W. Scott Simon
The Employee Retirement Income Security Act of 1974, as amended (ERISA) is the exclusive federal law that governs retirement plans in America. In some columns, I’ve highlighted the word “Employee” in the law’s title as a reminder that the center of the ERISA universe is composed of plan participants (and their beneficiaries). The side in the ongoing Fiduciary Wars that just doesn’t want to be fiduciaries tends to overlook that minor fact.
In this month’s column, I’d like to highlight the term “Retirement Income Security” in ERISA’s title. This reminds us that ERISA is concerned ultimately with the security of plan participants’ retirement income. After all, why do participants contribute to their retirement plan? Answer: to be able to generate sufficient income to maintain an adequate standard of living for the duration of their retirement. While that has always been true, of course, in the past the focus has generally been on accumulation of the largest lump sum possible in a participant’s plan account.
But it’s not written in the stars that greater retirement income security will necessarily result from the accumulation of a larger lump sum. For example, it’s always possible that even a large lump sum will be eroded sharply in purchasing power by a healthy dose of inflation. It’s difficult to understand today with many of the world’s economies flirting with deflation, but some will remember 1979-1980 when inflation was raging at nearly 15% per year.
Now that something like 10,000 Baby Boomers (i.e., those born from 1946 through 1964) will be retiring each and every day over the next 15 years, government regulators, plan service providers, et al. have (relatively) recently begun to turn their attention to the decumulation stage of the retirement process. That is, the stage when retiring plan participants will be disposing of their accumulated lump sum through an income stream over their lifetimes. More and more attention is now being placed on investment strategies that can generate sufficient retirement income rather than on those that maximize accumulation of wealth. In short, the name of the game–as ERISA reminds us–is (and always has been) retirement income.
Plan service providers–especially insurance companies–are straining at the leash to have lifetime annuities included (officially through a “safe harbor” granted by the U.S. Department of Labor) as investment options in retirement plans. However, in addition to their oftentimes high (and therefore hidden) costs, many annuities have the risk profile of a single stock. This is not in spite of insurance companies that stand behind their annuities with the use of that magical word “guarantee,” but because of it.
In addition to the (hidden) costs and risks of many annuities, some investors have shied away from them due to their complexities, which even many insurance salespeople fail to understand. In this regard, it should be noted that it’s difficult for an investor to rely on the advice of insurance salespeople to select an annuity and any riders (i.e., options) because of the inherently conflicted business model under which they operate. After all, insurance salespeople can be compensated only upon the sale of a product, and that makes their advice inherently suspect even when it truly is, say, in the sole interest of plan participants. You might even say that this business model has the effect of tarnishing the (actual) noblest intentions of conscientious insurance salespeople.
Another factor may be at play here in the seeming reluctance of many investors to embrace annuities whether in retirement plans or at the individual retail level. It seems to be psychologically difficult, when push comes to shove, for investors to part with some (or all) of their money and hand it over to another party–in this case, an insurance company.
It is one thing to invest in, say, a mutual fund, but at some point, that money (whether more or less than the amount invested originally) can be retrieved. Not so with an annuity; the money is “gone” in the sense that even though it can be retrieved, that’s possible only by undergoing a series of expensive tradeoffs. For example, with immediate annuities, an investor gives up all access to the funds invested in return for a guaranteed income over a set period of time. Most other types of annuities–whether indexed, fixed, or variable–do impose surrender charges upward of 7% over seven years in return for accessing principal. Some insurance companies (as well as some mutual fund families) do offer surrender-fee-free annuities. But they make up for that lack of revenue by charging higher annual fees on the underlying mutual funds in the annuity insurance wrapper than they would earn if the funds were simply offered on a stand-alone basis that didn’t involve an annuity. In order to “guarantee” an income stream, annual fees average an extra 120 basis points (1.20%) annually. In general, if an investor requires liquidity in an annuity, the promised guaranteed income is lowered drastically. Once liquidity or a return of principal is required, then annuities often seem to make little sense.
A viable alternative to annuities to help plan participants generate sufficient inflation- protected income are target date retirement income funds (TDiF). For example, Dimensional Fund Advisors has a series of 13 broadly and deeply diversified TDiFs that came out of registration in late 2015, and BlackRock has now made its CORI product available to the marketplace. All these financial products are registered under the Investment Company Act of 1940 (’40 Act fund). No doubt other entities are hard at work making similar products because they have found that the generation of inflation- protected retirement income should be their focus, not wealth generation per se.
