At-A-Glance Guaranteed Income in a Defined Contribution Plan: Important Considerations for Plan Fiduciaries By Tina M. Wilson, CFA Vice President, Product Development, MassMutual Retirement Services Division Zhivago Velasco Director, Product Development, MassMutual Retirement Services Division If a participant utilized the proposed strategy from 1978-2008, they would have reaped more income and a greater ending market value relative to the GMWB solution. Executive Summary The defined contribution plan is becoming an increasingly important part of the American retirement picture, especially in light of the decline in the traditional guaranteed sources the defined benefit plan and Social Security that past generations have come to rely on. According to the Investment Company Institute, defined contribution plans account for 25% of the total U.S. retirement assets (annuities, DC, DB, and IRA). Defined contribution assets declined 22% from $4.5 trillion at the end of 2007 to $3.5 trillion at the end of 2008. 1 Participants aged 55-64 with tenures greater than 10 years saw their average account decrease over 20%. 2 Today more than ever, plan fiduciaries are considering in-plan guaranteed income products due to the market volatility over the past year and, in particular, the impact it has had on plan participant s accounts near or at retirement. This paper is designed to offer important insights, provide a brief explanation of a Guaranteed Minimum Withdrawal Benefit (GMWB) and pose a series of questions to evaluate the GMWB. In addition, the paper suggests an alternative strategy to consider, which if utilized, plan participants would have reaped more income and a greater ending market value relative to the GMWB solution. In-plan guaranteed income products are designed to provide participants a guaranteed income stream for life. While the concept of guaranteed income products seems like a great idea, the reality is these types of products are much more complex than they may appear. Of note, participants draw down their own invested assets first and then the guarantee commences after the invested assets are depleted for the remainder of the payment period. To help plan fiduciaries make an informed decision on in-plan guaranteed income products, they need to evaluate the plan and the product offerings carefully. Guaranteed income products are still evolving, and certain features may not be appropriate or may prove problematic in the future. Knowing what questions to ask and what alternatives are available will help plan fiduciaries make the best decision on behalf of their participants, while helping them fulfill their fiduciary obligations. Retirement Strategies For Plan sponsor Use only.
A Four-Step Process Assessing in-plan guaranteed income products requires the plan fiduciary to: 1. Understand what information is relevant; 2. Ask the right questions to obtain the information; 3. Evaluate the information; and 4. Make informed decisions based on the information. 3 I. Guaranteed Minimum Withdrawal Benefit (GMWB): A Primer Guaranteed income products in defined contribution plans have become a popular subject in these days of economic uncertainty, in large part because of what their name implies guaranteed income during retirement. In volatile markets, a guaranteed income product could play an important role in retirement security for participants nearing or at retirement. GMWBs are being marketed as an answer to the retirement security question. First, let s define the GMWB: A GMWB is a feature within a group annuity contract that provides for a guaranteed minimum annual withdrawal calculated as a percentage of a base benefit amount; Base benefit amount is determined as of a particular date, typically on a participant s contract anniversary or birth date, based on the value of the underlying investment; The plan participant is invested in specific investments, like a target date or asset allocation option, determined by the issuer; and The plan participant can withdraw or transfer the account balance at anytime at the current market value. Upsides and Downsides of GMWB GMWBs do not provide protection for the underlying investment portfolio from market declines. The market value of the underlying investment portfolio is accessible, but not protected like the base benefit amount from which the guaranteed annual withdrawals are based. In other words, the participant has two different methods of accounting: 1. Market value, which is available to participants and their beneficiaries at any time; and 2. Base benefit amount, upon which the guaranteed annual withdrawals are based, but is a vapor value or value not accessible by participants or their beneficiaries. Therefore, the market value of the underlying portfolio available to participants may be far less, in a down market like we are currently experiencing, than the base benefit amount used to calculate the guaranteed annual withdrawals. Example: Mary, 66, invested $100,000 in Option A of the 401(k) group annuity with a GMWB in the beginning of 2008 which provides a 5% annual guaranteed payout. At the end of 2008, she decided she no longer needs the GMWB, because the annual payout from Social Security and her former employer s pension was enough. Mary s base benefit amount is $100,000, but the market value of her portfolio declined to $85,000. Mary would receive $85,000 if she withdrew the balance from Option A in her 401(k) (less any contingent deferred sales charge or other fees). GMWB Step-Up Feature Another feature available within the GMWB is the step-up feature at either contract anniversary or a participant s birthday, based on the specific group annuity contract. The step-up feature allows for the base benefit amount to increase if the market value of the underlying portfolio is higher than the existing base benefit amount on that particular day. There is no guarantee that a participant s base benefit amount will be higher on that particular day and there is a low probability that it will step-up during flat and down markets. 2
Value of the Guarantee in the GMWB Finally, the value of the GMWB is only useful if a participant utilizes the feature for the long term. As noted previously, the guarantee commences only after the participant has depleted their account value. For most participants, they will not benefit from the guarantee during their normal life expectancy. Thus, they will pay for the guarantee throughout their retirement, even though it may not be utilized. Illustration: David purchases an annuity with a GMWB feature with $100,000. The GMWB provides for a 5% minimum guaranteed annual withdrawal for a 1% annual fee. Let us assume the market returns 4% over the next 40 years. The result shows the guarantee would become useful around 30 years after the payments begin; assuming David is still living to receive the benefits (see illustration Value Over Time ). Value Over Time $120,000 $100,000 Base Benefit Amount $80,000 $60,000 $40,000 $20,000 Market Value Year 30 Guaranteed Withdrawals Commence $0 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 Years Hypothetical example for illustrative purposes only. Not intended to reflect the actual performance of any specific investment. Individual experience will likely vary. Impacts of Excess Withdrawals While the GMWB provides a contingent guaranteed annual withdrawal when the investor depletes their account value, withdrawals in excess of the annual guaranteed amount can have a negative effect on the future income stream. Example: Jane currently is investing in Option B with a GMWB feature in her employer s 403(b) plan. Her current guaranteed withdrawal amount is $15,000 annually. This year Jane needs an additional $20,000 in addition to her current withdrawal amount to pay for unexpected repairs on her home. How does the excess withdrawal affect Jane s future payments? 3
(example continued) The Guaranteed Withdrawals are reduced by $1,650 annually after the excess withdrawal. Assumptions: Current Base Benefit Amount: $300,000 Current Market Value (MV): $200,000 Current Guaranteed Withdrawal (GW): $15,000 Total Current Period Withdrawal (TCPW): $35,000 ($20,000 excess withdrawal) Results: Market Value after Current Guaranteed Withdrawal: $185,000 Ratio of Excess Withdrawals: $20,000/$185,000 = 11% or 0.11 Next Period Guaranteed Withdrawal [GW* (1-Ratio)]: $15,000* (1-0.11) = $13,350 New Base Benefit Amount: $267,000 The calculation is performed each time an excess withdrawal occurs, and may further reduce the GMWB payout. As you can see from the example, this is a complicated calculation and plan participants may not understand the significant implications of taking an excess withdrawal. Excess withdrawals are a real possibility given the rising costs of health care, reduced retiree health and retirement benefits from employers, and the uncertainty of the Social Security system, all of which can impact a retiree s expected income and expenses. A recent study by the Employee Benefit Research Institute (EBRI), concludes many are generally unprepared for both health care expenses in retirement and retirement expenses. The issue will become a greater challenge in the future as participants bear more of the responsibility for their own retirement. 4 II. Five Key Questions for Plan Fiduciaries 1. Will my participants lose the benefit if I switch providers? Portability is an important consideration. A GMWB feature does not guarantee the plan fiduciary s satisfaction with the overall retirement plan provider. This could place plan fiduciaries and financial intermediaries in a precarious position when they evaluate other providers in the future because the products currently available are not portable to other providers. If plan fiduciaries change providers, participants lose the GMWB benefit which they have already paid for, since it is not portable. 