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This topic has never been one that has much concerned either analysts or operators of programs which involve the purchase by a DC plan of an annuity contract. This one has always been in the purview of the engineer-those insurance legal and compliance folks who have well established procedures to deal with each state’s insurance laws.

However, when you look at it closely, especially in relation to the selection of any of these innovative DC lifetime income programs, you can see its relevance to the analyst, as least requiring they know something about it.

The issue: what is the state of issue of any annuity contract purchased under any of these programs, and how does choice impact the plan participants and the fiduciaries?

I think you start with a fundamental insurance rule that applies to ALL DC Lifetime income selected by any non-governmental plan sponsor: at some point, regardless of the design of the lifetime income program, the plan itself must be the purchaser of an annuity contract.

This is just not in the case of the “In Plan Annuity,” where the participant can direct the purchase of an annuity accumulations as an investment option of part of a plan’s internal managed account, or to be directly held by the plan and allocated to a participant’s account. It also includes those instances where the insurance guarantees are being accumulated under a CIT structure, and under those “purchase programs” where a participant can elect the purchase of an annuity contract at the time of separation from service.

In each of these instances, the plan itself must eventually, at some point in the process, be the actual purchaser of the annuity contract in order for the distribution of those rights to properly occur. For example, where a participant elects to take a distribution of the lifetime income guarantees accumulated under the typical CIT arrangement, the plan itself must actually purchase (or direct a purchase on its behalf) an insurance contract with those guarantees before they are distributed. This is also the case in those “purchase” programs, where the participant is given the ability to select from a menu of negotiated annuities offered by the plan at separation from service. The plan still must first purchase (or direct the purchase on its or the participant’s behalf) that annuity contract before then distributing it to the planned participant. In all of these instances, the plan participant is NOT the purchaser, the plan is. Looking at my recent blog on distributing annuity contracts may be helpful to understand this point.

In insurance lingo, this means that an insurance application typically must be completed, and a contract delivered (note, the process may be a bit different on the issuance of a certificate under a group annuity contract). There are actually three purchaser options: the “plan” (as a legal entity); the trustee of plan, typically a different entity, especially if part of a lifetime income program; or even the employer (which is permitted by the Code and ERISA to own an annuity contract on behalf of the plan). Often, each of these entities can be domiciled in different states.

And therein lies the rub. There are a bunch of nitty little insurance details related to that choice of purchaser but the REAL question which demands some attention by the purchaser relates to the “domicile” of the purchaser. Any insurance person will tell you that domicile is important, and you want to, if at all possible, avoid the contracts’ issuance being in particular states (indeed, a number of policies are not even filed in certain states because of the various state regulations and approval processes). Each annuity contract “form” is subject to the the insurance rules of the state in which the contract is sold. The question then becomes whether or not there is anything meaningful in there which affects anyone but the issuing insurer.

There are probably two separate answers to that question. The first is the most obvious one, but not one often discussed. Each state requires insurance companies required to participate in their state’s guarantee associations to protect the policyholders of all companies within the state in the case of the insurer’s insolvency. (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. However, an analyst, or fiduciary should, in any event be aware of what the rules limitations and restrictions apply to the purchasing plan in that state-which will then impact any participant’s rights, as the distributed contract will be considered as being subject to the laws of the state in which it was purchased.

The second answer is that the analyst should be having that conversation with the folks who are offering the product or program, for information on the impact of being purchased in one state rather than another, if that option is available. In many instances there is little meaningful difference, but it is a data point to be known.

Attention to these sorts of details will serve to protect fiduciaries in their selection of lifetime income programs.

I appreciate your reading my blogs, and hope you would consider “subscribing” to them, for free, in the column on the right side of this page. If you do so, each post will be delivered directly to your email address the day after it is posted, and you’ll never miss beat!

Thanks!

Bob

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One of the key fiduciary roles in the assessment of any DC lifetime income program process necessarily involves whether, and how, the plan or the vendor accommodates any required spousal consent rules related to the payout of annuities.

