Business of Benefits : Employee Benefits Lawyer & Attorney : Law Office of Robert J. Toth, Jr. : 403(b) Plans, Annuity & Insurance Law : Business of Benefits Blog

 EBSA and the IRS issued their long promised Request For Information on annuities-or, should I say, as promised by the EBSA. We had not expected this particular piece to be a joint effort. It shows that Phyllis's and Mark's agenda is getting policy effectively done, not engaging in damning bureaucratic turf warfare. Hmm. With this and the recent DOL/ SEC activities, we may be seeing a trend here somewhere....

The RFI is extensive and well thought out (though they do reference  the GAO report I criticized in an earlier blog). There looks to be a lot of work put into the effort already, as it well identifies the key issues facing the idea of providing lifetime income streams.

Importantly, it does not make the mistake of focusing on "annuities." Instead, it focuses on how an adequate retirement policy addresses three key risks: longevity, Investment and Inflation (OK. So at least on THIS point the GAO report got it right).  I believe the recent attacks by the Investment Company Institute, as well as Jack Brennan, on "annuities" misses the point: there are solutions needed to each one of these risks, solutions which can have a critical role for mutual funds, investment managers and the insurance industry. This is NOT an industry specific effort, as one industry alone cannot address all three of these risks without the others.

As promised, the RFI focuses strongly on transparency (yes, yes, my Annuity Transparency blog is coming), relevancy for the average participant, portability and cost. But I was intrigued by the questions related to 404(c) and IB 96-1 (on participant education).  I am particularly interested in the insurer solvency issue, which to me is the key fiduciary risk (next to transparency), but you need to look closely in the RFI to find that issue.

The substance aside, one must be impressed by the process. We always thought the Borzi/Iwry combination would be an extraordinarily effective one, and this is proving to be true. Seeing these two longtime compatriots openly cooperate with the goal of effective public policy is something for which we have long waited.

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Any discussion on any tax issue addressed in this blog (including any attachments or links) is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code or promoting, marketing or recommending to another person any transaction or tax-related position addressed therein. Further, nothing contained herein is intended to provide legal advice, nor to create an attorney client relationship with any party.  

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Annuitization from DC plans suffers from the lack of clarity on a number of key technical rules, which need to be resolved before such annuities can be widely implemented. The IRS has taken a major step in its issuance of PLR200951039, a complex PLR which- for the first time-defines what an annuity really is for purposes of DC annuitization, and when the annuity election election occurs. This is critical for determining which RMD rule  applies, and when spousal consents will be required. It also, very importantly, recognizes the Plan Distributed Annuity (see my prior blogs)  and the qualification rules which will apply to them.

Even the informed reader is likely to get lost in trying to parse through this particular PLR.  Suffice it to say that there is a highly involved set of facts related to an insurance company's specific group and individual annuity products. The relevant features are:

• It is an annuity purchased by a DC plan for distribution to participants-either from the group annuity contract held by the plan (and not being a "plan asset", by the way) or as an individual annuity contract purchased by the plan and distributed to a participant-the classic Plan Distributed Annuity.
• The contracts have account balances within them which are invested in variable separate accounts. The retirement distributions from these contracts are actually treated by the contracts as withdrawals from the account balance. Every dollar taken out reduces the account balance by the same amount.
• At the time the participant starts taking payments, the participant elects how the amount of the withdrawals will be calculated. The  choice is that the payment will be equal that which would be paid under either a single life annuity or a joint and survivor annuity. This particular product gives the participant the right to actually choose the interest rate at which the annuity will be determined. 
• The amount of the withdrawal is adjusted every year to reflect investment performance relative to the interest rate selected. It is also adjusted for any "extra" withdrawals taken by the participant during the year. 
• At a certain age (typically age 85, but the plan can elect the age, within a range), the account balance actually disappears. All payments now come directly from the insurance company, not from the participant's account, and that payment is guaranteed for a lifetime. This particular product has an interesting twist, called "variable annuitization." This feature actually allows the participant to elect to have their annual payment adjusted in accordance with investment performance using a sort of "phantom" set of accounts.

Here's what the IRS has importantly said:

