Best laid plans

By David Wray, President of the Profit sharing/401(k) Council of America, on the market for annuity solutions.

Soon, the baby boomers will start to withdraw what will eventually amount to trillions of dollars from their employer-sponsored defined contribution plans and rollover funded IRAs. Many of these retirees will want to use some or all of their retirement accumulations to ensure lifetime streams of income. It is clear, however, that participants in defined contribution plans with an annuity distribution option are rejecting the current approach – to convert their entire retirement accumulation into a single-life or joint and survivor annuity on the day they retire.

In response, some urge that participants in such plans be more effectively confronted with an annuity choice when they retire. Others believe that the conversion of lump sum amounts to an annuity should be the plan’s distribution default or even be mandatory. I believe that there are good reasons for the current rejection of annuities by defined contribution plan participants. I also believe annuities will become a greater part of the retirement income management equation, but only if we avoid additional regulation. It is my opinion that new market-driven solutions will fit annuities to the needs and expectations of US retirees in ways that are also comfortable for defined contribution plan sponsors.

The current situation

Social security
Average wage workers are already provided with a substantial annuity when they retire. According to the 2005 Social Security Trustees Report, the average 65 year-old retiring in 2005 will receive a Social Security benefit that replaces 43.2 percent of pre-retirement income. Those with average earnings at 45 percent of the national average wage will receive an annuity equal to 65 percent of their pre-retirement income. These annuity payments are subsequently adjusted for inflation. Married couples can each elect to receive their own benefit or 150 percent of the higher benefit. For the average wage earner with a spouse who does not work, Social Security will replace 64.8 percent of income. Social Security provides a 100 percent survivors benefit. In two-earner families, the surviving spouse can switch from their own benefit to the spousal benefit if it is higher.

According to the 2004 Aon Consulting/Georgia State University Replacement Ratio Study, the income replacement ratio to replace the pre-retirement purchasing power of a retiree with US$40,000 in pre-retirement income is 80 percent. For such a retiree, Social Security will provide more than half of pre-retirement income.

All or nothing
Participants today are typically faced with a total account or an all-or-nothing annuity decision when they retire. It is often in their best interest, however, to annuitize only that portion of their retirement nest egg necessary to supplement other annuity payments sources, like Social Security or defined benefit payments, to cover a specific income need. Being faced with an all or nothing annuitization choice deters participants from making any decision at all.

One point in time
For how many does it make sense to irrevocably convert plan assets to an annuity at age 62 or age 65, especially when available annuity options do not provide for inflation adjustment? For all of their planning, retiring plan participants have yet to experience retirement and retirement income needs. Is it not sensible to wait until one has lived a few years in retirement and really understands retirement realities before making irrevocable decisions?

Limited provider choice
Participants generally have either no choice or a very restricted choice of annuity providers if their plan provides an annuity option. They deserve not only broader choice of annuitization options, so that they can customize their purchase to fit their specific financial needs, but also choice of providers.

For best pricing, competition is needed. When I was the plan administrator for a 175 employee organization, we shopped lump sums for those wishing to annuitize. I found that competition was meaningful, and the bidding process resulted in increased lifetime income for my retiring participants.

Later annuitization
The assumption that retirement lump sums are never used to purchase an annuity is incorrect. It is true that nearly all retirees roll their lump sum into an IRA or leave their assets in the employer’s plan at retirement, even if their defined contribution plan is one of the approximately 25 percent that offer annuities. However, some retirees choose subsequently to convert some or all of their remaining plan or IRA balance into an annuity, while retaining the tax favored status for the amount converted. For example, my father annuitized his tax deferred accumulations when he was 80.

The future is here

Innovation and flexibility
Every retiring employee’s situation is unique. For example, retirement income management decisions need to consider age, marital status and other family factors such as health, wealth, potential inheritances and genetic dispositions. Participants need the ability to tailor solutions to fit their specific needs. Importantly, participants need the ability to select a cost of living adjustment as part of their annuity approach.

Within the next six months, an insurance company will market an annuity approach that permits the retiree to maintain their lump sum in an IRA, but gradually convert some or all of their deferred accumulation to an annuity payable immediately or sometime in the future considering the retiree’s risk, investment and estate preferences. This product will have the following features:

• All options can be stopped, started and changed at any time
• Automated Required Minimum Distribution (RMD) compliance
• Automated quarterly rebalancing
• COLA/Inflation Protection Option
• Dollar cost averaging annuity purchasing
• Flexible income start age
• Survivorship benefit option (50-100 percent) for spouse
• Legacy benefit option (25-100 percent) for heirs and beneficiaries
• Benefit exchanges – reduce survivor or legacy benefit in exchange for more income
• Liquidity reserve option (0-12 months of income) in a cash account

This approach will permit the retiree to move to a secure income based upon their risk tolerance, their chosen level of guaranteed income and their chosen period to fund an annuity.