The vast majority of the defined contribution plans comply with ERISA and the Code’s spousal consent rules by simply requiring spousal consent to the participants change in any beneficiary to someone other than the spouse. This simplicity does not change when a plan chooses to offer either an accumulation of lifetime income guarantees as an investment option under the plan (as opposed to the lifetime income benefit being provided as a stated benefit under the plans terms), or a program which offers the participant the ability to choose an annuity at the time of separation from service.

Where the circumstances may change, however, is when the plan actually takes the steps to either pay out the accumulated benefit in the form of an annuity contract, or offers to purchase and distribute an annuity contract at the time participants separate from service. This is where the fiduciary needs to be “in the know” as to whether, when and how any spousal rights apply to payment of that benefit. This involves being informed as to how and when a participant may elect during any “applicable election period” to waive a Qualified Joint and Survivor Annuity (QJSA); how the rights to revoke any such election during the applicable election period is actually implemented; as well as the operation of the right to elect something called the qualified optional survivor annuity (“QOSA”) during such period.

This involves a number of inquiries. One is whether these rules actually apply to the distribution. There is a difference whether the annuity contract is treated as a distribution annuity (see my prior blog, where I discuss those differences) or whether it is simply an in-kind rollover to an IRA. Another inquiry is to whether or not the plan itself must be involved in the execution of those rights, which may occur when immediate annuities are purchased and distributed at the time of separation from service. This inquiry will also include an assessment of the manner and timing in which any “right to revoke” an election impacts the election periods demanded by the law. Yet another inquiry is where the line is drawn between what the plan must do and what the insurer must do.

Particularly instructive, here, is Revenue Ruling 2012-3, which provides some pretty bright lines as to whether the plan itself or the insurance company-treated, for these purposes, as the plan administrator of the QPDA- is the responsible party.

This is where a prior post of mine regarding the “Engineers, Operators and Analysts” of Lifetime Income really comes into play. The plan sponsor or its advisor (the “analyst” in my category of things) need not be familiar with the intricacies of the application of these rules in all circumstances. THAT is under the purview of the “engineer” or the “operator” of these programs. What the analyst needs to know, however, is how the choices those “engineers” made in the program being reviewed impacts its fiduciary assessment of the program, including its judgment of the ability of the responsible party to actually pull it off.

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Often overlooked in a fiduciary analysis of any DC Lifetime Income Program are the impacts arising from the method in which any accumulated lifetime income guarantee is being distributed from any particular program. There are substantial differences between any of the available methods, and the impact of each of them on any participant. They really should be fully understood by the fiduciaries involved in the selection and maintenance any lifetime income program, especially if one is attempting to comply with the DOL’s proposed prudence safe harbor.

DC plans are probably the most efficient vehicle around under which to “accumulate” interests in guaranteed lifetime income. Whether it be through the periodic purchase of annuitization rights, and their effectively “averaging” of annuity purchase rates; accumulation of longevity bonuses under a GLWB; the increases in the guaranteed base; or any number of other features, there are very real and economically sound reasons to accumulate income rights through DC plans.

Distributing those rights accumulated in a DC plan is quite another matter. DC plans are, by their inherent limitations, lousy at making lifetime income payouts. This is mostly because of the same malady DB plans suffer: any plan sponsored by any employer can, and will (I would also argue, must) undergo transitions over a participant’s lifetime which is going to impact either access to or protection of accumulated guarantees-which, as we continue to see, can be a problem. For example, plan sponsors DO go out of business, and their plans terminated; plans regularly merge and change, often altering the fundamental nature of the plans themselves; employees, of course, leave employers, and need to find a way to effectively “port” those accumulated guarantees (who, after all, actually trusts their former employer with something as critical as this?)

The Holy Grail of Lifetime Income Programs is, to my mind, providing participants the ability to consolidate and protect hose accumulated guarantees someplace away from the actual DC plan itself. And protection of those guarantees is fundamental to any program’s design.

With all this in mind, there are a handful of ways to distribute accumulated guarantees from DC plans which fiduciaries need to keep in mind. (Note that some variants of these distribution methods also are being effectively used in some programs which focus on the cost-efficient and competitive purchase of the annuities using accumulated account balances instead focusing on distributing accumulated guarantees).

