POINT OF VIEW - DEFINED BENEFITS IN A DEFINED CONTRIBUTION PLAN                   Part of a thought leadership series pres...
POINT OF VIEW - DEFINED BENEFITS IN A DEFINED CONTRIBUTION PLANWith the accelerating decline of defined benefit pension pl...
POINT OF VIEW - DEFINED BENEFITS IN A DEFINED CONTRIBUTION PLAN    1. Fixed deferred income annuity (DIA – which is often ...
POINT OF VIEW - DEFINED BENEFITS IN A DEFINED CONTRIBUTION PLAN        The variable annuity with the GLWB feature provide...
POINT OF VIEW - DEFINED BENEFITS IN A DEFINED CONTRIBUTION PLANIn addition, it would also be fair to say that along with t...
POINT OF VIEW - DEFINED BENEFITS IN A DEFINED CONTRIBUTION PLAN    6. Ease of Plan Administration: If plan administration ...
POINT OF VIEW - DEFINED BENEFITS IN A DEFINED CONTRIBUTION PLANemerge if they are executed “right”. For example, while det...
POINT OF VIEW - DEFINED BENEFITS IN A DEFINED CONTRIBUTION PLAN        guarantee based on the portion of the contributions...
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Defined Benefits in a Defined Contribution Plan


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Plan sponsors appear intrigued by the possibility of providing a pension or lifetime income guarantee to DC plan participants. What are the issues relating to successfully providing an in-plan income guarantee for a defined contribution plan, e.g. 401(k).

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Defined Benefits in a Defined Contribution Plan

  1. 1. POINT OF VIEW - DEFINED BENEFITS IN A DEFINED CONTRIBUTION PLAN Part of a thought leadership series presented by … Garth A. Bernard, President & CEO THE SHARPER FINANCIAL GROUP LLC October 31, 2010 (updated December 4, 2010)©2010 The Sharper Financial Group, LLC Page 1 of 9
  2. 2. POINT OF VIEW - DEFINED BENEFITS IN A DEFINED CONTRIBUTION PLANWith the accelerating decline of defined benefit pension plans and the spectacular growth of definedcontribution plans in modern times, retirement plan sponsors have expressed overwhelming interest inproviding that benefit that is most highly prized by participants in defined benefit plans – a guarantee ofincome for the lifetime of the participant upon retirement. In other words, they want a DB-in-DC plan.Without such a guarantee – in fact, DC plans turn over the investment decisions to participants with nosafety nets whatsoever underlying the investment risks – and combined with the unfortunate levels offinancial illiteracy in the country, the DC plan concept is at risk of becoming a relic of history, a badlyfailed experiment in providing financial security for a generation of plan participants, including thosewho take the active step of saving for retirement. Already, innumerable stories are being accounted ofreal retirement plans of real workers gone array as a result of the great bear market of 2008-2009 andits impact on retirement wealth accumulation. A generation of workers is unprepared for the financialconsequences. Clearly, something must be done to rectify this crisis.Providers with Innovative OfferingsGiven this opportunity, a number of plan providers have brought innovative plan offerings to the DCplan sponsor arena containing an “in-plan” guaranteed lifetime income component. Examples include:  MetLife – Personal Pension Builder  MetLife/BGI – SponsorMatch  Blackrock/MetLife/BGI – LifePath Retirement Income  Hartford Life – Lifetime Income  Nationwide – 401kIncome (position paper only)  Genworth – ClearCourse  Prudential – Income Flex  Diversified/Vanguard/Transamerica – Secure Path for Life  John Hancock – GIFL  AllianceBernstein/AXA-Lincoln-Nationwide – Secure Retirement Strategies  UBS, Great West/Putnam – information not yet publicly available  Phoenix/Lockwood – GRIS (abandoned)The guaranteed component of the product is underwritten by insurance companies because theconstruct of the guarantee is an insurance guarantee which can only be provided by a legally authorizedinsurer. The investment component of the product is delivered either by the insurance company or aninvestment manager. The administration of the product is typically provided by the insurance company,but can be provided by a third party record keeper.The Nature of the Insurance Guarantee ComponentThe insurance component of the offerings can be categorized into four broad product groupings:©2010 The Sharper Financial Group, LLC Page 2 of 9