Access to group/institutional pricing
Retail annuities are more costly than annuities offered on a group or institutionally priced basis. Data shows that the difference can be substantial. On average, monthly income quotes are between 4-9 percent higher than comparable retail quotes. Plan participants who are at or in retirement will undoubtedly be best served by having access to group or institutional pricing.

Meaningful competition
Group/institutional pricing alone is not enough. It is the combination of this and meaningful competition that substantially improves monthly income amounts and offers the best possible result for each individual retiree. Meaningful competition is defined as real-time bids from a broad universe of issuers that constitute a representative sample of the current market. Such competition will be enhanced by standardized quote request and response formats.

Data across a random sampling of 148 quotes over a six month period of time shows that even in a limited universe of six to nine insurance companies, the differential between the highest and lowest quote amount can often be significant and at times can be a narrow range (see figure 1).

Maximum differential between high and low: 15.53 percent
Minimum differential between high and low: 1.68 percent
Average differential across 148 quotes: 9.16 percent

The differential between the high and low is significant (the maximum is15.53 percent, minimum is 1.68 percent and average differential across 148 quotes is 9.16 percent) but what may be even more important is the variability of pricing of an issuer’s quote on any given day. An issuer can move from being a top competitor on one set of quotes to offering below the median on another. Due to this pricing variability, the only way to ensure that a participant can optimize their retirement income is through a competitive quoting session involving a broad universe of issuers.

The sample illustration below shows the approximate benefits an individual may expect to receive when group/institutional and competitive quoting are combined. If you are a 59-year-old male purchasing a US$200,000 Life Income Annuity with a 10-year Period Certain, on average you would receive US$1200 a month when purchasing an annuity through the annuity program versus US$1140 a month buying a traditional retail annuity. This example is a difference of more than five percent, or a US$60 increase in monthly income. Over a 10-year period this differential equates to US$7200, over 20 years it is US$14,400 and over 30 years the difference grows to US$21,600.

Basic tools and education
Like today’s 401(k) investment modeling programs, web-based tools will become broadly available. Such tools will include a basic calculator that can help an individual determine what they may need to spend to achieve a specified monthly income or what a given dollar amount might convert to in terms of a monthly income. More sophisticated tools will help retirees determine their changing income needs as they age and fit their investments and annuity purchases to their specific needs. Preferably, the web-based tools will be tied to the annuity quote system as one integrated approach so that the retiree can obtain the right options and pricing.

Ability to diversify
Participants often have no opportunity to diversify an annuity purchase among more than one provider if they select their plan’s annuity option. The principal of diversification can be applied to annuity purchases as it is to other fixed income investments. Participants have that opportunity if they roll their plan assets into an IRA and then shop for an annuity solution. Participants should be therefore be given the tools to consider diversifying their purchases by issuer, making apples to apples comparisons.

Employer role
Employers that offer an annuity option are faced with significant administrative and fiduciary hurdles for a product for which there is very low demand. Many sponsors currently avoid these problems by not offering an annuity distribution option in their plans.

As the marketplace is becoming more innovative, flexible and efficient in providing annuity solutions that better meet the needs of retirees, innovative employers are playing a role in assisting plan participants in purchasing annuities using an IRA rollover.

Technology
Future best practices for annuities will combine flexibility, competition, employer involvement, and institutional pricing. Currently, technology solutions are being implemented to do just that. Kelli Hueler, President of Hueler Companies, said, the key is to combine critical best practice components (institutional pricing, competition, comparability, educations, transparency and choice) in an easy to use, easy to access format. These technology platforms, which can be easily offered to participants by any plan sponsor or service provider with no up front fees or onerous integration costs, will ease the administrative and communication constraints between buyers and sellers of annuities. These will provide electronic data delivery and reception in a uniform format for buyers and insurance companies in order to efficiently obtain and compare competitive market quotes. These annuity platforms will replicate the beneficial aspects of an institutional purchase process via a system designed for individual annuity purchase. The result is empowered participants with the tools necessary to substantially improve their purchase result. In fact, the future is here. IBM began offering such a solution to its participants 1 January 2005.

Final words
In the decades ahead, trillions of dollars from employer defined contribution plans and the IRAs funded by employer defined contribution plan distributions will be available to support the retirement of today’s workers. As a result, service providers seeking a role in managing these assets will be forced to compete, and should be forced to compete, with innovative services and products tailored to the individual needs of retirees if they want a role in managing these assets. As they do so, retirees will adopt retirement annuities as an important retirement income management tool.

David Wray is President of the Profit sharing/401(k) Council of America (PSCA), a national, non-profit association of companies that sponsor profit sharing and 401(k) plans for over six million employees. He is a nationally recognized authority on 401(k) and other defined-contribution plan issues and has testified before congressional committees and at Labor Department, Treasury Department, and Internal Revenue Service hearings.

Wray was the 2004 chair of the Department of Labor’s ERISA Advisory Council, which advises the Secretary of Labor on benefits issues, and was a member of the Certified Financial Planner Board of Standards Advisory Board. He also served as president from 1993 to 1996 of the International Association for Financial Participation (IAFP), a Paris based alliance of national organizations that promote the use of employee financial participation.