The following is a pretty accurate summary of the ways to distribute these guarantees:

  1. Annuity purchase at time of distribution. Purchasing a new annuity at the time of distribution is, surprisingly, a common method in CIT based Lifetime Income Programs, annuities which are then distributed under 2, 3, or 4, below. CITs are valuable tools in the lifetime income world, but many of the current designs unnecessarily don’t well accommodate their inherent limitations. CIT’s, themselves, can’t issue individual annuity contracts or accumulate a participant’s individual guarantees to such rights. This means that the plan (or the CIT’s vendor) must separately record the accumulation of income rights under the CIT arrangement. Then, at the time the guarantees are to be distributed (through liquidation of the related target date fund, separation of service by the participant, or termination of the plan, for example) the plan is then given the right to purchase an individual annuity contract on behalf of the participant. This newly purchased annuity reflects, as much as possible, the bookkeeping entries related to those accumulated rights, at as much as a similar cost as possible under the circumstances. These annuities can then be distributed under the plan using methods 2, 3 or 4, below. Any fiduciary needs to become familiar with any limitations, expenses and risks occurring throughout this sort of process leading up to the distribution.
  2. In-kind rollover of the annuity to, or as, an IRA. To the extent the plan’s design either accumulates income rights attached to an in-plan annuity (which can even happen when tied to a CIT), or purchases an annuity under the program under #1, above, that annuity (with its related income rights) can be rolled over as an IRA annuity under 408(b), or rolled over to an IRA custodial account under 408(a), both as non-taxable transactions. There are a number of technical differences between the two methods with which the fiduciary should become familiar.
  3. QPDA. That annuity sitting in the plan can, instead, be distributed by the plan as a Qualified Plan Distributed Annuity (see, for example, 1.401(a)(31) or, in the case of 401(a)(38), a qualified plan “distribution annuity”). Also a non-taxable event, the distribution of a QPDA has dramatically and fundamentally different treatments than the annuity rollovers in #2. The QPDA is not actually a rollover, it is technically a sort of plan to plan transfer: the contract is treated under the Code as an ongoing plan, and the insurer is treated as the plan administrator (whatever that means!). 403(b), 401(a) DB plans and insurers have been utilizing this approach for generations, and is a useful tool for 401(a) DC plans as well.
  4. Non QPDA in kind distribution. The plan’s design can instead, simply make a taxable distribution of the annuity itself with the accumulated guarantees; the participant would be taxed on the present value of that annuity, (a very interesting effort in and of itself); and the participant is now the proud owner of an annuity subject to the same annuity rules as apply to any purchaser of a retail annuity.

These distributions each can either be an individual annuity or an individual certificate from a group annuity; and in each of these scenarios, the annuity is considered as being distributed by the plan as it is no longer a plan asset. If properly constructed, none of these annuity distribution programs actually require terms which are not already a part of most pre-approved adoption agreements and plan documents. And, yes, it’s actually a pretty good design, for several reasons, for a plan to actually own individual annuities under which the participant is named as the annuitant.

It is these sorts of close details which will fall on the fiduciary’s plate, to be part of its assessment as to the prudence of the decision to select any particular lifetime income program for any particular plan sponsor.

It is our familiarity with these sorts of granular issues which led us to kick of our Lifetime Income Practice at the Fiduciary Law Center (see our fun vids on our thoughts on this at the lifetime income website). As an fyi, my email there is rtoth@fiduciary.net.
Bob

Businessman Happy to See His Water Bucket is Full While Business

We have all been well attuned over the decades since mutual funds became available to be daily traded under DC plans to a very particular view of an investment funds’ cost. ERISA’s participant investment disclosure rules have successfully established what I best described as a certain “language,” which permits any participant or fiduciary to assess whether the cost of any mutual fund investment is competitive and reasonable. These costs are strikingly explicit, well defined and even required under the SEC’s prospectus disclosure rules. This data then enables the fiduciary advisors’ “qualitative” exercise of judgement in their provision of advice.

