A 401(k) That Promises Never to Run Dry
While anything resembling your father's pension is unlikely to return, one large company has overhauled its 401(k) plan so workers can receive a paycheck for life.
Like many large employers, United Technologies, based in Hartford, Conn., closed its traditional pension plan to new workers a couple of years ago. The retirement plan that replaced it tries to solve one of the 401(k)'s biggest shortcomings and a thorny problem for retirees: protecting hard-earned savings from a volatile stock market while ensuring the money will never run out.
At first glance, the fix does not appear entirely new. United Technologies , an aerospace and building technology company with nearly 200,000 employees, uses target-date mutual funds — whose investments become more conservative over time — but there's a twist: the plan also incorporates annuities that offer a guaranteed monthly payout in retirement.
In fact, the plan is one of the first by a large employer to include annuities within the walls of its 401(k), specialists say. And in an even bolder move, the company is automatically enrolling employees into the program if they do not select other options on their own.
"They are breaking new ground," said Dallas Salisbury, president of the Employee Benefit Retirement Institute. "There are several other plan sponsors sitting and waiting to watch what their experience is."
Unlike traditional pension plans, the United Technologies plan keeps the responsibility on the workers to amass enough in retirement savings, though the company matches their contributions. The workers must resist any temptation to pull money out in turbulent markets — or for any other reason.
But the difference between United Technologies' lifetime income strategy and more traditional 401(k) investment options is that about midcareer, the worker's savings are gradually shifted into variable annuities that guarantee a minimum level of income for life, starting at retirement.
"We wanted to provide the opportunity to retire even if there was a market correction one or two years prior to when they were going to retire," said Robin Diamonte, chief investment officer at United Technologies, who led the effort to put the plan, designed by the investment company AllianceBernstein, into place.
The program's inner workings are complicated, and employees will probably have to read and reread the brochure before deciding whether the plan is right for them. And if it is not, workers can choose more traditional options like stock, bond and target-date mutual funds.
Here is how the new program generally works: Until age 48, employees invest their savings in something akin to a customized target-date fund, where the mix of low-cost stock and bond index funds gradually becomes more conservative as employees approach 65, when the company assumes they will retire. (Workers are allowed to retire as young as 60, though withdrawal amounts will be lower.)
Then, beginning when an employee is 48, the company gradually sells the stock and bond funds and reinvests that money into what it calls the secure income fund, which contains variable annuities that continue to hold a portfolio of stock and bonds — but also guarantee workers can pull out a set minimum amount each year, even if the market crashes. By the time employees turn 60, all of their money in the plan has been moved into the secure income fund.
So how much annual income does this strategy guarantee? It is basically a fixed percentage of the amount in the secure income fund. If by the time an employee reached 55 the fund's market value was $200,000 and the payout rate was 5 percent (more below on how that is calculated), at age 65 the worker could begin withdrawing at least $10,000 annually for the rest of his or her life. This would be the case even if the market plummeted or the account became depleted.
The amount of guaranteed income is recalculated each year on the employee's birthday and each time she or he adds money to the fund. So as employees make more contributions or if the market does well (after all, 60 percent of the fund remains invested in stocks), the higher amount becomes the new base from which payments will be drawn in retirement. And that means the income stream will also increase, as long as the employee sticks with the program.
"If the market goes up, you win,'" said Anthony Webb, a research economist at the Center for Retirement Research at Boston College. "And if the market goes down a lot, the insurance company bears the loss. From the viewpoint of the participant, you want to have this kind of fund investing in relatively risky assets to maximize the investor return in the event of it going well."
The employees' fixed payout rate, or the annual percentage allowed to be withdrawn, is based on the average benefit rate at which they acquired the annuities over time. In June, for instance, a 48-year-old would have bought annuities that paid about 4.8 percent, while a 60-year-old would have received a 3.86 percent rate.
Those rates are influenced by the age of the employee when the annuity was bought, the prevailing interest rates and the unique way United Technologies acquires the annuities for workers. The annuities are essentially acquired in pieces over many years.
Instead of the company's dealing with one provider, three insurers, Prudential, Lincoln Financial and Nationwide, bid on the company's annuity business each quarter. AllianceBernstein designed and handles this program.
"It's a balance of getting the best price the market is willing to offer and getting the benefit of diversifying across insurance companies," said Kevin Hanney, director of portfolio investments for United Technologies' pension investment group. (Still, a worker could end up with annuities from only one or two companies depending on how the bidding process proceeds).
