Benefits Products & Services

A measure of certainty

Prudential carries the standard for an in-plan annuity with a guarantee

By Thomas A. McCoy, CLU

What will defined contribution (DC) retirement plan participants and sponsors be looking for in their plans over the next few years? What products and features will address their long-term security needs in a meaningful way? Quite possibly the answers are not the same as they would have been prior to the financial crisis.

Prudential Retirement believes that the decline in value of so many retirement plans in 2008 and 2009 provides further validation for its in-plan variable annuity product with a Guaranteed Minimum Withdrawal Benefit (GMWB) feature. Prudential introduced the product, called IncomeFlex, about five years ago. It provides downside protection in falling markets, upside potential and, of course, the guaranteed minimum lifetime income.

Thus, notes a Prudential research report, the product addresses the "bear market risk," which slammed so many people cashing in their 401(k)s during the last couple of years; the "zero balance risk"—retirees running out of money in their lifetimes; as well as the "purchasing power risk" of eroding values linked to fixed income instruments.

The product is based on the idea that a retirement plan should provide a worker with more than the opportunity to get to retirement with a healthy DC plan balance—because at that point the individual confronts a new multitude of financial risks. The in-plan annuity with a guarantee is designed to get the individual through retirement.

Pru is one of a handful of companies offering such a product. Several have entered this market in the past two years, notes Srinivas D. Reddy, CFA, senior vice president, Institutional Income for Prudential Retirement.

For Pru and the others, sales of in-plan income solutions have been slowed by uncertainty over plan sponsors' perceived liability. How should these products be presented to participants? Could plan sponsors be considered to be providing investment advice? Last fall, at hearings before the Departments of Labor and Treasury, leading retirement plan providers made a strong case that regulators need to remove this uncertainty.

Reddy says that in February of this year, providers of in-plan solutions received an inquiry from the Senate Committee on Aging, asking for further details on their products. "It shows that there are other government agencies that are trying to learn what's out there," he says.

Prudential has been gradually educating plan sponsors and intermediaries on the benefit structure of the GMWB features, says Reddy. As a result, "During the last 18 months we've started to see adoption really take off. That's the first step of our journey. The second step is creating awareness with participants."

It takes time, he cautions, to build acceptance for an innovative product that deals with people's futures. "If you're a Google, you can test a product, make mistakes and it's not the end of the world. But in our business we're making promises for a very long time, so we want to make sure that the providers, the plan sponsors and the regulators are all thinking through the things that make sense."

One way Prudential is making its case for IncomeFlex is by integrating it with target date funds, a popular investment choice in DC plans. Reddy calls target date funds "a diversified investment vehicle that has gained significant popularity with plan participants."

However, he points out, "One of the lessons learned from the financial crisis is that when the markets don't perform well, even target 'A' funds don't perform well. That's okay if you have 20 or 25 years to go until retirement. The problem is that if you're five or 10 years away from retirement and are fully invested in target date funds, you can have consequences that were unintended."

Prudential has linked its own line-up of target date funds to IncomeFlex, calling the product IncomeFlex Target. As long as the GMWB is in place, the target date funds can do their investment work within the annuity product.

Reddy says that as Prudential watched its IncomeFlex experience evolve over the period of the financial crisis, it learned some important lessons about investor behavior in response to falling DC plan values.

"We initially thought we were on a marketing mission to create lifetime retirement income, which IncomeFlex absolutely does. But there's something else that seems to be a sideline benefit of having the guarantee. People with IncomeFlex seem to be making more rational decisions within their retirement plans than those without the guarantee," Reddy comments.

"When you look at the falling market we experienced in 2008 and 2009, 401(k) participants had a tendency to move some of their assets from equities to fixed income investments. Often they did it at the wrong time. For people who had the guarantees within their plan, we noticed that there was more stability in how they allocated their assets. They stayed the course. Just by having the guarantee in plan, having the peace of mind and the focus on the long run, it gave them the comfort and confidence to make the right decisions."

IncomeFlex is designed so that this kind of investment stability will continue after participants retire.

"In most target date funds, the allocation to equities goes down as you get older. But when you have a guarantee, we believe you can take higher equity exposure. So in our product you actually stay in a static 60% equity mix throughout retirement," says Reddy.

"The reason we do that is twofold. We believe that if you want to keep pace with inflation, you've got to be invested in the market. Second, since you have the floor of the guarantee protecting you, you don't have the same risk of running out of money that you would without it."

In evaluating the cost of this product for plan participants, it helps to remember that there isn't a financial advisor providing participant support, as there might be when one purchases a product outside the plan, says Reddy. "Plus, you have the purchasing power of the plan sponsor. An in-plan guaranteed withdrawal benefit in our design with target date funds, including investment management fees and the guarantee fees, will be about 1.59%.

"The alternative for most of these participants is that when they leave the plan, they roll over into a retail product. A retail mutual fund, even if the front-end load is waived, will charge about 1.41%. So if you think about having the guarantee versus no guarantee, the difference isn't significant."

Here's how the guarantee that is part of Prudential's IncomeFlex Target works for a plan participant, both during the individual's working career and on into retirement.

Participants invest in target date funds according to when they plan on retiring. Ten years before that target date, the guarantee "turns on." Reddy notes, "Until the guarantee is activated, you're only paying the asset management fee, which is 59 basis points."

The guarantee creates an "income base," set initially at the market value of the participant's assets. It can never be lower than this amount, plus any subsequent contributions from the participant. It also can increase as a result of investment gains.

After retiring, the participant will receive a guaranteed level of annual income for life, set at a percentage, such as 5%, of the income base at retirement. This income base can increase as a result of market performance, but it will never decline as long as withdrawals do not exceed the guaranteed minimum annual amounts.

A participant retains full control of the asset balances and is able to withdraw varying amounts of those assets, both before and after retirement. Any assets withdrawn before retirement, or those that exceed the guaranteed income after retirement, will lower the income base proportionately.  Upon death, the participant's remaining assets are available to the estate.

This is a product, says Reddy, that "allows you to take advantage of the upside while giving you protection on the downside. I like to think of it metaphorically as crossing a bridge. I hope I don't run into the guardrails on the side, but I'm glad the guardrails are there.

"When the market is going up, no one ever thinks about the guardrails," says Reddy. "It's unfortunate that you have to go through that kind of an experience to make it relevant."

With a large percentage of the workforce reaching retirement in the next 10 years, the need for innovative products has never been greater. In-plan solutions with guarantees may well be an attractive option.