2. Are the fees reasonable for the product and service being provided? Plan fiduciaries need to understand the value they are receiving based on the fees the plan or their participants are paying. Today s GMWB expenses range from 0.35% to 1.50% mortality and expense fee (M&E). This M&E fee is in addition to the investment management fees of the underlying investment option such as a target date fund. Combined with other plan charges, the total fees may be above 3%. Since in-plan income products are relatively new to market, assessing the reasonableness of fees may be a challenge. Currently only a few alternatives exist for comparison and there is little to no standardization of the features within the products. When evaluating fees, it is important to remember they are imposed during the accumulation phase and in retirement. Thus, it is possible participants pay over several decades. Part of the analysis, then, is to review whether the aggregate fee is reasonable. 3. Is the provider financially strong and stable? The financial strength and stability of the insurance company should play a major role in your evaluation. Since the products provide benefits for the long term (possibly 20 plus years), understanding the financial situation of an insurance company becomes very important, particularly during financial turmoil in the equity markets. Insurance companies have faced capital shortfalls and ratings downgrades due to the aggressive sales and pricing of living benefits, like the GMWB. To maintain their capital requirements and ratings, insurance companies have been raising additional capital to reserve for these guarantees through aid from the federal government, investments from other companies, or issuance of new debt and equity. 4
Insurance companies have pulled back from these types of living benefits, or increased fees, due to the cost of hedging the portfolios, increased volatility in the equity markets, and increased capital requirement due to the risk. According to Advanced Sales data, there were more than 126 substantive product changes in May. The modifications include reducing quarterly step-up provisions and withdrawal percentages and paring back products lines. 5 Others have made decisions to offer these guarantees to new plans only, and not to their larger block of existing plans, to mitigate the risk. 4. Will a plan participant understand the benefit? The GMWB has many complex features which can make understanding the benefit difficult. That is why a financial intermediary plays an important role in explaining these benefits to prospective clients. It is a challenge to explain the GMWB through marketing literature and other generic employee education sources, without one-on-one guidance, to institutional plan participants. Participants need to understand the guarantee provisions, withdrawal restrictions, investment restrictions and fees. 5. Are there other options? There are many products that provide for guaranteed income for life, not just GMWB products. For instance an income annuity and an equity portfolio with a systematic withdrawal plan may provide a better solution than a GMWB. According to a recent survey conducted by Vanguard of older investors, 90% or more of the respondents place a high importance on the following as motivational factors for withdrawals from their account guaranteed income, basic living expenditures, keeping control, ensuring assets last, unexpected expenditures, and keeping up with inflation. The income annuity with a cost-ofliving adjustment and systematic withdrawal plans from the equity portfolio address these important factors where the GMWB falls short on some, like inflation protection. III. A Better Approach MassMutual strongly believes the retirement income products available to retirement plans today have a number of shortcomings. That s why we are focusing on developing retirement income solutions that: are portable, create an income stream that is not compromised by the performance of the equity markets, provide access to additional capital when those needs arise without restrictions, penalties and/or excessive fees; and are easily understandable. Today, we believe another approach for plan fiduciaries to consider is to utilize a guaranteed stable value option in an asset allocation program during the accumulation phase and invest a portion of the account balance in an income annuity at retirement. During the accumulation phase, plan participants gradually increase their allocation to a guaranteed stable value option as they near retirement, which protects a portion of their portfolio from market volatility. The plan fiduciary can utilize professionally managed, customized, target date portfolios with the plan s existing underlying investments, which will automatically allocate an ageappropriate portion to the guaranteed stable value option. Income Annuity: An income annuity provides for a guaranteed lifetime income stream for an annuitant (or their spouse) or for a certain period of time in exchange for a lump sum amount. The insurance company bears the risk of providing the payments over time. Income annuities are also called immediate annuities or single premium immediate annuities. Systematic Withdrawal Plan: Participants can establish periodic payouts from their accounts for a set amount (typically a percentage) every period. 5
