Vanguard put a team of its experts to work on answering one of the major retirement planning questions of the day: Will adding an annuity, or an annuity-like feature, to a target-date fund inside a 401(k) plan really help workers get a modern alternative to the old defined benefit pension plan, or will it just create all kinds of complicated new financial riddles?
The team’s answer: It depends.
“The value offered to a participant depends on the design of the hybrid annuity TDF and is influenced by factors like timing and amount of the income funding strategy, annuity type, and share of the income funding strategy used to buy the annuity,” the team wrote in a paper that describes their findings.
But the plan sponsors and plan participants would still need personalized advice to know whether a “hybrid annuity TDF” was right for their own situation, according to Vanguard.
“Most hybrid annuity TDFs involve a decision to annuitize, and many participants are not actively engaged or informed enough to make an appropriate decision about when to purchase an annuity and how much to annuitize,” the paper states.
What it means: For workers who have no interest in retirement planning, a major new hybrid annuity TDF effort could be just another confusing part of the financial fog swirling around them.
For financial professionals, a major hybrid annuity-TDF push could create three separate forces:
The history: Many U.S. employers once promised workers guaranteed retirement income for life through defined benefit pension plans.
The plans were complicated and expensive to administer, but employers and their advisors handled all funding and investment decisions.
Falling interest rates and tough new federal employer responsibility rules pushed employers away from the defined benefit plan strategy.
Today, the typical employer with retirement benefits makes no promises about income and simply provides access to a menu of mutual funds and other investment options through a 401(k) plan, 403(b) plan or similar participant-allocated plan.
The Pension Protection Act of 2006 created ”qualified default investment alternatives,” or QDIAs, that protect the plan participants from having to allocate their own investments while they are accumulating assets.
Choosing the QDIA, or simply letting cash flow into the QDIA without making any conscious choice, is a way for workers to turn responsibility for asset allocation over to institutional money managers.
The income problem: Many economists, financial planners and others have argued that converting a nest egg into a guaranteed stream of lifetime income can be as complicated as allocating the assets during the nest egg accumulation phase.
Some have argued that adding some kind of built-in annuity or annuitization option to a retirement plan is to the income stage of retirement what providing a QDIA is for the accumulation phase.
Advocates for combining target-date funds with in-plan annuitization options, or what Vanguard calls the “hybrid annuity TDF,” contend that, for most workers, who have no real interest in actively managing their nest eggs, offering QDIA users default income options is an obvious path to follow.
BlackRock CEO Larry Fink has predicted that the annuity-TDF combination will soon be the most commonly used investment strategy at defined contribution retirement plans.
The Vanguard thinking: Here are five questions on the Vanguard experts’ minds, drawn from the new paper.
1. What kinds of annuities or annuitization options will be used?
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The Vanguard team notes that the income option could be a single-premium immediate annuity, or SPIA, which starts providing income immediately after annuity purchase, which could be when the worker retires; a deferred income annuity, which might start providing payments at a set future date after purchase; or a qualified longevity annuity contract, which might start providing payments when the worker is nearing the “oldest old” years, such as at age 78 or later.
The deferred income annuity and QLAC approaches may frustrate workers who want cash early in retirement but could be helpful for workers who need an affordable way to prepare for the possibility that they might live much longer than expected.
2. What do the performance simulations show?
Vanguard analysts looked at how much value an annuity added to a hybrid annuity TDF combination by increasing portfolio stability during periods when investment markets are performing poorly.
In the simulations, a bare target-date fund “has a lower average income shortfall than the hybrid annuity TDF in the early years of retirement but, given the guaranteed income payout from the annuity, the hybrid annuity TDF makes up for this income shortfall in the later years of the participant’s life-cycle,” the team says.
The hybrid is a little less likely to meet a worker’s retirement income goals than a bare target-date fund, but the size of the shortfall relative to the target could be much smaller starting around age 90, according to the team’s simulations.
3. What do the performance gaps between the bare target-date funds and the hybrid arrangements really mean?
The Vanguard team notes that employers and participants who care about financial performance will still have to do some thinking, even if, in theory, using a hybrid arrangement should reduce the need for active worker management of income-generation options.
Workers “who have high aversion to outliving their retirement savings may prefer a hybrid annuity TDF, whereas those with bequest or higher wealth objectives may not find sufficient value in a hybrid annuity TDF,” the team says.
4. Which annuities might work best in an annuity-TDF hybrid?
The Vanguard team votes for deferred annuities.
“When in retirement, participants are typically spending from their portfolio, which limits their ability to recover from market downturns and hence increases their exposure to market risk compared with the accumulation phase,” the team says. “This situation, combined with higher mortality credits, makes deferred annuities more attractive.”
Having extra guaranteed income late in life can supplement Social Security and protect workers who end up facing cognitive decline, the team adds.
5. Is a hybrid arrangement really simpler?
The Vanguard team suggests that a hybrid arrangement seems easier for the workers than expecting the workers to buy, structure and update annuity arrangements.
But “all hybrid annuity TDFs still require some level of active engagement from participants, since decisions such as the amount and timing of an annuity purchase must be made,” the team warns. “This level of engagement could be difficult to obtain from participants defaulted into a hybrid TDF product.”
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