For those of you who do not subscribe to BNA, BNA published as an "Insight" an article I wrote on QLAC and Rev Rul 2012-3 (yes, my author agreement permits me to post it here, with attribution). Look for Paul Hamburger's upcoming related article, delving into a number of technical and policy issues they raise, as well as discussing the releases on transferring to a DB plan. Link here: First Steps to Modernizing DC Annuitization: QLACs and Revenue Ruling 2012-3.
I will be speaking on a panel addressing this topic with Mark Iwry, Jeff Turner and Wally Lloyd at the ABA Section of Taxation's Employee Benefits Committee general session on May 12 in DC.
The Treasury's issuance of proposed regulations introducing the "Qualified Longevity Annuity Contract" is a substantial step in the efforts to better provide plan participants the ability to use their defined contribution balances to plan for retirement security. One of the QLAC's most useful effects is that it gives us a "base," a laboratory of sorts, which permits us to look closely at the legal and practical issues in "real time" which are related to using DC plans to help fill in the gaps left by the demise of defined benefit plans.
One of the fundamental issues the proposed regulation raises is one which is beyond Treasury's control: what is the fiduciary's exposure to the potential future insolvency of an insurer when choosing a QLAC provider? Absent a federal insurance system like the FDIC or the PBGC which ultimately guarantees this risk-which is likely to be a number of years off, if even possible-does this means that it will never be prudent for a fiduciary to purchase a QLAC, or any annuity, under which a single insurance company insures the risk?
Many of us have been seeking legislative and regulatory solutions to this for a number of years, to little avail. Having thought about this much, and having blogged on it on the issue on more than one occasion, I have come to the conclusion that it is unfair to expect the DOL (and likely well beyond its mandate) to develop much more of a standard beyond what it has already published. If you read its "annuity safe harbor" standard closely, you will see that it is comprehensive and describes the fiduciary standard well. But there still exists a queasiness about how to apply it.
I believe that the issue, however, is not as intractable as it seems, and the answer does not lie in further regulation. It lies in becoming more comfortable with the idea of risk and the commercial pooling of interests. Fiduciaries should be able to comfortably assess an insurer without either becoming insurance experts or- at least on the narrow issue of insolvency- having to rely on an expert's prognostication as to whether an insurer will be around decades from now.
The real issue, as made starkly clear by the SCOTUS in the oral arguments on heath care reform, is that there appears to be a serious lack of understanding in the legal, judicial and investing communities of the nature of risk and of the commercial pooling of interest. This lack of understanding seems to be underpinned by a reluctance to accept that we, collectively as a society, share certain risks that can only be managed at a more global level.
There are a few key (but not so obvious) concepts, that have existed for centuries that the law (and financial advisors) should recognize, and upon which fiduciaries should be able to rely:
- Risk is a natural part of life.
- Our individual risks often are inter-related. Thus people can, and have, well managed these risks by pooling interests with those who have similar risks.
- Managing this pooling is complicated and requires specialized knowledge which has been successfully accomplished commercially (which also provides a level of financial accountability which structurally may be missing in government based programs).
- Financial "scale" is necessary to make risk pooling commercially work.
- Such "scale" and complexity makes it impossible for any single policyholder to protect itself against fraud and mismanagement of the pool.
- Collectively acting through government provides the regulatory scale necessary to protect citizenry from insurance (pooling) mismanagement and fraud, and the regulation of pooling is significant. Making sure commercial insurance is able to fulfill the pool's promise is an appropriate government function for protecting the well being of its citizenry.
In the end, the risk of insurer insolvency is a societal risk for which no fiduciary should be held accountable, as long as they are familiar the regulatory structure which is in place and uses it in making their decisions.
Regrettably, I believe much of the misunderstanding about pooled risk is reflected in deeply rooted political beliefs which was epitomized by the "Ownership Society" concept promoted by the Bush II administration. Though no one can deny the need for accountability, one should neither deny that longevity risk can really only be managed by acting in accordance with our common, and thus pooled, interests.
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I have spent much of my career studying and practicing in the law of annuities as it applies to retirement plans-starting even prior to my long stint with an insurance holding company, when the Master Trust of the Fortune 100 company for which I was in-house ERISA counsel formulated its own synthetic, pooled GIC for the fixed account in its newly formed 401(k) plan back in 1986-87.
So it should have been no surprise when some very smart colleagues (whom I hold in high regard) were wondering about my enthusiasm about Treasury's newly released guidance on annuities (though there are a few others who do share this enthusiasm). After all, the rulings and the proposed regulation really seem minor in the grand scheme of things. They did not resolve a number of issues, and almost seemed to raise more questions than they answered.
Sometimes, it seems, one can get too close to an idea and think that-of course-everyone sees what I see!
So, I've attached a graphic of how DC annutization works to help explain why the Treasury guidance is so fundamental and crucial to the next steps. I invite you to take a close look at the chart in the first 4 pages of the patent application that Dan Herr and I filed in 2007, after actually working on it for a few years (it was assigned to my former employer, who has never used it; the patent was initially denied, never has been granted, and don't think it ever will (or can be)). It shows how your basic mutual fund 401(k) plan can serve as an annuity processing platform; how the distribution of annuities from the plan works; and why things like spousal consent and annuity starting date are so important to making it work.
The chart shows one way its possible to set up a QLAC with an automatic withdrawal program, using the plan's mutual fund, separate account, or even pooled investments which are then backed up with a QLAC or other lifetime guarantee. The chart is complex, in that the lifetime income demonstrated can be a set lifetime amount (such as a QLAC), variable annuitization, or even a GMWB. It also shows how to do it within the plan itself, or to be distributed out of the plan, and how to do it using either an "in-plan" or "distributed" GMWB as well as a QLAC.
I was invited to Treasury's de-brief in DC the day the guidance was released, and it became clear to me then how this 6+ year old chart really puts the QLAC to great use (even for rank and file), and takes great advantage of the clarity provided in 2012-3. Now can you understand my enthusiasm?
It ain't easy (yet), and it ain't pretty (yet). I caution that the description is in bureaucratic-speak, written by a patent lawyer in the way engineers are trained to do. But take some time on the charts, as they may help understand a few things about what may be going on with these things.
The chart shows that Treasury actually answered key questions with its guidance. But my point is not that DC annuities are the "be all and end all" of retirement security, though they have an important place in making the system work right. Nor is it that the insurance industry is the knight in shining armor (clearly, I know its underbelly well) for which I am some apologist. Its just that we now have the basic structure in place under which an important set of other operational and legal questions can be identified, asked and answered in an identifiable framework; the argument-so to speak-has been framed. The rulings importantly recognized that DC annuities will be treated as investments, with some strings attached to protect spousal rights; that there is a basic annuity starting date rule; that there is a forfeitability approach; and that Treasury is thinking about reporting and disclosure. Given this, we now know what even to ask.
Join us, by the way, for a teleconference by the ABA's Joint Committee on Employee Benefits on March 1, where we will go over some of this stuff, in English....
Treasury nailed it (or, as our eldest son is fond of saying, they just "friggin’" nailed it).