Drinker Biddle & Reath LLP has created the Retirement Income Team to help our clients address what some are calling the post-retirement income crisis: the risk that today's retirees will outlive their retirement savings. The Retirement Income Team grew out of discussions with Fred Reish, with whom I have collaborated for many years on ERISA and securities law issues in the retirement marketplace, and the efforts of a number of our colleagues, particularly Bruce Ashton, Bruce Dunne and Dan Krane. Our goal was to bring together seasoned lawyers with diverse talents in multiple practice areas, including employee benefi ts, investment management, securities, insurance, income taxation and government relations, to provide one source to which fi nancial services companies and plan sponsors could look for help in resolving complex legal issues that impact the design and sales of retirement income products and their selection for use in defi ned contribution plans.

Our newsletters address legal issues faced by retirement industry service providers -- insurance companies, mutual funds, banks and trust companies, investment advisers, broker-dealers, third-party administrators and record-keepers – as well as by plan sponsors and fi duciaries. They also provide timely and valuable information regarding recent or expected regulatory developments and industry trends.

The Retirement Income Team can be most effective by focusing on the issues, developments and trends that impact you. Please let me or any other member of the Team know if there is a matter relating to retirement income products or services that is of particular interest to you or if you have any comment or question regarding the information in our newsletters or on our website.

For additional information about the Retirement Income Team and legal, regulatory and other issues affecting retirement income products and services, please visit our website at http://www.drinkerbiddle.com/services/practices/investment-management/retirement-income-team.

John Blouch
Chair, Retirement Income Team

SELECTING AN ANNUITY PROVIDER

By Bruce L. Ashton, Joseph C. Faucher and Joan M. Neri

Annuities may be the most obvious choice for providing lifetime income to participants in defined contribution plans (principally, 401(k) and 403(b) plans). If annuities are offered as a plan investment or distribution option, the fiduciaries responsible for selecting the annuity provider must satisfy the fiduciary provisions of ERISA. This means that the responsible fiduciaries must undertake the selection process under the prudent process requirements of ERISA.

In 2008, in response to a requirement in the Pension Protection Act, the DOL issued a regulation designed to establish "a safe harbor for satisfying the fiduciary duties under the prudent man rule of ERISA in selecting an annuity provider and annuity contract for benefit distributions from an individual account plan."1

In understanding the scope of this safe harbor, it is important to appreciate its limitations:

  • First, it does not establish the only means by which fiduciaries may satisfy their fiduciary obligations in selecting an annuity provider. Rather, it sets out an optional means of satisfying this obligation.2
  • Second, it does not establish a "standard of care" or even minimum standards but rather provides a guide to fiduciary "best practices" in selecting an annuity provider. This is true because the regulation indicates that fiduciaries may satisfy their obligations other than by following the regulation. Since "safe harbors" ordinarily are viewed as creating a higher standard than what the law requires, the regulation exceeds the "baseline" of what ERISA imposes on fiduciaries in meeting their obligations under the prudent man rule.
  • Third, the regulation does not provide a "bright line" test that can be followed to meet the safe harbor. Instead, it outlines a process, a series of steps for fiduciaries to follow that are essentially those required for any fiduciary decision.

To avail themselves of the "safe harbor," fiduciaries need to take the following five steps3:

  1. Engage in an objective, thorough and analytical search for the purpose of identifying and selecting providers from which to purchase annuities.
  2. Appropriately consider information to assess the ability of the annuity provider to make all future payments under the annuity contract.
  3. Appropriately consider the cost (including fees and commissions) of the annuity contract in relation to the benefits and administrative services to be provided under the contract.
  4. Appropriately conclude that, at the time of the selection, the annuity provider is financially able to make all future payments under the annuity contract and the cost of the annuity contract is reasonable in relation to the benefits and services to be provided under the contract.
  5. If necessary, consult with an appropriate expert or experts in connection with their consideration and conclusions.