• Payment as an annuity/not as an annuity. Payments made from the contract after the account balance is "shutdown" IS annuitization. All payments before then are NOT considered annuitization, but systematic or periodic  withdrawals (let's call it the "access period"). Those "access period payments"  are also considered RMDs, but only up to up to the calculated RMD amount. (This, by the way, means that the amounts up to the RMD cannot be rolled over, but the amounts in excess of that can be). 
• Application /Timing of  spousal consent rules. Spousal consent is required at the time the participants elects distribution from the annuity- even though the payments during the access period are "non-annuity" payments. Electing the form of computing the payment at the time withdrawals begin is necessary under this product to make the systematic withdrawal "match up" with the actual annuity payments, to make it resemble a guaranteed income stream that is set for life. This then makes the election the same thing as currently electing an annuity payout at age 85 (or whatever age is elected), even if the intervening periodic payments are not paid as an annuity. This means that the spousal consent must be received  if the basis for computing the payment (and ultimate annuity payment at a later age) is other than (at least) 50% Joint and Survivor. Though one may quibble whether this is the right decision, we finally have  a rule we can use. As a practical matter, this may cause some problems if there is an intervening divorce and remarriage during the access period.
• Spousal beneficiary. The account balance during the access period will still be subject to the spousal consent rules on the naming of the beneficiary.
• RMD.  In determining the RMD, the RMD for the for payments during the access period will be determined using the account balance  under the standard DC rules. AFTER the account balance disappears, the DB method of computing the RMD will apply.

Finally, it is the overall message of the PLR which bears importance: the IRS further affirms the tax treatment of an annuity that was distributed from the plan, for an annuity that meets the requirements of 404(a)(2).

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 Any discussion on any tax issue addressed in this blog (including any attachments or links) is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code or promoting, marketing or recommending to another person any transaction or tax-related position addressed therein. Further, nothing contained herein is intended to provide legal advice, nor to create an attorney client relationship with any party.  

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 Annuity companies have been innovative in addressing marketplace concerns in the sale of guaranteed income annuities to individuals outside of 401(k) and 403(b) plans. The recession has spurred even more interest in these products, with insurers  telling us they are seeing an increased interest in both annuitization and in other  guaranteed insurance products. A number of these annuity products for the "non-pension" markets are beginning to show up in some defined contribution plans, though awkwardly so. Those product  designs don't typically fit well with ERISA's rules, and are often administered on computer platforms which don't support ERISA compliance.

The nut that is proving the hardest to crack is finding a way make these products available to 401(k) participants in a simple, compliant and seamless way, either as a form of distribution or as a way for participants to otherwise protect their investments within the plan-and many vendors have designed products attempting to meet these criteria.

Plan Sponsor co-hosted a webinar a few weeks ago with MetLife, in which the use of annuities as distributions from defined contributions were discussed. Kent Mason, an old friend and a fine lawyer with Davis and Harman, commented that he believed that one of the key reasons annuities and other longevity products were not being used by DC plans is because of the way the RMD rules apply to them. Though I hold Kent's opinions in the highest regard, I have to disagree with him on this point. I think instead the fiduciaries' concerns lie with the fear of locking up funds for a lifetime with a single company. I would go with the view of another longtime friend, Dan Herr of Lincoln Financial Group.  Dan's experience tells him that the key obstacle to the purchase of annuities for individuals  is something he calls the "4 I's": Irrevocability, Inflexibility, Inaccessibility and Invisibility. 

In applying Dan's theory to the 401(k) marketplace, it seems to me that addressing those "4 I's" would also serve to address the concerns of fiduciaries, to which I would add a fifth "I": Immobility (or, to be more precise, portability).

Lets take a look at each one of those "I's" separately, from a fiduciary's view. In this Part 1, I'll discuss Irrevocability. The other "I's" will be covered in blogs soon to come.

 Irrevocability

The traditional annuity, one in which a set price is paid for a set amount of lifetime income, is typically irrevocable. I call this "your grandpa's annuity."  Once a participant commits a substantial payment to the insurance company, it is gone for good.  This gives both fiduciaries and participants a great deal of heart burn. It locks a participant up for a lifetime, raising some very difficult fiduciary concerns about the predictability of an insurers' solvency. It is not a new concern, as  Individuals live with that same fear when they buy any life or annuity product-a concern about what I call the "30 year risk" (my apologies to the actuaries). 

It sees to me that the first element in an adequate fiduciary review is to get at least a layman's  grasp on the nature of insurance and insurance regulation. Pooling risks with others is an uncomfortable concept that is foreign to a fiduciary with a defined contribution mindset. The pooling of risk and the undertaking of this "30 year risk" are critical societal functions, but they pose significant risks to a state's citizens whose policyholders are unable to address individually. Because of this, states have uniformly stepped in to protect their citizenry by regulating insurance in ways of no other industry:

1. Reserves are required for the risks taken (one of the big AIG failures was that large levels of risk were taken on without any reserving by a non-insurance subsidiary which was not governed by an insurance regulatory authority);
2. The manner in which the reserves are  invested are heavily regulated for investment risk and type;
3. Insurance companies are regularly and comprehensively examined by state insurance authorities and must do substantial regular reporting on their assets and the nature of them.
4. Insurance companies are required to participate in their state guarantee associations to protect the policyholders of all companies within the state. (See the NOLHGA site for further information). This is an imperfect system, and insurance companies are severally restricted by law from discussing this guarantee with their policyholders. The best solution for the future is the proposal for a sort of FDIC program for plan annuities, as described by the David John,  Bill Gale of the Retirement Security Project and Mark Iwry, Ass't Treasury Sec'y.
5. Review of marketing material of all insurance products is required.

