Offering 403(b) Participants Secure Retirement Income Through an Innovative Solution: New Model Portfolios that Operate like Target Date Funds and Allocate into Fixed Annuities As of April 2019
A common defined contribution (DC) question asked at conferences and in articles is: how can a plan sponsor offer the best elements of a defined benefit (DB) plan within a DC plan? The heart of the question is trying to understand how an organization can continue to fund a DC plan while still offering some form of secure retirement income as the DB plan was intended to provide. Combining these plan attributes also limits the exposure of a corporation’s balance sheet to the volatile nature of employee retirement benefit liability.
- Offer Participants Secure Retirement Income
- Limit a University’s Balance Sheet Exposure to Employee Retirement Benefit Liability
History of the 403(b)
Due to the restricted options for investment vehicles, the industry often views a 403(b)—the defined contribution (DC) plan offered to universities and non-profit hospitals—as outdated.
- 1958–1974: Annuities were the only investment vehicle available within 403(b) plans.
- 1974: An amendment to the Employee Retirement Income Security Act allowed for the creation of 403(b)(7) custodial accounts that permits investment in mutual funds.
- Today, annuities and mutual funds are still the only two investment vehicles available to 403(b) plans.
- Only 1 in 3 workers will have saved enough to retire comfortably by age 67. 1
- 80% want some form of guaranteed income in retirement. 1
- 3 out of 5 worry about running out of money in retirement. 2
- Over 2 out of 3 trust their employer is genuinely trying to help optimize their savings to enjoy a comfortable retirement. 2
Growing Interest Fuels Current Regulatory Efforts
As a DC industry, the focus on retirement income within DC plans is on the rise again. But this time it feels different as we are seeing regulatory efforts evolving to support plan sponsors.
- April 2, 2019, the House Ways & Means Committee unanimously passes H.R. 1994, the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019, legislation that expands opportunities for Americans to increase their retirement savings, provides a more clear safe harbor for selecting a lifetime income provider in DC plans, and improves the portability of lifetime income options from one plan to another.
- March 8, 2018, the 115th Congress proposed a Senate bill S.2526—Retirement Enhancement and Savings Act of 2018 (RESA) containing language that further helps plan sponsors select a lifetime income provider.
- Aon believes sponsors already have safe harbor guidance for selecting an annuity provider in DC plans from the Department of Labors (DOL) Field Assistance Bulletin No. 2015-02.
While this trend is encouraging, keep in mind that the majority of 403(b) plans have been selecting annuity providers since 1958 and already have a retirement income option available.
Increased Assets in Default Plans
Aon believes there is a solution where plan sponsors can offer the best elements of a defined benefit (DB) plan within a DC plan. The key to success is to build that solution with retirement income as the plan’s default.
As we watch the impact of the Pension Protection Act of 2006 (PPA) on DC plan defaults, we are seeing more than 80% of all new dollars being contributed to the plan default.
We also observe that target date funds, the most common default, have grown from 1% of plan assets in 2005 to over 33% of plan assets at the end of 2017.1
The increased usage of target date funds has also pushed down the average number of funds held by a participant from 3.5 to 2.5 over the same period.2
Innovation in Model Portfolios: Operating Like Target Date Funds While Allocating to Fixed Annuities
We are challenging the perception that 403(b) plan regulations stifle innovation by leveraging the 403(b) plan’s limited investment vehicle choice and focusing solely on solving the secure retirement income problem.
Aon believes the answer is to use existing recordkeeping technology to build new model portfolios that operate like a target date fund and allocate into secure income for retirement. Using model portfolio technology, we can develop an investment solution that brings together the best aspects of current DC and DB plan designs.
The Use of an Insurance Company as Guarantor
If a DC plan offers an investment solution that includes some form of secure income, then a participant can annuitize some or all of that investment, creating a stream of retirement income. That stream of retirement income activated by the participant, and just like a DB plan, is backed-stopped by a guarantor. The difference with this investment solution is that the guarantor is a prudently selected insurance company within the DC plan and not the balance sheet of the corporation sponsoring the DB plan.
Target Date Solution with Secure Income
A custom target date solution that incorporates secure income can replicate the asset allocation of an off-the-shelf target date fund. This can allow participants to experience similar return patterns during their working years, replicating an off-the-shelf asset allocation. The added benefit for this custom solution is realized in retirement.
Modeling the Benefits
As shown in the following exhibit, we stochastically modeled two participants who are entering retirement on the same day with similar accumulated wealth. What we observe from our models is the participant who has a solution with secure income can choose to annuitize some or all of their investment in the fixed annuity. Then they are projected to increase their average expected retirement income adequacy incrementally and lower downside risk.
- Asset allocation policies shown are based on a moderate risk custom target date solution glide path with 40% return-seeking assets at retirement
- The only difference in asset allocation policy is that the participant represented by the yellow diamond’s risk-reducing asset allocation is implemented with passive U.S. core fixed income instead of the fixed annuity fund.
University 403(b) Case Study
In 2018, Aon helped a client design a custom target date fund with secure income that was funded in 2019 with over $2.7 billion. This solution at its core will allow participants to grow their retirement savings through payroll contributions and the capital markets while building up secure retirement income through a fixed annuity.
The glide path with the fixed annuity fund increases both expected, and downside, income adequacy over the baseline glide path with passive U.S. core fixed income, even if the fixed annuity fund is not converted to a life annuity.
The asset allocation policies shown are based on a moderate risk custom target date solution glide path with 40% return-seeking at retirement. The only difference in asset allocation policy is that yellow diamond’s risk-reducing asset allocation is implemented with passive U.S. core fixed income (nonsecured income) instead of the fixed annuity fund (secured income). The teal circles leading up to the square invests in the fixed annuity fund as its risk-reducing asset allocation. We then vary the teal circles by the amount of that fixed annuity allocation that a participant is assumed to have converted to a life annuity at retirement.
We have come full circle — the annuity that was once old in 403(b) plans is now new again. We believe that 403(b) plans have the building blocks in their DNA to lead the innovation curve to accomplish the long-desired goal to integrate the best attributes of a DC and DB plan into a single solution.
We’re here to empower results.
To learn more about Aon’s thought leadership for DC solutions, visit https://aon.io/DC.
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