When public pension reforms are discussed, defined contribution retirement plans are frequently criticized for not providing the guaranteed lifetime income that defined benefit pension plans offer their members. But traditional public sector pension plans across the country are deeply in debt and the average state pension plan is only 73 percent funded. Because of this fiscal reality, an understanding of how defined contribution plans can incorporate lifetime income into plan design will become increasingly important for public sector retirement systems.
Lifetime income provisions simply supply a predictable income stream for the duration of a participant’s life and can be designed in a variety of ways. While lifetime income can be included in any retirement plan, it is true that 401(k)-type retirement plans typically do not offer lifetime income distributions.
Some defined contribution (DC) plans, however, have long contained provisions that offer guaranteed lifetime income options to participants. This is especially true for core DC retirement plans in higher education.
The simplest way to provide lifetime income within a defined contribution retirement plan is to allow the option for a plan member to purchase a lifetime annuity option at the end of his or her employment. At this time the participant could use some, or all, of the assets in their DC account to buy an annuity and secure lifetime income. This inclusion would allow the plan participant to utilize employer-provided guidance of industry experts while selecting an annuity among the universe of annuity products.
While straightforward, this is not necessarily the best option an employer can offer. The biggest risk with this “point of sale” annuity purchase is timing. Because of various economic conditions, the annuity purchase rates (the amount of ongoing income the assets will purchase) at the time of purchase may not be ideal and could be very costly for the employee.
A more effective approach to providing lifetime income is to include fixed and/or variable annuities within the investment mix of the plan during the asset accumulation phase. Under this scenario, individuals could choose to invest some, or all, of their retirement contributions into annuities and essentially purchase shares of future lifetime income. This approach to the purchase of annuities can reduce the endpoint risk of buying an annuity product.
If the individual decides that they do not ultimately want to purchase a lifetime income annuity at the time of retirement, then no harm is done. The pre-retirement annuity product, in most cases, functions just like a mutual fund with all inherent distribution options intact.
Since most defined contribution plans allow members to vest immediately or within a few years of employment, it is much more likely that a public employee in today’s world would actually receive lifetime income from a DC plan offering an annuity than from a traditional pension.
Traditional pension plans require employees to work for anywhere up to 20 years before they receive their full pension benefits. Given the increasing mobility of today’s workforce, fewer public employees are vesting in their pension benefits.
One potential obstacle for a public employer looking to provide lifetime income options in its defined contribution plan may be in finding a benefit or investment consultant who appreciates the importance of public retirement plan objectives, mainly to provide a secure retirement to the employee at a reasonable cost to taxpayers and employers. Deferred fixed or variable annuities may have higher fees than some comparable mutual funds. Plan sponsors and their consultants should realize, however, that these investments are offering a more diverse distribution menu than a typical mutual fund. And guaranteed deferred annuity products may include some period of illiquidity that is often disliked by investment consultants because it may hamstring their ability to recommend fund changes. These illiquid periods, however, are necessary for the issuer to ensure the risk inherent in the product and are often accompanied by higher interest rates than those available in fully liquid products.
The inclusion of annuity offerings within a primary defined contribution retirement plan is a study in tradeoffs and speaks directly to plan objectives. The objectives of a retirement plan should be clearly articulated, in writing, and should be focused on enabling public employees to maintain their standard of living throughout their lifetimes. Achieving this objective for employees is a balancing act, necessitating the careful balance of risks and rewards, and the need to provide certain provisions within a retirement plan that differentiate it from a simple savings plan.
Annuities and other lifetime income provisions are a proven method of providing public workers a secure retirement while allowing employers to maintain financially responsible retirement plans that do not load taxpayers with debt. Public pension plans without lifetime income options should consider adopting responsible and valuable annuity policies to better meet plan objectives and help ensure adequate and reliable retirement income for their members.