I would think that an adequate fiduciary review would have the fiduciaries acknowledging that the task they undertake is different from the mere investment of account balances; the standard against which they will be judged has necessarily a stronger insolvency risk; and that they have addressed that risk adequately-in part-by understanding and relying upon the state's regulatory role in managing the risk.

Fiduciaries can then further manage the risks by looking closely to the terms of the annuities being purchased. They can look for products that offer terms which address their concerns. For example, they can look  well-priced "outs" in the form of cash surrender options;  for products which are funded in part with separate accounts which are protected from the insurer's creditors; or for funds and guarantees which are partially re-insured by an unrelated insurance company-thus spreading the risk.

This should then be balanced and integrated into looking at how the other 4 "I's" are addressed- a topic of soon to be published blogs.

NOTE: I have moved offices (though still with Evan and Monica), moving back downtown (yes, Fort Wayne has a very nice downtown!).  I needed to change telephone numbers in the process.

My new contact information is:

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It has been a couple of weeks since we've last posted a blog, and with good reason. Between Evan, Monica and I, this two month span has us doing some 15 presentations and articles, whie keeping up with clients (and a couple of us squeezing in some overdue vacation time!).  Monica is speaking this week at the Plan Sponsor 403(b) Summit in Orlando; Evan will be speaking this week at a TIAA Client Forum in DC and at the CUPA Eastern Regional Conference in two weeks; and I am speaking at the IRS/ASPPA Great Lakes benefits Conference in Chicago next week and the NIPA Annual Conference in Las Vegas the week after. Come up and say hi if you see us! 

DC annuitization seems to be picking up a head of steam recently, with attention being paid to guaranteed income streams because of the effects of the recession on 401(k) and 403(b) accounts. As our good friend and fellow blogger Jerry Kalish has posted, the train is pulling out of the station. The Retirement Security Project has been espousing this for a few years; many of the major insurance have developed products specifically for this market; and even mutual fund companies are working with insurers to develop solutions. We have also blogged and published on this issue a few times.

Now Phyllis Borzi, the President's nominee for Ass't Secretary of Labor for the EBSA, is reported to hold the same conviction as well.

So, the real question is now what? Most consultants, TPAs and lawyers have only a passing familiarity with annuities, particularly the new breed of annuities which offer innovative guarantees. How does one go about deciding which annuity is right, whether the fees are appropriate, and whether the insurance company is solvent enough?  How do you explain their features to plan participants, and what part does it play in an employer's benefit program? What do you need to know about state guarantee associations, and what about rating agencies and the problems they now seem to be having?

In short, the things a plan has to look at to buy these financial guarantees creates quite a "fog" for an industry unaccustomed to them. The products are not difficult to understand, but their features, documentation and issues are much different than the typical plan investment we have been dealing with over the past few decades.

The DOL has made a first stab at things,  publishing an annuity safe harbor  designed to assist fiduciaries in their choice of annuity policies as a distribution option under their individual account plans. The insurance industry is not enamored by the safe harbor, as it seems to set some pretty high standards for fiduciary review, one which competing long term investments don't seem to have to suffer.

Imperfect as they may be, take a look at the DOL regulation. It does provide a chance to help begin to understand these products so that fiduciaries may become more comfortable with them.  We'll be addressing a number of those issues raised in the reg in the next few blogs.

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It is back to the future, in an odd sort of way. There is growing trade press coverage on the interests of 401(k) plans and plan participants on turning a portion of participants' account balances into a "defined benefit-like" guaranteed income stream. Follow, for example, this link to Plan Advisor.com.

There are really two ways transform that 401(k) account balance into annuity payments.  The first is to annuitize from within the 401(k) plan itself. This means that you need to

• take care that you don't turn the 401(k) plan into a defined benefit plan;
• deal with the pesky issue of handling an "outside asset" not typically held by the plan's custodian; and
• figure out how to make those guarantees portable.

The second way is to offer a distribution option from the plan of a  "plan distributed annuity." This opens up a whole world of guarantees that can be provided using a 401(k) account balance, as well as being a potential answer to the portability issue mentioned above.  

We will post over the next several weeks a number of blogs which will discuss some of the legal and technical issues related to these sorts of programs. For starters, if you're interested, take a look at the articles we published with BNA and CCH last year which discusses some of the legal issues involved: 

• BNA paper, "Annuitizing From 401(a) Defined Contribution Plans" 
• CCH paper, "Distributinfg Annuities Fom Defined Contribution Plans"

Please note that the reference in the BNA paper to my former law firm is now incorrect!

We look forward to carrying on the conversation.   

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