  3. 3. POINT OF VIEW - DEFINED BENEFITS IN A DEFINED CONTRIBUTION PLAN 1. Fixed deferred income annuity (DIA – which is often incorrectly referred to by the moniker, “longevity insurance”, which is one instance of a deferred income annuity) – MetLife, MetLife/BGI, BlackRock/MetLife/BGI, Hartford, Nationwide; 2. Variable annuity with a variable annuitization benefit and a minimum payout “claw-back” floor guarantee (VA with deferred variable annuitization) – Genworth; 3. Variable annuity with a fixed guaranteed lifetime withdrawal benefit (GLWB) – Prudential, Diversified/Vanguard/Transamerica, GreatWest/Putnam; 4. Unbundled fixed guaranteed lifetime withdrawal benefit (UGLWB) which can be wrapped around underlying mutual funds – Phoenix/Lockwood, Hancock, AllianceBernstein, UBS.These groupings are arranged in the order in which they were introduced to the market. Coincidentally,the order also reflects the “age” of the insurance products in the annals of insurance industry’s history,although DIAs have been re-popularized only within the last 10 years. In a sense, this order expressesthe evolution of innovation of lifetime income guarantees within the insurance industry.Differences between the Insurance VehiclesThere are tremendous differences between the four vehicles for delivering the lifetime incomeguarantee:  The DIA represents the vehicle with the highest leverage of future lifetime income guarantee to insurance premium and has the lowest fees of the group (zero) – it is the purest form of deferred annuitization, delivering only future income and no other benefits in addition to the guarantee. The guaranteed income is a fixed amount (which can be level or may have a COLA adjustment). However, in its purest form, it has no liquidity. Its price is dependent on the age and gender of the attained participant. The price is also heavily dependent on the level of long- term interest rates at the time the premium is paid. Finally, it exposes the insurance carrier only to interest rate and mortality risks – risks that insurers have mastered for decades.  The variable annuity with a floored variable annuitization provides a future minimum floor income guarantee which serves as the lifetime guarantee. Because it uses a true annuitization to provide the income payments, it delivers a fair amount of leverage on the lifetime income per dollar of insurance premium. The actual income payments may fluctuate up and down but never less than the minimum guarantee. The fees for the guarantee combined with the base insurance fee (called the mortality, expense and administration charge or ME&A) can be substantial. It offers full liquidity during the accumulation phase, although there could be charges for premature termination. There is no liquidity during the distribution phase. Other benefits, such as death benefits may also be provided. It exposes the insurance carrier to the risk of market declines over the long term and during the period over which the income payments are made – risks that are difficult to hedge, and that are relatively new to the carriers.©2010 The Sharper Financial Group, LLC Page 3 of 9
  4. 4. POINT OF VIEW - DEFINED BENEFITS IN A DEFINED CONTRIBUTION PLAN  The variable annuity with the GLWB feature provides guaranteed income in the form of fixed withdrawals from the accumulated assets followed by an insurance benefit of an annuitized benefit if the withdrawals happen to deplete the assets. The insurance benefit is thus most accurately described as a “contingent deferred income annuity.” The level of the guaranteed withdrawal and thus the guaranteed insurance benefit is usually determined by a complex formula applied to a shadow account (called a “benefit base”) which provides potential for increases in the allowable withdrawals – the existence of a separate shadow account and the associated formula exposes this vehicle to potential confusion and misperceptions about the nature of the benefit. The leverage on the guarantee is relatively low compared to the vehicles that use purer forms of annuitization. The fees for the guarantee combined with the base insurance ME&A fee can be substantial. In return, this vehicle provides full liquidity during both the accumulation phase and the distribution phase until the point the assets are depleted. The vehicle may deliver other benefits such as death benefits. It exposes the insurance carrier to the risk of market declines over the long term and during the period over which the income payments are made – risks that are difficult to hedge and that are relatively new to the carriers This risk may be higher than the risk exposures in the variable annuity with variable annuitization and a floor because it is compounded by the sequence-of-returns risk – the risk that portfolios may be more dramatically impacted by market risk when subject to a stream of consistent withdrawals.  