United States: The Long Read - Lifetime Income Products in CITs on the Rise

As recently noted by the US Department of Labor (“DOL”), since the passage of the Employee Retirement Income Security Act of 1974 (“ERISA”), “the retirement plan landscape has changed significantly, with a shift from defined benefit plans (in which decisions regarding investment of plan assets are primarily made by professional asset managers) to defined contribution/individual account plans such as 401(k) plans (in which decisions regarding investment of plan assets are often made by plan participants themselves).”¹

Or, in the drama-infused words of Senator Bernie Sanders, “traditional pension plans have become an endangered species, on their way to extinction.”² 

Market Response to Shift to 401(k) Plans

The general shift in retirement assets from defined benefit to 401(k) plans, and the resulting transfer of investment and longevity risks from plan sponsors to participants and the control over retirement investing from professionals to participants, has caused significant concern among policy wonks, Congress, government agencies, organized labor, and employers regarding the ability of the average employee to generate sufficient assets while working (the “accumulation phase”) and to maintain a smooth stream of income throughout their remaining life after retirement (the “decumulation phase”). In particular, uncertainty regarding an individual’s longevity in retirement makes the decumulation phase a particularly challenging task for the average individual. Further, as reported by the Alliance for Lifetime Income, America is reaching an “historic surge” in individuals attaining age 65, with the number anticipated to reach 4.1 million per year through 2027: “A concerning trend is emerging as a significant portion of the ‘Peak 65’ generation lacks sufficient protected income, putting them at risk of outliving their savings.”

The market has responded over the years to the shift from defined benefit to 401(k) plans with the development of a variety of products designed to provide individuals with protected income for their remaining lives in retirement. Products include, among others: single premium immediate and deferred annuities, purchased at retirement with assets in a participant’s account balance; variable annuity products in which participant accounts balances are invested over time under the variable contract, with all or some portion annuitized at retirement; and guaranteed minimum withdrawal riders to insurance contracts that allow an individual to withdraw a percentage of a specified “base amount” each year until assets are exhausted at which point a fixed annuity for the balance of the individual’s life may become payable.

In some cases, products offering lifetime income are integrated into a managed account program pursuant to which a gradually increasing portion of a participant’s account is invested in a guaranteed product or portfolio of products. Increasingly, we are seeing the development by asset managers of collective investment trusts (“CITs”), often structured as target date funds (“TDFs”), which include embedded in-plan accumulation annuities and/or guaranteed minimum withdrawal features and are offered as investment options under 401(k) plans, frequently as qualified default investment alternatives (“QDIAs”). Oversimplifying somewhat, where a plan fiduciary has prudently selected an investment fund that qualifies as a QDIA under DOL regulations—and the investment of a participant’s account balance defaults to that fund, if the participant has not made an investment election—the plan fiduciary will not have exposure for losses associated with that investment.

CITs Overtaking the Market?

CITs with in-plan lifetime products, particularly guaranteed minimum withdrawal features, may overtake the market for multiple reasons:

1. TDFs are by far and away the most popular QDIA among plans, and while it has been reported that, as of early 2024, mutual fund TDFs hold slightly more assets than CIT TDFs, assets held by CIT TDFs have been increasing rapidly relative to their mutual fund analog. The upswing in CITs, relative to mutual funds, as the vehicle of choice for TDFs appears largely due to cost. For structural and regulatory reasons, they do not have boards of directors and are not subject to SEC filing requirements, and their target market consists of institutions rather than individual investors, resulting in lower marketing costs. With the explosion of excessive fee litigation relating to 401(k) investment options, plan fiduciaries have become increasingly sensitive to cost. Although mutual fund expense ratios have generally declined, CITs remain a bargain in many cases.
2. Guaranteed income options can be included in CITs as part of their target date strategy, and employers interested in exploring the provision of in-plan lifetime income products may view this as a “lower exposure” approach than causing the plan to contract directly with an insurance company. Because CITs are treated as holding ERISA plan assets, the entity managing the CIT is a discretionary investment manager subject to ERISA with the responsibility for choosing the insurers that provide the guaranteed income options within the TDF. The act of choosing an insurer is a fiduciary one. Many employers who are reluctant to cause their plans to enter into insurance contracts directly with insurers on account of the fiduciary exposure are more comfortable selecting a CIT TDF, with an investment manager responsible for choosing the insurers backing the lifetime income options offered by the TDF. While the choice of the TDF as an investment option is itself a fiduciary act, many plan fiduciaries are more comfortable with evaluating the fund and its manager than with evaluating different insurance carriers. In the Setting Every Community Up for Retirement Enhancement Act (“SECURE”) Act of 2019, Congress created a new fiduciary safe harbor for choosing an annuity provider of “in-plan” annuities, but plan sponsors may continue to prefer that the choice of insurers (and satisfaction of the conditions of the safe harbor) be performed by a TDF investment manager.
3. There has traditionally been significant employee resistance to traditional fixed annuities for many reasons, including loss of earnings growth on the assets used to pay the premium, irrevocability of the decision, loss of access to assets and inflexibility of pay-out (i.e., no partial withdrawals and no acceleration), and a possible shorter-than-expected lifespan with no assets remaining for heirs. Guaranteed minimum withdrawal products are intended to address these issues by allowing participants to enjoy (at least in some cases) earnings on their account, even during the decumulation phase, to access assets in their accounts, to de-select the guaranteed product by cashing out their accounts, and to leave any remaining assets to their heirs.

Gap in IRS and DOL Guidance

The IRS and DOL published guidance during the 2012-2014 period to ease some of the regulatory impediments faced by in-plan lifetime income products, including liberalization of the required minimum distribution rules for deferred annuities that meet certain requirements, guidance on the application of the qualified joint and survivor rules (“QJSAs”) to in-plan accumulation annuities, clarification that certain target date funds with vintages that include in-plan accumulation annuities and are restricted to participants over a certain age do not violate the nondiscrimination rules, and recognition by the DOL that a target date fund with a sleeve of in-plan accumulation annuities may constitute a QDIA under a 401(k) plan. Unfortunately, the published guidance did not address several aspects of these products, especially those of guaranteed minimum withdrawal products, and the gap in guidance has widened with the development of more, and more sophisticated, versions of these products.

As noted above, the SECURE Act created a new fiduciary safe harbor for choosing annuity providers, and in addition included provisions enhancing the portability of lifetime income products. Legislation adopted by Congress in 2022 (SECURE 2.0) further liberalized the minimum distribution rules as they apply to annuities offered under defined contribution plans, but neither of the Acts addressed a number of gaps in existing IRS and DOL guidance.

Given the importance of lifetime income products, it would make sense for the agencies to issue amplified guidance on these products. 

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1) 29 CFR 2510; 88 Fed Reg 75890, 75892 (Nov. 3, 2023)

2) Senate Committee on Health, Education, Labor and Pensions hearing on Feb. 28, 2024.