee and generally are priced at 10 basis points a year. That compares with the average annual fee of 217 basis points for annuities sold by insurers, according to Morningstar. The income IRA also offers investors the assurance that their principal will be safeguarded while generating enough income to live on.

"This addresses actuarial risk without the perceived negatives of annuities , the high fees and the permanence," explains Jerome Golden, president and CEO of Golden Retirement Resources, a New York,based consulting firm that worked with Principal to develop the package.

In mid-February, in an effort to better serve the postretirement market, Vanguard Group added a fixed annuity to its product roster. Its variable annuity, introduced ten years ago, now holds $6 billion in assets (out of the firm's total $600 billion in assets under management). "There is value in annuitization, particularly for people who are worried about outliving their assets, but to date the costs of variable annuities have not outweighed expected longevity," says Robert Nestor, who heads Vanguard Annuity and Insurance Services. "A better choice is a tax-efficient mutual fund."

Vanguard's new fixed annuity is underwritten by Aegon Insurance Group with Vanguard as the investment manager and distributor. The contract fee paid to Aegon is just 27 basis points, while Vanguard is only collecting 10 basis points as the recordkeeper and administrator.

Indeed, Vanguard is addressing a problem with most annuity products: cost. Many insurers charge a standard annual management fee of 335 basis points. That comes after the up-front sales charge, which can be as high as 700 basis points. Compare that with the average cost of an actively managed equity fund, about 120 basis points, or an index fund, less than 60 basis points.

Annuity fees are well spent, industry lobbyists argue. The National Association for Variable Annuities recently hired PricewaterhouseCoopers to do an actuarial study of variable annuities. The study showed that the power of tax deferral on the income earned by the investments underlying the annuity outweighed the costs of variable annuities.

As annuities providers seek to bolster their share of the postretirement market, their rivals in the financial services industry will be fighting just as hard to hang on to their own turf. The stakes are big, and getting bigger.