Annuities inside defined contribution plans

A 401(k) or 403(b) plan does one job well: it accumulates savings. It is much less effective at the second job, turning a balance into income that lasts as long as the participant does. Lifetime income options are meant to close that gap, and committees are being asked about them more often by participants, by recordkeepers and by consultants with a product to place.

What a participant faces at retirement

A retiree with a lump sum carries three risks that are hard to manage alone. The first is outliving the money. The second is sequence risk: a poor market in the first years of retirement does permanent damage that the same market ten years later would not. The third is behavioral and under-appreciated: many retirees spend too little out of fear of the first two, and die with balances they could have used.

An annuity addresses all three by converting part of the balance into a guaranteed payment for life. Longevity risk moves from the individual to an insurer that can pool it across many lives. The participant gives up liquidity and, usually, a bequest on the annuitized portion in exchange.

The forms it takes

• A guaranteed income feature inside a target date fund. As the participant approaches retirement, part of the fund buys a guaranteed lifetime withdrawal benefit or deferred income. This can serve as the plan's qualified default investment, which is why it reaches the most participants and draws the most fiduciary attention.
• A standalone in-plan annuity that participants elect while working, building guaranteed income over time at each year's pricing.
• An out-of-plan purchase at retirement, often through a bidding platform that quotes several insurers, with the plan providing education and access rather than a product.
• A qualified longevity annuity contract (QLAC), a deferred annuity that starts late, often at 80 or 85. SECURE 2.0 raised the premium limit to $200,000, indexed, and removed the old 25 percent of balance test, which made these contracts practical for more participants.

What changed in the law

The SECURE Act of 2019 did three things that matter here. It created a fiduciary safe harbor in Section 404(e) for selecting an annuity provider. It required lifetime income illustrations on participant statements, showing the balance as a single life annuity and as a joint and survivor annuity at 67, using prescribed assumptions. And it made in-plan annuities portable: if the plan drops the option or changes recordkeepers, participants can take the contract with them without a tax penalty. SECURE 2.0 added the QLAC changes above and allowed partial annuitization to be aggregated with the remaining balance for required minimum distributions, which removed a practical obstacle.

Questions the committee has to settle

Insurer selection. The safe harbor protects fiduciaries who follow a documented process: an objective, thorough and analytical search; a conclusion that the insurer is financially capable of meeting its obligations; a conclusion that the cost, including fees and commissions, is reasonable in relation to the benefits and features provided; and written representations from the insurer about its licensing, reserves, audits and financial condition. The safe harbor rewards the process, so the file matters more than the choice of logo.

Fees and value. Guarantees cost something, often in the range of a percent of assets per year on the guaranteed portion. The committee should know what participants pay, how it compares to alternatives such as buying an annuity outside the plan, and whether the benefit justifies it for this workforce.

Default or opt-in. Embedding income in the default fund reaches participants who never make an election, which is most of them. An opt-in feature leaves the decision with the participant. Each has implications for communication and for fiduciary exposure if the product disappoints.

Portability and recordkeeper capability. Not every recordkeeper can administer every product. The committee should know what happens to accrued guarantees if the plan changes providers, and should get that answer in writing before adding the option.

Participant understanding. Income products are harder to explain than funds. A communication plan, including how the illustration on the statement connects to the option in the plan, should be part of the decision rather than something handed to the recordkeeper afterward.

Where to start

Start with the participants, not the products. Average balances, ages, turnover, whether the employer also sponsors a defined benefit plan and whether retirees have access to retiree medical all affect whether an in-plan option adds value. We analyze the workforce data, model expected retirement income with and without the option, compare the cost against alternatives and document the committee's process from first meeting to final minute.

This article is general information about the topics discussed and is not actuarial, legal or tax advice for any specific plan or employer.