Having more wealth, as noted in the case of inflation, does not necessarily secure the income that it generates. The whole point of TDiFs is to secure inflation-protected retirement income. Research by noted academics has identified duration-matching U.S. government-backed Treasury Inflation-Protected Securities (TIPS) as the best and lowest-cost hedge available in a ’40 Act fund.
Retirement income is subject to a number of risks such as a) inflation risk (reduction in purchasing power over time), b) market risk (stock market going down in value sometimes a lot and/or for a long time), c) interest rate risk (receiving unattractive rates when interest rates have moved higher; e.g., an investor collecting only 2% when current rates are 4%) and d) longevity risk (running out of money over a long retirement). A TDiF is designed to address these risks by providing a smoother and more probable level of income. The aim is to give every plan participant the best chance possible of maintaining an adequate inflation-protected standard of living in retirement.
In the early working years of a participant invested in a TDiF, its plan contributions are invested primarily in income growth assets (U.S. and international stocks and bonds) that are expected to increase in value over time. Later in the participant’s career, the income growth assets are converted to TIPS. As a participant approaches retirement, a TDiF’s investment focus shifts from global stocks and nominal bonds to TIPS in order to help manage the transition from future income accumulation to managing income in retirement. In retirement, a TDiF remains focused on income risk management assets in an effort to guard against the risks to future retirement income noted previously.
At this point, it’s useful to compare how the investment goal of a TDiF–whether that of BlackRock, Dimensional, or others that will eventually create their own TDiFs–stacks up against that of a traditional target-date fund. As noted, a TDiF’s goal is to generate inflation-protected retirement income. In contrast, the goal of a traditional target-date fund remains focused on the right asset allocation in order to generate wealth per se. (I’ve never understood the heated debate that broke out after the experience of 2007- 09 over the “right” asset allocation. To me, the widely varying asset allocations in target-date funds were just a different riff on the same old silly story of (expensive and risky) active investment management and its stock-picking, market-timing, track record investing, etc., all predicated on the assumption that it’s possible to accurately predict the future.)
Comparing the investment goal of TDiFs with that of traditional target-date funds reveals that target-date funds are a less desirable alternative to annuities because they have different investment goals. This leaves TDiFs–which seek to generate a stream of inflation-protected income during retirement–as the more viable alternative to annuities when compared with target-date funds. The investment goal of TDiFs is very similar to annuities.
Given that TDiFs and annuities have similar investment goals, which is better for investors such as participants in retirement plans? Although annuities carry a “guarantee,” that makes them take on, as noted, the risk profile of a single stock. TDiFs don’t carry a guarantee. It then comes down to a choice for a plan participant: Is the insurance company’s guarantee with its illiquidity, higher costs and risk, and lack of protection from inflation worth the perceived safety of the guarantee? Or is a TDiF’s liquidity, significantly lower costs (e.g., the Dimensional TDiFs range in annual costs from 21 to 29 basis points) and risk, and protection from inflation worth the lack of a guarantee?
Plan sponsors and responsible plan fiduciaries will likely find the answer to these tradeoffs an easy one at this time. Until there is an actual safe harbor for the inclusion of a lifetime annuity product in a retirement plan, it would seem fiduciary suicide for a plan sponsor to select one because of the uncertain fiduciary risk and the uncertain long-tail aspects of that risk. (Think Tibble and the statute of limitations issue involved there.) What person in his or her right mind–knowing and understanding all the material facts and issues involved in selecting a lifetime annuity as an investment option for a retirement plan–would want to sign on as a fiduciary to a plan that is either going to select an annuity or has selected an annuity in the past (Tibble, redux)?
W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations and trials as well as in written opinions. Simon is the author of two books including The Prudent Investor Act: A Guide to Understanding. He is a member of the State Bar of California, a Certified Financial Planner® and an Accredited Investment Fiduciary Analyst™. Simon received the 2012 Tamar Frankel Fiduciary of the Year Award for his “contributions to advancing the vital role of the fiduciary standard to investors, capital markets and to society.” The author’s views expressed in this article do not necessarily reflect the views of Morningstar.