At retirement, the participant can purchase an income annuity with a portion of the account balance to create a predictable guaranteed retirement income stream to cover known fixed expenses and the remainder of the balance can be invested in an equity portfolio using a systematic withdrawal plan for additional income to cover discretionary or unexpected expense in retirement. This combination addresses the inherent challenges often mentioned when each strategy is used separately and provides for a predictable guaranteed level of lifetime income, potential for continued growth in equity value, and liquidity if unexpected events happen. Alternate Approach v. GMWB Income Annuity with Cost-of- Living Adjustment + Systematic Withdrawal Plan GMWB for Life Benefits Guaranteed lifetime income Liquidity Guaranteed lifetime income Challenges Inflation protection Income does not decline No investment risk No liquidity Interest rate risk at purchase Plus Investment flexibility Growth potential based on market value Additional income Investment risk Growth potential based on step-up Liquidity Income doesn t decline provided the withdrawal benefits rules are followed Available for an additional charge Investment restrictions Excess withdrawals impact future payments May pay for a benefit never used No inflation protection 6
In the following illustration, if a participant utilized the suggested strategy using representative market data for the time period between 1978 and 2008, they would have reaped more income and a greater ending market value relative to the GMWB solution. The illustration provides a look at an alternative using a combination of an income annuity and a systematic withdrawal plan (SWP) from an equity portfolio compared to a GMWB In the case of an income annuity, less of the balance is needed to create the same level of income than the GMWB (historically 8% vs. 5% respectively). Thus, the investor with an income annuity maintains a balance in other, accessible investments without impact to the income stream. The investments outside of the income annuity can provide for additional liquidity needs and potential for growth. The illustration assumes the purchase of an income annuity with a 3% cost-of-living adjustment to address the concerns of inflation risk and longevity risk (outliving your assets) and a 3% annual withdrawal from the equity portfolio to provide additional income and withdrawal flexibility. Illustration: The story of two defined contribution participants Edward and Raymond have been planning for their retirement for several years with the help of their financial intermediaries. Both are turning 65 this year and plan to retire after a long career with XYZ Organization. At age 55, both men began thinking about their income needs at retirement and implemented strategies to provide for a guaranteed level of income. Edward invested his $100,000 account balance, at 55, in an investment portfolio comprised of 40% equities benchmarked against the S&P 500 and 60% in a guaranteed stable value option. Edward continued to contribute $6,000 per year in the investment portfolio for the next 10 years. Edward planned to purchase an income annuity with a cost of living adjustment at age 65 with 50% of his account balance and invest the remaining portion in an equity portfolio. In addition to the annual payments received from the income annuity, Edward also plans to set up an annual 3% systematic withdrawal plan from the equity portfolio. Raymond invested his $100,000 account, at 55, in the same investment portfolio as Edward except it provided for a GMWB feature with a 1% fee. At age 65, the GMWB feature would allow Raymond to withdraw up to 5% per year from the based benefit amount offered by the GMWB. How did the income annuity and SWP strategy compare to the GMWB over the 31-year period? 6 Edward s portfolio over the 10-year period 7 before retirement outperformed Ray s portfolio as expected $346,804 compared to $313,333 respectively. Both men were invested in the same portfolio, but the 1% fee for the GMWB in Raymond s portfolio accounted for the difference of $33,471 or 10.7%. At retirement, Edward s portfolio utilizing the income annuity 8 and SWP 9 provides 38.2% more in payments received cumulatively over the 21-year period compared to Raymond s portfolio utilizing the GMWB 10 over the same period (see illustration Total Cumulative Payments 1988-2008 ). In addition, Edward can transfer more wealth to his beneficiaries at the end of the 21-year period compared to Raymond s portfolio. The market value of Edward s portfolio is $576, 232 versus Raymond s portfolio of $342,941 (see illustration Market Value 1988-2008 ). 7