The unbundled GLWB is essentially the GLWB “lifted” off of a variable annuity and “wrapped around” mutual funds that are not managed within a variable annuity. Its characteristics are identical to that of the variable annuity with GLWB with the following exceptions: (a) it uses funds that are outside of an annuity wrapper; (b) because there is no annuity wrapper from which to extract a fair profit, the insurer must rely solely on the fee for the feature to provide the profit – the fees for this benefit will be higher than the same guarantee inside of a variable annuity wrapper; (c) a variable annuity may provide mechanisms to buffer the insurer against risks of a market decline, but since the UGLWB is not afforded such buffers being outside the annuity wrap, it creates the greatest risk exposure relative to the other vehicles, for the insurer underwriting the guarantee; (d) the tax implications of receiving distributions of dividends and capital gains as withdrawals under the “wrap” of the insurance guarantee is not yet been ruled on by the IRS … however, this is not an issue for qualified funds.Good Ideas Are Not EnoughAll of the offerings represent a degree of innovation in the space. Some industry executives havedescribed the efforts as “bringing together the best features of the insurance products and theinvestment products”. In fact, many of these ideas have “tested” exceedingly well in focus groups ofconsumers, advisors and sponsors. However it would be fair to say that the ideas have not been broadlyaccepted by the plan sponsor market in execution. (It may be too early to judge the most recent offeringfrom BlackRock/MetLife/BGI as will be demonstrated later).©2010 The Sharper Financial Group, LLC Page 4 of 9
  5. 5. POINT OF VIEW - DEFINED BENEFITS IN A DEFINED CONTRIBUTION PLANIn addition, it would also be fair to say that along with the “best features” of the insurance andinvestment world, the offerings by definition also bring the biggest challenges associated with theseinsurance and investment products.And therein lies the essence of the innovation opportunity for new entrants – the innovations to datehave been product centric and have retained the issues and challenges associated with the products. Forexample, considerable feedback has arisen in the retail market where insurers have sold their annuitiesfor years regarding the complexity and misperceptions of the offerings. Yet, the features have simplybeen migrated to the plan sponsor market without much effort to address these issues. In theinvestment arena, target date funds have come under increased scrutiny – many investors in thesefunds assume that the funds guarantee principal on the target date.In addition, there are a number of unique challenges to delivering a successful in-plan product designthat includes a lifetime income guarantee that must be addressed by the insurance company-investment manager-administrator. Here is a list of requirements (not necessarily in order of priority): 1. Simplicity: The product should be simple – easy to understand – by sponsors, advisors and participants alike. This would make it conducive to due diligence review, reduce fiduciary liability exposures, and allow participant expectations to be met. In short, this is necessary for broad market acceptance. 2. Default Option: It should be compatible with a default option so as to leverage adoption. If it is not compatible with a default option, it should be a simple intuitive choice that can be elected at the time the employee commences participation in the plan. 3. Portability: The product should be portable. 4. Participant Level Statements/Tools: Participants need to understand where they stand in terms of asset values (traditionally provided), income guarantees at the retirement date in which they are vested to date, and where those income guarantees are projected to be if they maintain their current participation levels in the plan and they should be able to explore ”what-ifs.” Capabilities should be available online especially for younger participants. And the information should be easy to understand. 5. Participant Easy-On/Off Switch: The ultimate goal of a future income guarantee is to provide a floor of income impervious to the markets (and thus regardless of the condition of any of the retirees remaining assets) so that the retiree’s basic/essential retirement expenses can be met, when the vested in-plan income is considered along with other sources such as Social Security. The plan sponsor may also wish to make lifetime annuities available at the point of retirement as an additional source of guaranteed income. It is quite possible that some in-plan income guarantee designs may provide too much income without the ability to “stop” the addition of incremental guarantees. An easy to use on/off switch is desirable©2010 The Sharper Financial Group, LLC Page 5 of 9
  6. 6. POINT OF VIEW - DEFINED BENEFITS IN A DEFINED CONTRIBUTION PLAN 6. Ease of Plan Administration: If plan administration becomes a nightmare, the product will never be accepted. Thus ease of plan administration is necessary for broad acceptance. Many of the insurance offerings are such that they could previously only been administered on the proprietary systems of the plan provider. This does not allow for an open market which fosters competition and true innovation. With the advent of the SPARK Institute’s standards for “Data Layouts for Retirement Income Solutions” which will facilitate the administration of in-plan income guarantees, the plan administration bar has been significantly lowered and should be a catalyst for true and rapid innovation. The only plan administrator who has provided a compliant platform is SunGard. But this in itself is a testament to the pace with which innovation can now proceed – the standards were officially announce only one month ago at the time of this writing. As in other industries, technology could be a major element of the innovation and will likely be a determinant of the solutions that will gain the broadest acceptance and adoption. 