Converting defined contribution assets to a
defined benefit-like income stream.
Our retirement system depends heavily on defined
contribution savings, but many employees prefer a stable
income stream akin to the defined benefit programs of old.
Imagine a typical employee ready to retire at age 65. If he
wanted, he could cash out of his 401(k) or IRA account,
pay the necessary taxes, and use the lump sum to purchase
an annuity to provide a lifetime of income. He will need
to do his homework, manage the transfer, be satisfied by
the soundness of his insurer and the terms of his contract,
but this is a viable way to convert retirement savings into a
lifetime of income.
Retirement plan sponsors can provide a similar solution on
a larger scale to their plan participants. There has been
an explosion of interest in new products - called income
replacement products - which exist to generate a lifetime of
income within the structure of a defined contribution plan.
In simple terms, think of an income replacement option as
standardized annuity program. Some income replacement
options are like fixed annuities, with limited upside
potential. Some income replacement options are like
variable annuities: they invest in underlying investments
(like a balanced mutual fund of equity and fixed income)
with the potential for appreciation in the markets. The
income replacement funds may borrow other features
common to variable annuity “rider” provisions. For
instance, they may guarantee a minimum market value,
and provide a stable income stream based on “high-water
marks” of that minimum market value. The provisions
depend on the specific income replacement fund.
The advantages to income replacement plans
Arguably, the greatest benefit of these products is the
removal of a key liability to retirees: outliving your
money. The insurer now bears the risk that an employee
will continuously receive predictable benefits during a long
retirement.
Second, these products reduce market risk for employees.
Employees have suffered through two significant market
crashes in the past decade and trading volatile assets for a
predictable income is a notable advantage.
Third, income replacement options impose a spending
discipline by making the consequences of overdrawing
immediate to participants. The products generate a
predictable income stream, typically around 4% to 5%,
of the total market value of the underlying investment.
Withdrawing beyond that amount deducts from the
investment principal and lowers the future income stream.
As a related advantage, an investor’s retirement budget is
easier to predict since they know what their accumulating
savings will generate.
Fourth, when comparing income replacement products
to traditional annuities, these products are often able to
create an effective economy-of-scale. Income replacement
products are more expensive than a direct investment in the
underlying investments (i.e. – buying shares of an ordinary
balanced mutual fund), but they are often less expensive
than a comparable annuity contract that an individual could
purchase from an insurer.
Lastly, these products work within the structure of an
existing, tax-deferred 401(k).
Research shows that
simple, easy-to-access solutions have the greatest impact
on participant behavior. Easy access to an annuity-like
income stream without the inconvenience of changing
accounts (or the immediate tax bill of moving assets into a
taxable account) is a clear benefit to employees.
The disadvantages to
income replacement plan