Retirement plan sponsors have offered in-plan insurance company annuity conversions with very little success (less than 5% utilization and many in the industry say less then 1%). Retail annuity offers to convert 401(k) balances are also said to have very low utilization rates. Yet, when presented the opportunity in the right light, roughly 25% of eligible employees choose lifetime income over a traditional account balance.
Here’s one way that 16 employers have been seeing an average of almost 25% of eligible balances converted since 2007. These employers offer retiring employees the option to convert all or part of their 401(k) balance to lifetime income options through the company’s defined benefit plan by transferring a portion of their balance into the defined benefit plan. Although this has not been a well-publicized option, IRS Revenue Ruling 2012-4 clarifies the use of this option and protects employees by requiring conversion rates based on high quality long bonds specified in the ruling. The 24% utilization rate reflects almost 1/3 of eligible retiring employees electing to convert an average of 78% of their account balance to lifetime income. While this still leaves 2/3rds of employees that didn’t convert any of their account balance to lifetime income, it still shows a much higher utilization rate compared to the traditional lifetime income options offered to employees.
Key Considerations To The Offering
So what goes into this type of account balance to lifetime income opportunity? The following are key considerations when implementing this type of program.
RISK – The plan sponsor would be adding assets and liabilities to their defined benefit plans. This adds risk and may go against a sponsor’s goal of de-risking. This can be mitigated by earmarking a hedged, long-bond portfolio to back these liabilities. This can be done from the outset to minimize any funded status risk by adding these liabilities as well. Some sponsors, though, may prefer managing the assets as part of their larger portfolio and expect to earn more than the long bond rate on these assets, which can also reduce current year pension expense. The point is that there are options to how the risk is addressed giving plan sponsors flexibility in deciding what is best for managing how the benefits are funded.
PBGC PREMIUMS – If these participants are already in the existing defined benefit plan, there would not be an increase in premiums. However, if they are not currently in the plan and a plan sponsor wants to limit their PBGC premium exposure they can limit participation in the program to existing defined benefit participation (subject to discrimination rules). Note that these benefits would be protected as priority category 2, above all employer provided pensions, as these benefits are derived from employee contributions. This means an added level of protection of their lifetime income.
PLAN SPONSOR NEEDS A DEFINED BENEFIT PLAN TO OFFER THIS – OR DO THEY?
The short answer is yes, clearly the sponsor needs a defined benefit plan to offer this type of arrangement. But if a sponsor doesn’t have one and is interested in providing retirement security to their retirees in this way, a sponsor can set up a new defined benefit plan simply to hold and manage these retiree annuities. This can be setup to be quite a bit less of a burden or risk than it sounds!
SO, WHAT’S IN IT FOR THE COMPANY??
In addition to the satisfaction of providing employees with a viable and cost effective lifetime income option to help them avoid outliving their retirement account balances, this strategy can provide significant workforce and direct financial benefits to an employer. As more and more companies use defined contribution plans (e.g. 401(k) or 403(b) plans) to provide for retirement income (above Social Security), more and more risk is placed on retirees. Longevity, inflation, and investment risk are significant when not pooled and are instead placed on the shoulders of an individual or married couple. When these concerns are substantial enough, employees delay retirement.
Delayed retirement can have costly financial consequences to an employer. Promotion rates and opportunities can drop causing blockages that force highly talented employees to voluntarily terminate. With employees delaying retirement there is also the potential for increased health and welfare benefit costs and increased time loss benefit costs as a result of an aging employee base. In addition, as retirement eligible employees actually retire, an employer may decide to not replace them at all or replace them at lower average compensation and benefits costs, thus saving the employer significant costs.
There is substantial evidence that shows that lifetime income options are of interest to employees. But to see this interest employers have to look beyond the traditional lifetime income options available in the defined contribution plan market today. Employers should consider the other cost effective options to provide employees what they are looking for.