7. Fees: Recent research conducted by some insurers has found that consumers may be quite willing to pay high fees for guarantees of lifetime income. However, such research may be self serving. The bottom line is that if a given guarantee can be provided for a range of fees, the designs with the lowest fees should be preferable, all other things equal. Fees should be commensurate with the market and the goals of the participants. An income guarantee may not the only benefit participants desire. Leaving a legacy (having assets to pass on to heirs) may also be important in retirement. Designs that assess high fees could substantially reduce assets accumulations and reduce net performance on those assets, decimating potential legacies. 8. Fund Choices: Some of the product designs have placed limitations on funds that can be offered with a guarantee – for good reason – the limitations are a control mechanism for limiting risk exposures the insurance carrier must bear to make good on the guarantee. However, limitations on fund choices may be confusing or unattractive if participants do not understand why they are there, or if desirable choices are eliminated. There has been a move toward target date funds that might help resolve the insurers risk management issues as well as provide simple desirable investment options. 9. Strength of the Guarantor: An insurance guarantee is only as good as the insurer standing behind it. Sponsors and advisors are encouraged to do their due-diligence homework especially on the product designs behind which the guarantor must stand. 10. Multiple Guarantors: Having a single insurer provide the lifetime income guarantee creates a potential fiduciary liability from several standpoints – cost of guarantee and guarantor strength. A solution which provides access to multiple insurers for the income guarantee – just as the investment component may provide access to multiple investment managers in each asset class – may provide benefits to both the participants and the fiduciaries.So while bringing together the best of the insurance and investments has been a good idea, good ideasare clearly not enough. Innovations which effectively address all the key requirements can begin to©2010 The Sharper Financial Group, LLC Page 6 of 9
  7. 7. POINT OF VIEW - DEFINED BENEFITS IN A DEFINED CONTRIBUTION PLANemerge if they are executed “right”. For example, while details as of the date of this writing are scant,the BlackRock/MetLife/BGI offering appears to be an attempt to address more of the market’srequirements.It is also interesting to observe that MetLife has 3 offerings which have appeared in the time sequenceof “Personal Pension Builder >> SponsorMatch >> LifePath Retirement Income Solution”. It isreasonable to interpret this evolution of ideas as MetLife’s “learning” portion of the innovation process,and supports the view that the ultimate offering may have a better chance of gaining broaderacceptance – how broad remains to be seen.Other Obstacles That Have Kept Evolution Inside-the-BoxThere are three key obstacles to real innovation of income guarantees in the in-plan space. These issuesregard the definition of “inside-the-box”. If these barriers to the innovation process are cast aside,perhaps they may reveal approaches and solutions that might not have otherwise been considered bythe traditional insurance design process.Here are the three barriers to additional innovative solutions: 1. Insurance plan designers may be overly influenced by what has worked well in the retail space. For example, variable annuities with GLWBs have been extremely successful in the retail annuity markets. Variable annuities are a $120 billion-a-year market. And according to LIMRA, 90% of variable annuities are sold with some form of guaranteed living benefit (primarily GLWBs). It is therefore tempting to believe that it is this guarantee feature that attracts buyers of the product and causes them to purchase. In reality, the buyer’s decision is heavily influenced by the recommendation of an advisor. This personal advice process is not present in the retirement plan arena until perhaps the participant is at or nearing the point of retirement. At this point, the solutions recommended are often not the in-plan solution(s). Clearly, if a potentially viable in-plan guarantee turns out not to be related to retail offerings, popularized by retail advisors, a major opportunity may have been missed by plan designers. 