These well-established data points are all now turned topsy-turvy when fiduciaries attempt to apply some version of them to assessing the annuity investments in a DC plan. After all, these annuity products are widely offered in tandem with mutual fund investments in target date funds and as elements of managed accounts.

There then becomes a two-fold challenge: first, how do you assess the prudence of the purchase of the annuity coverage, and, secondly, how do you then cobble that assessment together with the independent assessment of the mutual fund investments to which they are tied? There is then the added complication of the “fixed account” portion of these arrangements, often funded by an insurance general account, which has its own standards against which it must be benchmarked.

Though annuities can, and often do, provide access to equity exposure through either their separate accounts in variable annuities or indices in fixed indexed annuities which CAN be easily benchmarked, assessing the prudence of an insurance guarantee of lifetime income is quite a different matter. This is in large part because of the nature of the purchase: the fiduciary isn’t simply choosing an objectively benchmarked investment; it is paying the insurance company for its financial exposure to actuarial risk; investing in and maintaining the infrastructure necessary to support that risk over generations; and its costs in establishing the expertise necessary to providing those sorts of services. These types of intergenerational costs are not given to the sort of fee disclosure to which we have all become accustomed.

Mutual funds or CITs are incomparable, as they don’t need to build what it takes to guarantee payments over a lifetime. A very simple example is the annuity contract itself: in order to be able to be sold to a plan in any state, the terms of the contract have to (1) accommodate that particular state’s legally required terms, and (2) it has to be submitted independently to each state for its own approval. There is no such demand of a CIT.

There is recognition of this state of affairs. For example, the DOL’s Model Participant Disclosure form actually started to lay the foundation for what needs to be done. “Table 4-Annuity Options” under the 404a-5 regs recognizes this state of affairs by looking at “Objectives/Goals,” Pricing Factors,” and “Restrictions Fees.” It is this from which we should all be building.

One of the biggest obstacles is that he defined contribution market is still generally unfamiliar with-and reticent to use- the terminology and concepts related to these annuities. Much of the confusion and reluctance seems, however, to relate to the lack of familiarity of fiduciaries and participants with annuity terms, and not necessarily due to any inherent complexity in their use.

I expect that, just like the defined contribution market becoming comfortable over time with the terms and concepts of mutual fund investments and their operation, the market will eventually achieve a similar level of familiarity with annuity terminology. The manner in which to properly benchmark those products will then become routine. It does involve, oddly enough, acceptance and use of something other than the traditional view of “costs” which have dominated the equity market-a quantitative assessment which may otherwise be considered “opaque” in the equity world. But it also entails the insurance industry accepting more transparency in explaining to fiduciaries what it does.

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AI’s limitations became pretty apparent after yet another delightful and “robust,” shall we say, conversation with an old friend, an economist, about intriguing ideas on how to universally effectuate, accumulate and port lifetime income guarantees derived from employment. That conversation got granular, as it often does, with voices raising over details of certain innovative infrastructure tweaks, in progress with some clients, which may serve to make these ideas more usable and welcoming to employers and employees.

AI’s value is no doubt apparent through these sorts of conversations, as it really is a very useful tool we use in sorting out all manner of chaff. Yet my small corner of the world entails a unique weaving together of seemingly unrelated details between what conventional wisdom considers completely different structures to make the sorts of policy initiatives under discussion actually work. This is where AI has a more limitied value.

The need for these conversations isn’t going away, either, because of the value of the policy initiatives underlying them. As noted in Brookings Retirement Security Project’s important 2019 paper by David John, William Gale and Mark Iwry“ From Saving to Spending: A proposal to convert retirement account balances into automatic and flexible income” summarized that

In our view, as discussed above, the right goal should be for retirement savings plans to offer automatic mechanisms that would make it easy for participants to convert saving balances into income. Properly structured and regulated, automatic retirement income structures could help new retirees in much the same way that automatic enrollment and escalation help savers.”

