Aon Hewitt Consulting | Retirement
Deferred Annuities in Target Date Funds An Explanation of Guidance Issued by the Department of the Treasury November 2014
Risk. Reinsurance. Human Resources.
Aon Hewitt Consulting | Retirement
Target Date Funds and Deferred Annuities—A Match? On October 23, 2014, the U.S. Department of the Treasury (Treasury) issued Notice 2014-66 (Notice) on deferred annuities in target date funds1. Treasury attempted to clarify a technical consideration for sponsors offering deferred annuities to participants in a target date fund (TDF) series. The Notice provides a special rule allowing plan sponsors to satisfy qualified plans’ nondiscrimination requirements if certain criteria are met. This paper will focus on how deferred annuities with target date funds work, the considerations regarding nondiscrimination rules, and other plan sponsor implications. This latest Notice is the most recent guidance on retirement income usage in defined contribution (DC) plans. In July 2014, for example, Treasury released regulations on qualified longevity annuity contracts (QLACs) for DC plans2. Aon Hewitt anticipates the DOL will likely provide additional regulatory guidance on ERISA fiduciary issues relating to offering annuities in DC plans and reporting retirement income on participant statements in early 2015. Helping participants protect themselves from outliving their assets is an important goal for all stakeholders. Aon Hewitt’s previous research has shown there is a retirement savings gap among U.S. plan participants3. Additionally, on October 27, 2014, the Society of Actuaries released new mortality tables quantifying how much longer people are now living. The result is that many participants are, or will be, exposed to significant longevity risk in retirement.
How Does a TDF Series with a Deferred Annuity Work? If a TDF includes a deferred annuity, it acts as another investment option within the TDF series. In the Notice, Treasury indicates a deferred annuity is similar to a fixed income investment. In fact, many fixed deferred annuities have underlying investment structures similar to intermediate or long-term bonds. However, one important difference is that annuities offer individuals the benefit of longevity protection. As the investment manager constructs the investment glide path for a target date series, the asset allocation typically becomes more conservative over time. Therefore, as a participant ages, his or her investment strategy becomes more conservative. In TDFs without annuities, assets systematically move from equity allocations to fixed income allocations over time. For TDFs that use deferred annuities, the investment manager may have no allocation to deferred annuities at the start of the glide path and, at some point in the glide path, begin incrementally to add deferred income. The sample glide path below shows a hypothetical TDF series/family. Hypothetical Glide Path4 with No Deferred Annuity
At age 35 in the 2045 TDF fund, the allocation might be equity 90%, fixed income 10%
At age 65 in the 2015 TDF fund, the allocation might be equity 45%, fixed income 55%
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Treasury Notice: http://www.irs.gov/pub/irs-drop/n-14-66.pdf Aon Hewitt’s white paper on this topic is available at https://retirementandinvestmentblog.aon.com/BlogHome/Blog/October2014/Weekly-Update-27-October-2014.aspx. 3 Real Deal Study, 2012 Aon Hewitt: http://www.aon.com/attachments/human-capitalconsulting/The_2012_Real_Deal_Highlights.pdf 4 Please note the above glide paths are hypothetical and are intended only to illustrate the deferred annuity concept for the reader. 2
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Aon Hewitt Consulting | Retirement
Hypothetical Glide Path with Deferred Annuity
At age 35 in the 2045 TDF fund, it might be equity 90%, fixed income 10%
At age 50 in the 2030 TDF fund, it might be equity 65%, fixed income 30%, annuity 5%
At age 65 in the 2015 TDF fund, it might be equity 45%, fixed income 30%, annuity 25%
As shown above, for some current TDF products that use annuities, the deferred annuities may not receive an investment allocation until a later age (e.g., age 50). Once someone reaches age 50, the glide path allows an increasing allocation to the deferred annuity as the fund proceeds toward maturity. This approach is used because at younger ages, like 25 or 30, glide paths generally put people into heavy growth strategies—so it may not be beneficial to purchase deferred annuities. Because of this strong age correlation and the fact that the annuity purchase price is age-contingent, some target date fund strategies restrict TDFs that use deferred annuities to older participants. Younger participants cannot purchase a TDF with a deferred annuity until they “age” into the option. This creates a potential “rights and features” disparity for younger participants, who are generally lower paid. This group would not have the same current access to deferred annuity products as older participants, which could be problematic since plans may not offer benefits that discriminate in favor of highly compensated employees.
