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Target Date Funds and Auto-Annuitization

The stress over how to drawdown retirement funds is a very real dilemma. Spend too much too quickly, and you risk running out of money. On the other hand, hoarding the balance can result in living with a poorer quality of life than necessary. In a recent Market Watch article, author Alicia H. Munnell,  director of the Center for Retirement Research at Boston College, discusses this tricky situation as it pertains to the 401(k) system.

According to Munnell, there are three reasons why reluctance to spend retirement funds is a great threat than spending. For starters, people tend to form an unhealthy attachment to their assets which they have spent most of their life accumulating. Second, people are fearful of end-of-life health and long-term care expenses. And finally, many people want to leave a bequest to ensure their immortality. For these reasons, many hoarders live in self-imposed deprivation.

It was with these concerns in mind that the Department of Treasury collaborated with the Internal Revenue Service (IRS) and the Department of Labor (DOL) to issue guidance on how to incorporate auto-annuitization features into target-date funds (TDFs). This arrangement, established in 2014, allows participants (age 50 or older) to invest part of their assets in deferred annuity accounts. When the fund reaches the target date, participants receive an annuity certificate that provides for immediate or deferred annuity payments. The remaining portion of the participant’s investment would need to be reinvested, either by the participant or a plan fiduciary.

Issues of discrimination in favor of older, highly-compensated employees was addressed because the annuity purchase is age-contingent. The Treasury/IRS stated that if certain criteria were met, a series of TDFs that include deferred annuities in their assets would be treated as a single benefit, therefore not raising plan qualification concerns. Additionally, the Treasury asked for DOL views on these TDF/deferred annuity structures:

  • The DOL confirmed that the TDF series with the deferred annuity feature may qualify for the designation of Qualified Default Investment Alternative (QDIA).
  • The DOL said that the annuity selection safe harbor (2008 Safe Harbor) that is applicable to the defined contribution plans establishes a way for plan fiduciaries to satisfy responsibilities under the Employee Retirement Income Security Act of 1974 (ERISA) regarding annuity selection. According to the 2008 Safe Harbor guidance, fiduciaries must 1) conduct an objective, analytical, and thorough search; 2) assess the ability of the annuity provider to make benefit payments; 3) pay attention to fees; 4) conclude that the annuity provider can make future payments and that fees are reasonable; and 5) hire an expert to assess the above criteria.

These guideline, established in 2014, were formed to encourage plan sponsors to help employees manage their defined contribution plan accounts, like 401(k), so that their retirement savings last throughout their Golden Years. Unfortunately, 3 years later, few firms have adopted lifetime strategies in their target date funds, leaving Munnell and other industry experts, scratching their heads and wondering why.

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