Getting to this “properly structured and regulated” system of converting savings to income does require a bit of Zigging Down the Zag (Dr. Seuss), especially when we are trying to do it in a system designed to simply accumulate savings. It is a challenge faced in asset accumulation systems worldwide, and has had its fits and starts here. We in the U.S. , however, actually have an advantage of an extensive “kit” in the DC system from which to work. Deconstructing things like CITs, target date funds and annuities and reconfiguring them-within regulatory bonds, of course- to try to effectively pull off the policy initiatives is a fascinating (and workable) task, which will serve us well going forward.

These sorts of efforts are well beyond the ken of existing AI systems. And in the future? Perhaps, but it may require integration with the ability to sit down in a pub and draw on a napkin with us…. (see the beer napkin annuity).

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“No Duh!”was my favorite response by a colleague to the DOL’s alt asset proposed regulation, which is replete with references to the need of the fiduciary adviser to “read and critically review” the core documents of any of a plan’s investments. That proposed reg does grant plan sponsors some grace, only requiring that they (who retain the investment adviser) “read and critically review” the assessment of that fiduciary adviser, without imposing on them the obligation to also read those underlying investment documents. Sponsors can rely upon their 3(21) and 3(38) advisers to fulfill that obligation.

This is just not an “alt asset” investment requirement: it looks to have been wrapped up as part of a general prudence expectation for non-alt investments, as well, such as annuity contracts and mutual funds (or at least some their procedures). I strongly suspect that this now explicit prudence requirement that fiduciaries read and critically review documents will NOT be changed in the process of finalizing this regulation. This function is, as one may say, as American as apple pie. I think that it is a general assumption that fiduciary advisers actually do “read and critically review” these base documents (thus the appropriateness of the “no Duh” comment) as part of any fiduciary review, or their firms’ technical staffs actually accomplish this feat. Yet I also strongly suspect that this procedure has been generally more strongly honored in its breach. Having written many annuity contracts, CIT documents and other investment documents over time-while having had to read and assess far too many of them in the process- I also will assure you (as if you didn’t already know!) that these documents are not written to be read-or even understood by the faint of heart.

This really goes to the core of the matter, I think. With ERISA having no readability standards, the advisers seeking to take advantage of the benefits granted (see, for example, Matthew Eickman’s excellent write up on these opportunities) to them by the safe harbor (or now just to be prudent) are likely to find themselves having to translate some of these very ugly documents into a sort of plain English that is decipherable by their plan sponsor clients. It looks as if a successful “translation” may become a part of the advisers’s own fiduciary obligation.

Plan English has been a goal eluding federal and state regulators in the retail market for a very long time. The SEC, in its A Plain English Handbook, actually has some meaningful suggestions about what this standard could look like:

We’ll start by dispelling a common misconception about plain English writing. It does not mean deleting complex information to make the document easier to understand. For investors to make informed decisions, disclosure documents must impart complex information. Using plain English assures the orderly and clear presentation of complex information so that investors have the best possible chance of understanding it.

Plain English means analyzing and deciding what information investors need to make informed decisions, before words, sentences, or paragraphs are considered. A plain English document uses words economically and at a level the audience can understand. Its sentence structure is tight. Its tone is welcoming and direct. Its design is visually appealing. A plain English document is easy to read and looks like it’s meant to be read.

Applying this in the context of DC Lifetime Income Programs, I have always strongly felt that their successful implementation really does require a knowledgeable advisor. Its not that such matters are particularly complex, they are just in an area in which the typical plan sponsor has little familiarity. With these newly explicit prudence requirements, advisers probably now need to dive in where they probably have not in the past.

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Executive Order 14330 had, unfortunately and probably unintentionally, swept annuities into a classification of investments intended to promote the use of private equity interests in participant directed defined contribution plans. I do understand the desire to address tontines, but this broad inclusion did not recognize the potential rippling impact that treating annuities as “alt assets” could have.

So, separate from any future substantive discussion regarding the resultant proposed reg, it is first worth noting that the DOL adroitly addressed this potential annuity conundrum in two ways. First, it broadly applied its guidance to all plan investments, not just to alternative assets. Secondly, it specifically provided assurances as to its view of the nature of annuities and tontines, noting that “the Department has also added guidance on lifetime income longevity-sharing pools, which are a risk-sharing mechanism that can incorporate many investment strategies, rather than itself constituting an alternative asset.” I suggest that this means that as we all work forward to reviewing the efficacy of the proposed reg and to suggest changes, it will be helpful to keep in mind that annuities and tontines are not classified or treated as unusual “alternative assets” under the proposal.