Total cumulative payments from the income annuity and SWP portfolio outpace the GMWB by 38.2%. Illustration 1 Total Cumulative Payments $700,000 $600,000 $500,000 $400,000 $300,000 $200,000 $100,000 $0 Edward Raymond $648,674 $469,543 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 Year Hypothetical example for illustrative purposes only. Not intended to reflect the actual performance of any specific investment. Individual experience will likely vary. Edward is able to transfer 68% more wealth to beneficiaries from the income annuity and SWP portfolio than the GMWB. Illustration 2 Market Value Both show best case scenario where there are no portability issues. If the plan fiduciary decides to change providers during the payout period, the change affects both Edward and Raymond in different ways. Edward will continue to receive the same income from the income annuity he purchased and can rollover his existing equity portfolio into the new provider s program or an IRA with a similar investment to continue the 3% annual systematic withdrawal plan. Raymond, on the other hand, will not be able to rollover his account to the new provider s program. If available from the existing provider, he can rollover his entire balance to a retail version of the GMWB with that provider. By doing so, Raymond may pay higher fees for the retail version than the institutionally priced GMWB offered through the plan. IV. Conclusion Plan fiduciaries have to play an active role in understanding and monitoring in-plan income products offered to their participants. They must follow a prudent process in selecting and monitoring in-plan income options as they do with other investments within their plan. While the promise of downside protection and income for life is a very enticing marketing pitch, unfortunately, the marketing is often better than the actual products. It is incumbent on the decision makers to truly understand these products and to go beyond what is conveyed in the marketing materials. They can ask the questions to help provide a deeper understanding of the GMWB proposed by some providers. $1,200,000 $1,000,000 $800,000 $600,000 $400,000 $200,000 $0 1988 Edward Raymond 1990 1992 1994 1996 1998 Year $576,232 $342,941 2000 2002 2004 2006 2008 As an alternative, plan fiduciaries may consider a strategy using an income annuity and an equity portfolio utilizing a systematic withdrawal plan. Using historical returns over the past 31 years, this strategy provides more total income and a higher market value over the same period as the GMWB. While past performance is not a guarantee of future returns, it gives an alternative view of the benefits of an income annuity, which have been in the market for a long time and continue to see year-over-year increases in sales over the past decade. 11 Hypothetical example for illustrative purposes only. Not intended to reflect the actual performance of any specific investment. Individual experience will likely vary. 8
To take advantage of our comprehensive retirement solutions. Contact your advisor, TPA or a retirement services professional at www.massmutual.com/retire, or call 1-866-444-2601. MassMutual is a leading innovator with a passion for service and the power to maximize retirement success. We re the difference between just thinking about retirement success and helping make it happen. 1 The U.S. Retirement Market, 2008, Investment Company Institute Research Fundamentals, June 2009. 2 Change in Average Account Balances From January 1, 2008 January 20, 2009 Among 401(k) participants with Account Balances as of Dec. 31, 2007, The Employee Benefit Research Institute (EBRI), February 2009. 3 Fiduciary Considerations in Offering a Lifetime Income Feature to 401(k) Participants, by Fred Reish, Bruce Ashton & Joe Faucher. 4 Savings Needed for Health Expenses in Retirement: An Examination of Persons Ages 55 and 65 in 2009, ebri.org NOTES, June 2009. 5 Mad Rush to Revamp Variable Annuities, Ignites, June 5, 2009. 6 The 31-year period for the illustration is represented by the performance of the S&P 500 from 1978 to 2008. 7 The 10-year period used in the analysis is 1978 to 1987. The portfolio returns are based on 40% of S&P 500 index performance over the 10-year period and 60% of a 5.5% expected credited rate for the stable value option over the same 10-year period. 8 MassMutual quote as of June 2009: Male, 65 years of age, single life only, 3% cost-of-living adjustment. 9 Portfolio returns represented by performance of the S&P 500 index over the 21-year period between 1988 and 2008. 10 Portfolio returns represented by 40% of S&P 500 index performance over the 21-year period of 1988 to 2008 and 60% of a 5.5% expected credited rate for the stable value option over the same 21-year period. 11 Insurance Product Comes of Age: Immediate fixed annuities are drawing attention, The Cerulli Edge Retirement Edition, 2Q 2009. 9
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