Guidance for Target Date Funds The Treasury Notice gave technical guidance to address this potential discrimination issue under the Internal Revenue Code. For purposes of the nondiscrimination testing rules, the plan could be treated as having a single right or feature provided that certain conditions are met. Such treatment alleviates the burden to perform testing to ensure that the target date fund series does not discriminate in favor of highly compensated employees. A target date fund series must meet the following requirements with respect to the limited offering of deferred annuity contracts to attain single “benefits, rights, and features” consideration and avoid nondiscrimination issues:
Glide path fund differences. Investment managers must construct the TDF series based on prudent portfolio asset allocation theory. However: –
The only allowable “rights and features” difference among the funds in the TDF series is the asset allocation mix, in order to achieve the appropriate level of risk for individuals at particular ages; and
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Deferred annuity allocations must be available to younger participants once they reach the appropriate, designated age band.
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Targeting specific ages. The deferred annuity can be available only to older participants. However, the annuity cannot include a feature called a “guaranteed minimum” or “guaranteed lifetime” withdrawal benefit.5
Transparent securities. There can be no TDF series investments in employer securities that are not readily tradable on established securities markets.
All other rights and features consistent. Except for the differences in asset mix described above, all other “rights and features” for TDF series participants must be consistent.
Other Notable Guidance In addition to how TDF series may satisfy Internal Revenue Code nondiscrimination requirements, Treasury asked for the Department of Labor’s (DOL) views on these TDF/deferred annuity structures. As a result, in a letter from Department of Labor Assistant Secretary Phyllis Borzi to Treasury Department Assistant Secretary Mark Iwry, dated October 23, 20146, the DOL provided helpful guidance:
QDIA status confirmed. The DOL opined that the TDF series with the deferred annuity feature may qualify for Qualified Default Investment Alternative (QDIA) designation. This recognition is helpful guidance to plan sponsors offering TDFs as their default for participants failing to make an affirmative investment election. If a TDF satisfies all remaining requirements that constitute a QDIA, the deferred annuity feature will not cause the TDF to lose QDIA status.
Fiduciary considerations. Many plan fiduciaries also were concerned about the fiduciary guidance under ERISA for the selection of deferred annuities in DC plans. The DOL’s most recent guidance indicates that the annuity selection safe harbor7 applicable to DC plans (2008 Safe Harbor) establishes a means for plan fiduciaries to satisfy responsibilities under ERISA regarding annuity selection. At a high level, the 2008 Safe Harbor guidance for annuities says fiduciaries must: 1. Conduct an objective, analytical, and thorough search; 2. Assess the ability of the annuity provider to make benefit payments; 3. Consider the fees for the annuity contract relative to the benefit payments and administrative services received; 4. Conclude at the time of annuity provider selection that the annuity provider can make future payments and that fees relative to benefits and administrative services are reasonable; and 5. Hire an expert to assess the above criteria, if needed.
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Guaranteed minimum withdrawal benefits (GMWB) and guaranteed lifetime withdrawal benefits (GLWB) are two types of deferred annuities that provide income to participants. The GMWB provides benefits over a certain specified time period rather than for the lifetime of the contract owner or annuitant. The GLWB provides benefits over a participant’s lifetime regardless of deteriorating investment performance or asset level. GMWBs/GLWBs are not fixed annuities, but are variable annuities that pay a set, established periodic income (withdrawal) amount (e.g., 4%) based on the annuity value. There are specific features and considerations for GMWBs/GLWBs that are beyond the scope of this paper. We will discuss the implications on TDFs below. 6 DOL letter to Treasury: http://www.dol.gov/ebsa/regs/ILs/il102314.html 7 DOL regulation—Section 2550.404a-4: https://webapps.dol.gov/FederalRegister/PdfDisplay.aspx?DocId=21588 Deferred Annuities in Target Date Funds
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Aon Hewitt Consulting | Retirement
The DOL’s letter to Treasury made two other meaningful comments regarding fiduciary considerations8. 1. The plan fiduciary must prudently select and monitor the designated [TDF] investment manager at reasonable intervals to ensure the appointment is still appropriate; and 2. The designated and appointed [TDF] investment manager as a fiduciary under section 3(38) of ERISA is then responsible for selecting the deferred annuity provider.
