Written by: Andrew Stumacher, Christopher Nikolich and Howard Li
Lifetime income solutions are high on the wish lists of defined contribution (DC) plan participants, with the certainty of a guaranteed lifetime income stream ranking as the top feature in our surveys over the past decade. More than half of DC plan sponsors want such a solution, too.
The SECURE Act has made plan sponsors more comfortable as fiduciaries in taking action to evaluate and implement lifetime income solutions. But with many options to choose from, plan sponsors need to evaluate a wide range of choices—each with its own structure, benefits and costs.
Assessing Costs: Looking Beneath the Surface
Whether it’s a managed-drawdown option, immediate annuity, deferred fixed annuity, qualified longevity annuity contract (QLAC) or guaranteed lifetime withdrawal benefit (GLWB), each plan sponsor must choose the option that provides the best value to participants. To make that determination, the sponsor must assess benefits versus explicit fees and implicit costs—from the individual participant’s perspective.
What’s the difference between explicit fees and implicit costs?
An explicit fee is a stated charge to a participant…like an expense ratio for an investment option. Implicit costs aren’t listed like stated fees—they’re inherent costs stemming from the way a solution is designed. For example, one implicit cost is forgoing long-term growth potential when surrendering assets to buy a fixed annuity. Another implicit cost is the spread: the difference between what an insurer earns on assets that participants surrender up front and the lower amount the insurer pays to the participant in guaranteed income.
So, the total cost of lifetime income solutions can look like an iceberg: some costs are explicitly visible above the surface, but what’s under the water matters, too. Because the SECURE Act requires plan sponsors to prudently evaluate the costs and benefits of lifetime income solutions, it’s critical to accurately measure all costs—and resources are available to help.
What Influences the Cost of Lifetime Income Solutions?
To illustrate how design distinctions can influence costs, let’s briefly compare two lifetime income approaches: a GLWB (typically accompanied by a target-date portfolio) and a fixed annuity.
Explicit Fees: With a GLWB contract, participants keep ownership of their assets, paying an explicit annual management fee and insurance premium. These fees cover the insurance company’s obligation to continue paying lifetime income if a participant’s account assets run out. A fixed annuity requires participants to surrender all assets up front in exchange for lifetime income, so annual fees typically don’t apply. This distinction prevents a direct comparison of explicit fees.
Understanding a lifetime income solution’s full cost requires analyzing how design influences potential outcomes—and the ultimate value to participants.
Implicit Cost—Growth Opportunity: When participants retire, they expect to live for decades. That makes it vital to maintain enough exposure to growth investments, such as stocks—even during retirement. With a fixed annuity, a participant surrenders assets up front, essentially passing those growth assets to the insurer in exchange for receiving fixed payments like those of a long-term bond. This exchange sacrifices growth opportunity compared with a GLWB, where participants keep their assets, including growth investments—with potential gains raising the level of lifetime income.
Implicit Cost—Inflation: Fixed-annuity payments are typically not linked to inflation dynamics, which can erode the buying power of income over time. Participants can boost fixed-annuity income later in life by adding a rider with a cost-of-living adjustment. Riders typically increase income payments by a fixed 2% per year, while at the same time reducing the participant’s initial payout amount.
This approach essentially shifts income from earlier retirement years to later retirement years in order to create a self-financed buffer for expected inflation. It’s not a true cost-of-living adjustment, though, because it doesn’t hedge the risk of unexpectedly high inflation that can erode living standards the most.
With a GLWB, if participants’ assets grow over time, it boosts the income base—the annual high-water mark of the asset value—and therefore income payments. Since rising prices for goods and services can pass through to companies’ revenues and profits, stocks have tended to outpace inflation over time. This relationship gives the GLWB’s income level a link to inflation dynamics that may help hedge against unexpectedly high inflation.
Implicit Cost—Mortality Risk: All annuities hedge against longevity risk—the possibility that participants live longer than expected and require income for longer. However, fixed annuities (or QLACs) pose mortality risk—the possibility that a participant passes away before expected, missing out on income.
With fixed annuities (or QLACs), participants surrender assets to the insurer at retirement in exchange for lifetime income. If an individual participant passes away before the average death age used to price an annuity, they ultimately receive less total income—an investment loss due to mortality risk. A death benefit rider for fixed annuities can help address this implicit cost, but at the cost of a lower income payment. Mortality risk is a key distinction from a GLWB, a solution that enables participants to retain ownership of account assets, eliminating mortality risk.
Implicit Cost—Lack of Liquidity and Legacy: Many participants want liquidity in their retirement accounts—and asset ownership is a key determining factor. The chart of a typical participant’s retirement spending looks something like a smile: high in the first decade, declining in inflation-adjusted terms as life and spending patterns slow during the second decade, then rising again later in life as healthcare and other costs grow. Having liquidity to support spending later in life is a key consideration with lifetime income solutions.
Asset ownership has an impact at the end of participants’ lives, too. With a GLWB, remaining assets can help support higher spending later in life, and any remaining assets will be transferred to beneficiaries when a participant passes away. Because assets are surrendered up front with a fixed annuity, a participant won’t have added liquidity to support higher spending or leave a legacy to beneficiaries.
The distinctions between lifetime income solutions can create big differences in how much income is paid to participants for how long and in what level of assets—if any—remain at the end of life. Because these features drive implicit costs, it’s vital to compare all solutions on a level playing field—making it an imperative to consider income, liquidity, explicit fees and implicit costs.
It’s Total Costs—Not Just Explicit Fees—with Lifetime Income Solutions
Just because a guaranteed income solution has no explicitly stated fee, as with an investment option or GLWB, plan sponsors shouldn’t assume that the annuity benefit has no cost. What’s more, given the strong legal and regulatory emphasis on fee and cost transparency, plan sponsors should also consider whether a lack of clarity might be confusing or misleading for participants.
Translating design features, such as income payments and asset ownership, into cash flows and asset-value outcomes for individual participants can help plan sponsors objectively compare the benefits, costs and value of lifetime income solutions. A prudent, robust process that evaluates diverse solutions on a level playing field leaves plan sponsors better equipped to identify the best one for their plan.
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