So, then I put on my Engineers Cap (see my posting on the “Engineers, Analysts and Operators of DC Lifetime Income”) to lend further credence to the DOL’s position by putting up a reminder of the basic and long-standing financial services DC annuities have always provided to participant directed plans. This list is neither nuanced nor complete, and the features I list may not even be available in a single contract type. We’ll discuss at a later point more detailed descriptions of the provisions of these services under the VA, FIA, RILA, fixed annuities and straight life annuities, and specialty riders like GLWB, along with their transparency challenges, btw.

Annuity contracts have long provided the following capabilities to DC plans:

  1. Asset accumulation. Though you would not know it by reputation, annuity contracts actually can provide one some of the most cost effective asset accumulation tools in the market-depending on their design and pricing. This is by way of a “separate account,” by variable crediting rates under indexed based annuities, or even by contract simply guaranteeing periodic crediting rates. For example, as to separate accounts, I best describe their potential as a CIT on steroids. They can hold virtually anything (yes, including “alternative assets”); can be managed by any manager chosen by the insurer, any management fee (if any ) at which the insurer wishes to offer the market; and even the unrelated general account provides a measure of scale advantages. As to index contracts, there is the oft-overlooked opportunities for accumulations where market exposure is managed by the insurer.
  2. Protection of asset accumulations. Annuities have the ability to set a floor on some portion of losses on those accumulated assets.
  3. Accumulations of guarantees. The annuity contracts also can give participants the ability to accumulate guarantees over time, and, under certain circumstances, provide longevity bonuses.
  4. Protection and distribution of guarantees. Annuities have the ability to then guarantee the distribution of income related to these accumulated guarantees, or the assets supporting them, either in the plan itself or through distributions of contracts from a plan.

The question raised by the DOL’s proposed prudence safe harbor, at least from the lifetime income side, will be whether and how any of the description of the standards apply to any of these particular features-and the different types of contracts under which they are provided. The DOL’s approach at least gives us the opportunity to reasonably assess the rules without the cloud of being labelled an “alternative asset.”

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An important and separate “tool,” if you will, in the professional’s portfolio for use in assessing and understanding the manner in which any lifetime income program will fit into any particular DC plan is simply recognizing that annuities (1) are a necessary element of providing lifetime guarantees under DC plans; (2) are normal; (3) have been used in DC plans for, literally, generations; and (4) that their use is supported by a substantial legal and regulatory infrastructure.

These conclusions resulted from Evan Giller1 and I sitting down for beer and Detroit style pizza in a DC bar (something about beer and annuities, it seems) during the most recent annual TE/GE Council Annual meeting. We were trying to work out how we were going to approach our next day presentation on lifetime income, with Dominic DeMatties and Mark Iwry. Both Evan and I are long time insurance lawyers, each of us having managed law staffs at major insurers which specialize in annuities in DC plans. It finally struck us during dinner that night that our conversations with attendees to the meeting that day starkly showed that few practitioners are familiar or comfortable with the notion on which both Evan and I have spent careers: the normality of annuities in DC plans.

Think about it. Though 403(b) did not show up as an actual Code section until 1958, TIAA started issuing those teacher annuities (what are now 403(b) plans) as early as 1918, and other insurers eventually followed suit; the 1939 Code recognized the non-inclusion in income of those teacher annuity premiums; and the 1954 Code actually first formally provided favorable tax treatment to “Qualified Annuity Plans” under 403(a), which are based upon 401(a) of the Code.2 An interesting historical point is that insurance companies at one time regularly issued 403(a) annuity contracts which had IRS determination letters and whose terms looked a lot like pre-TRA 86 401(a) profit sharing plan documents.

