When 401(k) plans appeared in the 1980s, some Wall Street observers hailed the accounts as an innovative step in the evolution of capitalism: opening the capital markets to the small saver. Blue-collar workers could now buy and sell stocks and mutual funds in tax-favored accounts for their own retirements. While paternalistic companies once provided traditional pension plans, now the workers would control assets themselves. But within a decade, academic researchers spotted flaws in the 401(k) system. It turned out (surprise!) that many janitors, clerks and office workers didn't necessarily understand basic concepts of investing, much less the nuances of Modern Portfolio Theory or asset allocation. Even highly paid employees seemed unable to match the results of traditional pension plans.
That problem was brought into stark relief when in 2001, Enron employees intoxicated by the apparent success of their own company, lost $1 billion in their 401(k)s; plan sponsors began scrambling to find solutions to protect the employee from himself. One answer was to make 401(k)s more like traditional pensions. In the old-style defined-benefit plans, of course, a professional, dedicated staff makes the investment decisions, often with the help of outside consultants who help set asset-allocation targets and choose asset managers. Seeking to replicate that approach, many 401(k)s began offering “lifestyle” and “target date” funds: diversified portfolios that require little thinking on the part of plan participants because the asset allocation and individual asset-manager decisions would be made by professionals. But the lifestyle funds lack a key selling point of traditional pensions: guaranteed income for life.
Learning To Love Insurance Companies
Now, half-a-dozen insurers have introduced 401(k) plans that aim to deliver monthly checks. So far, the annuity-like programs are tiny, but assets under management are climbing. “The new accounts are going to grow,” predicts Robyn Credico, national director of Defined Contribution Consulting for Watson Wyatt. “Eventually annuity-type products could account for a significant percentage of 401(k) assets.”
To be sure, insurers have been marketing annuities to plan participants for years. Any retiree can take the assets from a 401(k) and purchase an immediate annuity, which provides lifetime income. But only 4 percent of 55-year-old retirees have purchased immediate annuities, according to a Department of Labor study. “Almost no one chooses to buy an annuity,” says Credico. “Plan participants fear that if they turn assets over to an insurance company, they will lose control of the money.”
The new 401(k) plans aim to make annuity-type products easier to use — and allow participants some control over their assets. Consider MetLife's offering, which is sold through Merrill Lynch 401(k) platforms. In a typical MetLife program, the participant can select from among half-a-dozen stock and bond funds. There is also an option called Personal Pension Builder, which provides lifetime income. The participant can put all (or some) of his assets into the guaranteed- income choice. With the program, a participant can know exactly how much he needs to contribute in order to receive a fixed monthly check. For instance, if a 45-year-old puts $100 a month into the annuity program, he could retire at 65 and receive $314 a month for life. If a plan participant changes his mind before retirement, he can take the cash value out of the annuity plan.
Several products come with death benefits. Say a participant dies while accumulating assets for The Hartford Lifetime Income plan. A beneficiary can elect to get back the principal that was invested, or the heir can choose to maintain the annuity and receive lifetime income.
The 401(k) programs offered by The Hartford and other insurers have a crucial advantage over immediate fixed annuities. With an immediate annuity, you make the purchase on a particular day. If interest rates are low at the time, you could be stuck with weak returns for life. But in the 401(k) plans, you make a series of small purchases over decades. The interest rates on the annuity products adjust constantly. “With the 401(k) plans, you are dollar-cost averaging into the annuity,” says Jody Strakosch, national director of Retirement and Savings at MetLife. “You are not saddled with the rate offered at a particular time.”
Prudential Income Flex, an annuity-like product, gives participants a wide variety of choices. To begin, the participant invests in one of five diversified funds that hold mixes of stocks and bonds. The investing styles range from conservative to aggressive. Say a participant enters the program at 50, and stocks soar. When he retires at 65, the account has $500,000 in it. The participant can take out the cash, or elect to receive a minimum of 5 percent of the assets — or $25,000 — annually for life. “We promise that even if you exhaust the assets, we will continue making payments for life,” says Mark Foley, vice president of Prudential Retirement.
Now suppose the Prudential client continues to be lucky after retirement. By the time he is 70, the nest egg has grown to $600,000. The client's annual payment adjusts to 5 percent of the portfolio, or $30,000. If the stock market collapses a year later, and the portfolio value drops to $400,000, the client will still receive his highest payout of $30,000. However, the protection from the insurance company is not free; Prudential charges an annual expense ratio of 0.95 percent. “Participants tell us that they are willing to pay the price in exchange for knowing that their savings are secure,” says Foley.
Barclays Global Investors aims to protect assets in a new annuity package called SponsorMatch. The program offers plan sponsors a diversified choice that could be used for matching employees' contributions. Under the Barclays' offering, a 24-year-old hypothetical employee earning $50,000 a year might be entitled to a 5 percent company match, or $2,500 deposited into the 401(k) account. About 5 percent of that matching contribution would go to purchase a deferred annuity that would pay the employee $9 a month for life starting at age 65. The other 95 percent of the matching contribution would go into indexed and actively managed funds. As the employee ages, the amount of the matching contribution earmarked for annuities would rise gradually to 53 percent at age 65; the rest of the match would go into the Barclays' funds. Assuming that the hypothetical employee receives average pay increases and historic market returns, he could retire at 65 with a monthly income of $3,700 from the annuities that were purchased over the years. In addition, the account would hold more than $800,000 invested in funds. Under that scenario, the retirement plan would deliver solid income, and the 401(k) plan would live up to its promise as a vehicle for providing security.
GUARANTEED FOR LIFE
The sooner a 401(k) participant starts saving, the more income he can expect at retirement. Here is an estimate of what participants could receive in the Hartford Lifetime Income annuity program.
|Age contributions begin
|Monthly income starting at age 65
|Employee rolls $100,000 lump sum into the 401(k) annuity
|Monthly income starting at age 65
|Source: The Hartford