2. Designers tend to think of portability in the traditional sense of liquidation of assets and transferring cash from one provider to the next. Real innovation requires that designers view portability from an outside-the-box perspective – as long as the end result is a seamless transfer of the “construct” from one provider to the next, the end result is the one desired. With the facilitation provided by the new “data exchange standards” promulgated by the SPARK Institute, portability can be viewed and executed in new ways. 3. There may be a tendency for plan designers to think of the guarantee as “in-asset” rather than “in-plan”. What is meant by “in-asset”? This is simply the notion that the current in-plan designs tie the guarantee, in some way, to the amount of assets or contributed assets (contributions), or asset-allocation the client has in their portfolio, or that the client allocates to the product. For example, the GLWB and the UGLWB all define the income benefit in terms of the assets “wrapped” by the product via the benefit base that is a function of assets. The DIA provides a©2010 The Sharper Financial Group, LLC Page 7 of 9
  8. 8. POINT OF VIEW - DEFINED BENEFITS IN A DEFINED CONTRIBUTION PLAN guarantee based on the portion of the contributions directed to it. This is a very “investment- centric” way to look at the problem. This is probably a natural response to the environment of the DC plan – it is, after all, an investment vehicle – but there is no requirement that the problem or the solution be viewed in such restrictive dimensions. It is instructive to take a step back to a “clean sheet of paper” and re-examine what the market has demanded – an investment vehicle (the DC plan) with a guarantee. By divorcing the phrase, “with a guarantee”, from the context of “an investment vehicle”, designers may arrive at solutions that are outside the investment box. This is a very “protection-centric” view. Insurance companies may thus be well served by stepping back and seeing themselves as insurers first and investment managers second or not at all as it relates to the opportunity. The desire to have a role in both components of the solution, or to connect the pieces together too quickly, may be a significant impediment to the innovation process. Once the innovation process is complete, the insurer is free to once again compete for the investment role if that is part of the desire.ConclusionThe opportunity to build a winning product that delivers an “in-plan” lifetime guarantee remains wideopen. It requires that the insurance provider meet all of the requirements of the market, as well asbroaden the innovation process by seeing itself as an insurer first. This may liberate and accelerate theinnovation process so that unique solutions unlike the retail insurance products may emerge.©2010 The Sharper Financial Group, LLC Page 8 of 9
  9. 9. POINT OF VIEW - DEFINED BENEFITS IN A DEFINED CONTRIBUTION PLANGARTH A. BERNARD, MAAA Mr. Bernard is Founder and CEO of the Sharper Financial Group, a consulting practice specializing in design and marketing of retirement income solutions. He is also CEO of Thrive®, a firm that markets and distributes a retirement income selling system that is supported by a web-based platform for delivering solutions. He is also a Principal of Retirement Income Solutions Enterprise. RISE® helps advisors profitably educate, win and satisfy more clients with compelling retirement solutions delivered via a process called Mature SimplicityTM.Mr. Bernard has over 25 years of experience in the US and Canadian financial services industriesand is widely recognized as an expert in retail and in-plan retirement income solutions andannuities. He has written several articles on both subjects and is often quoted in national andindustry media. He has been a frequent speaker and participant at retirement industryconferences and serves on numerous retirement industry committees.Prior to launching his own company, Mr. Bernard was a senior executive at MetLife where hewas responsible for developing innovative retirement solutions including a broad suite ofinvestment and insurance products and for product management of several annuity productlines across MetLife’s retail distribution channels. He also held executive level roles at KeyportLife, ReliaStar Northern Life, Providian Capital Management, Transamerica and National Life ofVermont where he had responsibility for various functions including marketing and productmanagement, asset-liability management, reinsurance pricing and customer relationshipmarketing for life and annuity lines.Mr. Bernard is Past President of the International Association of Black Actuaries. He is amember of the Advisory Board for the American College’s Retirement Income Center. He alsoserves as the contributor for “Ask an Expert” at the Center for Due Diligence. He has been aMember of the American Academy of Actuaries for over 20 years, and holds a Masters degreein Mathematics from the University of Waterloo, Canada.©2010 The Sharper Financial Group, LLC Page 9 of 9