Wednesday, October 7, 2009

Adding Less Risk: The Safe Harbor Option

There is no easy answer for how much risk is too much risk or too little. In the aftermath of this past year, plan sponsors are looking for a way to insure that those close to retirement have the money they invested over their careers there when they need it. The key word is insure. And it is the industry that offers this sort of product that is being considered as a possible option. But are annuities the option worth considering?

One of the most difficult things to do is provide protection for already accumulated money in a defined contribution plan. Currently, even in what the industry refers to as megaplans, the options are limited to targeted-dated funds or some sort of option that offers fixed income protections. These types of options adjust the level of stock market exposure as the employee ages, shifting from more aggressively invested dollars to more conservative investments.

The reason for the increased popularity of these products is the result of a Congressional mandate. Target-dated funds were made the default investment for those entering the workforce replacing other less retirement oriented funds such as money market accounts. This allowed the worker to begin investing for their retirement in what the industry called the best option for those who do not know what to choose.

But now, with the focus on asset preservation rather than the typical asset accumulation, a particular concern for older workers nearing retirement, the pension industry is considering annuities. There are several problems with this, first and foremost being the involvement of the insurance industry.

Annuities are designed to be purchased as a stand alone product that provides guaranteed income. The insurance company makes certain commitments to how much you will receive in retirement from accumulated assets. The cost of this quasi-investment/insurance product is high in the first seven years of the purchase and the underlying investments made by the insurer are designed to provide the insured with a lifetime income.

The introduction of such a product in your defined contribution plan presents all sort of problems, not only for plan administrators but for the participants as well. According to Pensions and Investments Online, this would involve tweaking the already suspect target-dated funds. (I say suspect in large part because they have yet to prove they are able to do what they were designed to do.)

PIonline suggest that these target-dated funds could allow their investors to buy "slivers" of an annuity from several insurers. This would keep some of their money invested even after they retire and some of it as guaranteed income.

The second option and probably the most costly would be to offer a "guaranteed lifetime withdrawal benefit". This would essentially allow the investor to roll the assets they have accumulated in the annuity where the insurer would offer income based on a high water mark withdrawal based on a certain percentage. This would, insurers suggest, provide income even when the market moves in unsavory directions during retirement.

Robert Reynolds, chief investment office at the conservative Putnam Fund has been making noise since taking over the once powerful investment house. Among his proposals:

Mr. Reynolds would like to create "a national insurance charter and an FDIC-like fund to back up lifetime income guarantees". This will essentially force employers and employees to consider this option. The FDIC-like fund, not federally insured but instead insurance company guaranteed would offer protections for assets already accumulated.

Involving Washington is the trickiest part of his proposals. He would like Congress to add tax incentives to both employees that participate and employers who offer matching contribution "that would require "employers to offer a lifetime income option, either through annuities or other insured methods".

Of course for such a move to pass muster, the insurers would need to have set "caps on the equity exposure in target-date funds as they become mature". Such action would need the support of legislation that would "require employers to enroll all of their workers in 401(k) plans automatically and increase their contributions over time." This would put pressure on the smallest of firms to comply, a costly maneuver and force the largest firms to take away what some feel is the most important aspect of the 401(k) plan: choice.

This would also jeopardize the portability aspect of the plan. Few insurers would continue to cover an employee after they leave a firm and would probably not participate in a rollover to an individual retirement account (IRA). The reason: no former employee would continue to pay the outsized costs on an individual basis which could be spread over a large group inside a 401(k) plan.

“Usually after a tough period like this you're presented with an opportunity to make the system better,” Mr. Reynolds said in an interview. “We need to fix 401(k)s, which have become the retirement plan of this country. At Putnam, we want to get out in front of the issues.”

This is scary talk indeed.

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