Our presentation ended up focusing on the “normality” of DC annuities, a point with which few in the room were familiar. Our point was that professionals who are armed with the knowledge that annuities are not such strange creatures whose inclusion in DC lifetime income programs are not anomalies of some sort provides them a “leg up” in working through the lifetime income program details for their clients. They’ll find that, historically, there has been little legal risk attendant to plans purchasing, maintaining and distributing annuities in DC plans, and that fiduciary standards have long been met using these heavily regulated and monitored financial products. I‘ll credit Evan with the observation that, indeed, in utilizing one of those annuity rules lurking in the dark corners of the regulatory framework, distributing annuities from plans actually serves to minimize a plan sponsor’s risks in providing lifetime income from a DC plan.

There have been a number of key pieces of guidance issued by both the IRS and DOL over the past decade or so which have served to “bridge” those long standing, dark corners rules, modernizing them to enable the use of specialized annuity designs in retirement plans. A great example of this is Rev Ruling 2012-03, which provided key tax guidance supporting the simplified distribution of QLACs from DC plans. Though that Revenue Ruling further clarified the manner in which the long standing treatment of spousal consent rules apply to QLACs distributed from plans, it effectively brought back to light the also-long-standing manner under which such products can be treated as in-kind distributions of plan investments instead of the payment of an annuity form of benefit under the stated terms of a plan.

It is not an unreasonable observation that professionals have longed looked at annuity contracts in DC plans with, shall we say, “concern,” particularly given some of the opaqueness of important terms upon which parts of the industry have sometimes practiced in the past-to their own detriment. Of course, fiduciaries continue to need to conduct appropriate due diligence. However, annuity products designed for this new generation of lifetime income programs are well worth a closer look, and their use actually has a substantial regulatory infrastructure supporting it.

  1. Of Counsel to Boutwell and Fay, and co-author of the 2013 paper by the NYU Review of Employee Benefits and Executive Compensation “Regulatory and Fiduciary Framework for Providing Lifetime Income from Defined Contribution Plans.”
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  2. It has been long forgotten, btw, that a 403(a) plan offers 401(a)-like- plans, without the top-heavy rules.
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oldmen

SECURE and 2.0’s efforts to open up the availability of defined contribution plan balances for personal emergencies, including the establishment of those goofy PLESA accounts, really have their roots in what was-at the time- a pair of thoughtless  changes made to the Code under Tax Reform Act of 1986 (the “86 Act). Even then, those particular changes (in what was otherwise a massive retirement law package) were not received well by the plan sponsor community.

Prior to 1986, the first 6% of a participant’s s after tax deferrals into a 401(k) plan were excluded from the ACP test. This actually encouraged plans to offer this arrangement to all of their employees, as it effectively permitted the highly compensated employees to place greater sums into the plan while benefitting lower paid employees. It did so by affording employees free access to their plan after-tax deposits (assuming the “aging” rule was met) without having to suffer a formal “hardship.”  This meant that participants could save larger amounts to their plans, knowing that funds were easily available for “routine” expenses. Back then, plans also typically matched those after-tax deposits -which even further encouraged savings for those who could not afford to lock up their funds.

Even better,  when the participant sought to withdraw those after-tax amounts, those in-service withdrawals were treated as withdrawing tax basis first. This had the effect of participants receiving back their after-tax contributions without tax, to be used for any number of personal purposes not covered by the hardship distribution rules.

Unfortunately, the ‘86 Act changed all of that. First, the 6% exclusion of after tax contributions from the ACP test was eliminated, removing employers’ incentive to offer after tax programs. Then to add insult to injury, any withdrawal of after tax contributions from the plan were treated in the same manner as the withdrawal of elective deferrals or employer contributions: the “basis” calculations were done on a pro-rata basis. This meant that after-tax withdrawals would be now subject to the same tax basis computation as the withdrawal of employer pre-tax contributions or elective deferrals.

Fast forward to the SECURE  and SECURE 2.0, where extreme efforts were made to allow participants to withdraw funds under personally exigent circumstances which otherwise created financial difficulties,  but did not fall into the category of a formal plan hardship. Though this was all done in the name of trying to entice participation in 401(k) plans by increasing access of  lower propensity savers to defer into a defined contribution plan, it has resulted in a plethora of  horribly complicated rules which are not being widely used. 