One of the biggest risks of buying annuities, of course, is the possibility that the insurer could fail, jeopardizing the buyer's income. If that were to happen, Mr. Hanney said, the annuity contracts would be insured by the state guaranty associations, though they may not cover the full amount of a worker's income guarantee because of caps the associations impose that vary by state. Still, the market value of the investments in the contract would remain available to the participant or the participant's beneficiaries, he said.
Variable annuities have become notorious over the years for their high fees. But in this case, specialists agree that they are fair, given the guarantee on offer. Workers 47 or younger pay 0.13 percent annually in fees for the underlying index funds.
The insurance in the guaranteed income fund costs a flat 1 percent of assets invested each year, much less than most variable annuities. So as workers buy more of that fund over time, their costs increase. Total costs, including investment and insurance fees, are 0.21 percent of assets at 48 and continue to inch higher until they hit 1.24 percent of assets for those 60 and older.
Workers can withdraw some or all of their savings in a lump sum (at market value) at any time, free of penalties, but that should be done only as a last resort. If someone withdraws all of his or her money after having started paying for the insurance, he or she will have paid higher fees for a benefit that is never cashed in.
"A 1 percent fee sounds relatively innocuous, but if you compounded it over 10 or 25 years, that is a great deal of money," Mr. Webb said. "The value of this thing only accrues to you if actually hold it until very advanced ages."
If an employee withdraws only some money in a lump sum, her or his payouts will be reduced proportionately.
Employees can also choose to take a joint benefit to cover a spouse, though the payout rate will be lower. They can leave any leftover funds to heirs. And if the worker leaves the company before retirement, he or she can roll the annuity over into an individual retirement annuity, which is essentially an individual retirement account for annuities. But executives said it would be more cost-effective to leave the annuities in the 401(k) plan, which would continue to reinvest the money in the secure income fund over time as if you were an active employee.
One of the biggest challenges employees are likely to face is simply trying to evaluate whether this is a good value. It is a mind-numbing calculation.
"My concern about all these products is that they are complicated and have opaque charges," Mr. Webb said. "Given the information in the brochure, my Ph.D. in economics leaves me ill-equipped to say whether this is a good buy. I have no idea how the average U.T.C. worker would be able to work out what to do."
United Technologies' executives say that education is essential, and the company provides its employees with brochures, workshops and videos to help them understand the strategy. The company also has a benefits call center that can provide more detailed answers, including income estimates based on an individual's situation.
"The nature of most if not all insurance is that you'll never really know in advance exactly how much insurance you purchase will pay out," Mr. Hanney said. But "participants choosing this option also may find immediate value in the knowledge that — even if the future brings extremely volatile equity markets — they can retire on schedule with a reliable income."
Though United Technologies' approach is rare, it is not the first to pair target-date funds and annuities. Prudential has offered a similar option, known as its IncomeFlex program, since late 2008. But that plan provides a fixed minimum payout of 5 percent annually, no matter the market conditions, and the annuities are backed only by Prudential. Its guarantee costs 1 percent of the account balance, and the underlying investment fees.
Prudential said that IncomeFlex was offered in more than 7,000 plans and more than 73,000 employees were participating in the program. Some employers are automatically enrolling their workers, though the companies are not as large as United Technologies.
Even though more guaranteed income offerings are available from other employers, only 16 percent of plans offer products within 401(k) plans that provide some way to help retirees create an income stream, including annuities and mutual funds that help retirees manage their withdrawals, according to a 2012 survey of more than 500 large employers conducted by Aon Hewitt, a human resource consulting and outsourcing solutions business.
More employers might consider insurance-related options if regulators clarified the rules; many employers are afraid of running afoul of their duties as a fiduciary.
"Few are comfortable determining, as required by current regulation, whether an insurer is capable of meeting all its long-term obligations under a long-term contract," said Sri Reddy, head of institutional income at Prudential, in his testimony to the Department of Labor's Advisory Council on Employee Welfare and Pension Benefit Plans in April. He said state insurance regulators should determine which insurers were healthy enough and plan fiduciaries should be able to rely on their judgments.
More than two years ago, the Labor Department and the Treasury started evaluating the use of income options in retirement plans to see whether they should act to make them more readily available. They held a joint hearing in September 2010 with industry representatives, consumer advocates and other specialists but have yet to act.
"The offering is undoubtedly good from the participants' point of view — to have the offering," Mr. Salisbury said. "But whether or not the participant decides whether it is the best thing to do given their age, their tenure and their plans becomes an individual question."