Implications for Plan Sponsors The guidance on retirement income from Treasury and the DOL indicates ongoing support from Washington. Plan sponsors can now contemplate offering a target date fund series that includes deferred annuities if it is appropriate for their plans—without running into complex nondiscrimination testing features due to the inclusion of a deferred annuity. Some lifetime income issues relative to this topic remain, and we cite a few of them below. 1. What about GMWB/GLWB deferred annuities? GMWB/GLWB strategies are deferred annuity variations sometimes used with TDFs incorporating lifetime income. Guidance from the plan’s legal counsel regarding these strategies may be helpful for further direction and appropriate sponsor action, particularly since the guidance in the Notice appears to address a particular “arrangement” that did not include a GMWB/GLWB strategy. The Notice says Treasury is considering whether to provide guidance at a future date relating to issues arising from these strategies. One open question may be whether GMWBs/GLWBs would be viewed as fixed annuities (similar to the arrangement described in the Notice) or variable annuities, and the implications of such differing viewpoints. If, however, the guidance is deemed unavailable to GMWB/GLWB products, the plan sponsor must assess the effect of GMWBs/GMLBs on its plan’s nondiscrimination testing. 2. Is fiduciary responsibility lessened for plan sponsors under the newly issued guidance? Possibly, depending on the role of the plan sponsor and the investment manager. To the extent that the plan sponsor chooses the TDF investment manager, it must use prudent selection criteria. After this selection (and allocation of the responsibility), the designated investment manager is responsible for evaluating, selecting, and monitoring the deferred annuity provider. The DOL notes that if the plan sponsor discharges its fiduciary responsibility properly, then the plan sponsor may not be liable for certain investment manager actions. There is an exception for potential co-fiduciary liability under ERISA Section 405(a). The selection and monitoring of the investment manager is a critical initial and ongoing consideration. However, delegating the responsibility of selecting the deferred annuity provider to the investment manager may make sponsors more comfortable. 3. How likely is it that investment managers will accept fiduciary responsibility for deferred annuities? Some investment managers may not want to accept full fiduciary responsibility for deferred annuities. The DOL noted to Treasury that investment managers must acknowledge in writing that they are a fiduciary for the plan. The investment funds in an investment manager’s TDF series typically consist 8
These considerations focus on common situations where the sponsor, acting as a named fiduciary, designated an investment manager under ERISA section 3(38) to manage the investments of the fund.
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Aon Hewitt Consulting | Retirement
primarily of its proprietary products. This applies to products offered by investment managers such as Fidelity, Vanguard, and T. Rowe Price. Designated investment managers would likely have few concerns serving as fiduciary for their own products, but they often decline to be the fiduciary for any given plan because their products are deployed in so many varied plan situations. Serving as fiduciary for an annuity could be interpreted as a different set of circumstances, but it is not clear whether proprietary product providers accept this notion. It will be interesting to monitor how this evolves in the investment manager community. 4. What about potential conflicts with investment managers and the annuity provider? The DOL guidance describes the investment manager as an independent party from the underlying insurance company(ies)/annuity providers. However, there are some TDFs offered by insurance companies that include deferred annuities from the same insurer. How should these annuity products be treated? Also, the potential fees from insurance products paid to independent investment managers must be included in any due diligence assessment. Third-party due diligence assessments may become the prudent approach in assisting the market to achieve transparency and demonstrate strong fiduciary process. Plan Sponsors may also opt for custom target date funds over “off-the-shelf” funds from a single asset manager to further promote transparency. 5. How should you view these TDFs with deferred annuities relative to other DC retirement income products? Plan sponsors will need to vet these products similarly to any other investment alternative in their fund lineup. Whether these alternatives are better for a specific plan or not depends on many factors including plan design, participant demographics, product considerations, fiduciary issues, and recordkeeping implementation.
Final Thoughts This latest guidance from Treasury and DOL shows that regulators have an interest in plan sponsor consideration of lifetime income. There are some technical items to consider, but these regulatory references may slowly move the market toward broader assessment and adoption. Although regulations are generally written in the context of “off-the-shelf” target date funds, deferred annuities may also be implemented in custom target date strategies with the same considerations and regulatory relief from discrimination challenges. Aon Hewitt believes that, as with many situations in the retirement markets, plan sponsors need to base their assessments on individual employer facts and circumstances. Does the plan sponsor still have an active defined benefit plan? Is the sponsor very paternalistic? Does the plan sponsor already offer in-plan or out-of-plan retirement plan solutions? There definitely is no one-size-fits-all solution. For some plan sponsors, deferred annuities in TDFs might make sense. Providing participants the ability to dollar cost average and purchase income over time can be a prudent and beneficial alternative. Aon Hewitt will continue to monitor these developing trends and provide careful and prudent guidance for plan sponsors.
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Contact Information Steve Shepherd Partner, Institutional Annuities and Life Insurance Solutions Hewitt EnnisKnupp, an Aon Company 1.203.523.8164
[email protected]
Scott Fisher, CFA Associate Partner, Investment Consultant Hewitt EnnisKnupp, an Aon Company 1.206.467.4610
[email protected]
Diana Jacobson Director, HR Outsourcing Defined Contribution Practice Leadership Aon Hewitt 1.414.221.7331
[email protected]
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Aon Hewitt Consulting | Retirement
About Aon Hewitt Aon Hewitt empowers organizations and individuals to secure a better future through innovative talent, retirement, and health solutions. We advise, design, and execute a wide range of solutions that enable clients to cultivate talent to drive organizational and personal performance and growth, navigate retirement risk while providing new levels of financial security, and redefine health solutions for greater choice, affordability, and wellness. Aon Hewitt is the global leader in human resource solutions, with over 30,000 professionals in 90 countries serving more than 20,000 clients worldwide. For more information on Aon Hewitt, please visit aonhewitt.com.
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