In hindsight, where the view is (of course) 20-20, what SHOULD have happened was a re-institution of some version of those pre-86 rules. They served us well back then. 

I actually encourage taking a look at my blog of a few years back on Asimov’s view of these sorts of matters, called the MMNC, the Minimum Necessary Change, which speak to the value of simplicity in such circumstances…

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Engineering, analytical and operations. These are the three distinct and dynamic categories (“stacks”, perhaps?) of knowledge into which the lifetime income markets seem to be organizing itself-out of necessity, I would argue.

We’ve known for a very long time that transforming defined contribution plans into vehicles which facilitate the accumulation and distribution of income guarantees (think, for example, of 403(b) plans-whose tile is even revealing: “Taxation of Employee Annuities…”) has different demands than those plans which have been simply used to accumulate wealth. Yes, defined contribution retirement plans have always demanded a unique blending of ERISA, tax, securities and insurance laws, but these new lifetime income programs now require application of all of those rules in ways unfamiliar to most-even for the typical, variable annuity based 403(b) plan.

Policymakers and regulators have been working at adjusting existing regulatory schemes in order to do so, without having to resort to developing yet another plan type. I think they have largely been successful, in part by adjusting relevant rules applicable to terminating defined benefit arrangements.

Which leads to my comment about these “stacks” of expertise. As lifetime income programs are beginning to become more widely accepted and used in the retirement plan space, retirement plan professionals have needed to concurrently develop the knowledge to support their clients. What we’re finding is that it is not necessary to garner comprehensive familiarity with everything that’s involved in these programs in order to provide the support clients need.

In my often long conversations with other professionals working their way through these matters, it really does appear that these three stacks are shaping up:

  • Engineering. Not many professionals need to know all of the pieces that go into developing a lifetime income program. If you are interested in putting out a new kind of lifetime income program, however, you’ll need a few engineers to do so. An old friend of mine once labelled the list we developed of all the pieces necessary to make a new program idea work the “aircraft carrier.” Those professionals working with plans and participants need not be familiar with the details of what is on that “aircraft carrier.” For example, who really needs to know the nuances of using individual insurance applications versus a master or group app, and the impact of who owns the policy? The engineer, however, does.
  • Operational. The operator bears the brunt of the work of the engineer. These are, generally speaking, the recordkeepers, custodians, TPAs and financial institutions who are trying to implement, and integrate into their existing services the (sometimes seemingly “harebrained”) engineers’ package. Those professionals are more focused on the pieces that fit into their own software and participant facing utilities, rather than the entirety of the design. The middleware provider is a good example of such services in the market today, a critical role until these integration processes become more normalized.
  • Analytical. The analyst is probably the key to making anything really becoming usable: they need to know enough of details of the program design and operation to being able to assess if any particular program or its outcomes meets the client’s needs or fiduciary standards. They also have to figure out how to sensibly compare these disparate programs.

Each of these stacks seems to be developing their own dialect and focus. An interesting case in point is the manner in which SECURE’s “annuity safe harbor” is approached by each stack. From discussions I’ve had, it seems as if each stack has a different sort of take on how it fits within their own responsibilities. It’s not a particularly big deal for the engineer, who is only concerned that the insurance company has processes in place to draft and update the safe harbor notice; the operator has a bit of a heavier lift, concerning themselves with the logistics of the delivery; but it becomes a very serious matter for some analysts, who can bear the brunt of assessing it, monitoring its implementation, and figuring how it applies to any particular client. As you could guess, this engenders a lot more serious attention for the analysist than for the engineer.

I also note that these stacks crossover from time to time.

Their importance lies in two circumstances, I think. The first is that the this really is making it clear that no one needs to know everything about any lifetime income program, and that, for example, analysts can be confident that they don’t have to know everything about a program in order to successfully assist their clients. The second is for those of us who educate on these programs. The audience is critical: an analyst’s knowledge needs are vastly different than that of the operator. Using this kind of model, we can finally fashion sensible educational efforts.