While these guidelines are helpful, they are devoid of details. With one exception, the regulation does not indicate what information to consider (step 2) or how to evaluate whether that information shows that the provider will be able to make all future payments. The exception, found in the preamble to the regulation, is that fiduciaries are told to look at negative information in rating agency reports. The absence of a clearer roadmap makes it especially difficult for the fiduciaries of small and mid-sized plans to engage in this analysis, which could have a deterrent effect on offering annuities in the large majority of plans.

Earlier this year, Fred Reish, Bruce Ashton and Joe Faucher wrote a white paper on the fiduciary issues related to the selection of annuity providers. In the paper, they provided a checklist of information that we believe a plan fiduciary should consider in order to satisfy the requirement to "appropriately consider information to assess the ability of the annuity provider to make all future payments under the annuity contract." To review the White Paper, go to http://www.drinkerbiddle.com/resources/publications/2012/Lifetime-Income-in-Defined-Contribution-Plans. 4

MUTUAL FUNDS AND LIFETIME INCOME GUARANTEES

By Bruce W. Dunne

Mutual funds have long served as principal investment options for defined contribution plans. Those plans traditionally focused on accumulating retirement savings for plan participants. Today, there is growing recognition of the need for products that will help transform those savings into a secure stream of lifetime income after retirement.

A mutual fund may seek to address longevity concerns by itself. For example:

  • balanced funds, by investing in a mix of equity and fixed income securities, aim to provide both income and ongoing participation in market growth as well as a measure of protection against market fluctuations;
  • target date funds, by shifting to a more conservative asset mix as a target retirement date approaches, seek to accumulate and preserve retirement assets up to, and in some cases, through retirement; and
  • managed payout funds seek to manage fund assets to provide specified withdrawal amounts for a fixed period or indefinitely.

These efforts, however, cannot lead to a guarantee of lifetime income payments or, for that matter, to a guarantee of any payment. A fund that sought to provide such a guarantee would find itself in unchartered regulatory territory. It could face questions under various provisions of the Investment Company Act of 1940 ("1940 Act"), including those relating to valuation and senior securities. An arrangement that sought to provide guaranteed payments for life could also subject the fund – and its distribution network – to regulation under state insurance laws. Moreover, as a practical matter, a fund by itself cannot provide a guarantee of payments because it cannot guarantee that fund assets will not be exhausted by withdrawals or negative investment performance.

There are two ways in which a fund may participate in an arrangement that provides a guarantee which the fund cannot provide itself. It may obtain the guarantee of a third party, or it may be offered in association with an insurance product that provides the guarantee.

Third-Party Guarantees

A third-party guarantee may run to the fund itself or to the shareholders of the fund. It would typically guarantee a minimum net asset value for fund shares, not lifetime income distributions. A guarantee may raise issues under state insurance laws, the federal securities laws and the Employee Retirement Income Security Act of 1974 ("ERISA").

Under some state laws, for example, a guarantee may be deemed to be a form of financial guarantee insurance that may only be issued by certain specialized (non-life) insurance companies.

Under the federal securities laws, a guarantee generally will not be deemed to be a security if it runs to the fund itself but will be deemed to be a security if it runs to the shareholders of the fund (because the guarantee of a security is itself a security). A guarantee that is a security must be registered under the Securities Act of 1933 ("1933 Act"), and that registration may subject the third-party guarantor to the periodic reporting requirements of the Securities Exchange Act of 1934 ("1934 Act").

A guarantee issued by an affiliated person of the fund may raise questions under Sections 17(a) and (d) of the 1940 Act, which prohibit certain affiliated transactions, may require exemptive relief from those provisions from the Securities and Exchange Commission5 and may implicate the prohibited transaction provisions of ERISA.

Combined Mutual Fund and Insurance Products

Instead of being offered with a third-party guarantee of net asset value, a fund may be offered in combination with an insurance product, with the insurance product providing a guarantee of lifetime income.

Traditional Insurance Products. Annuity contracts can provide guaranteed income payments for a fixed period or for life. They have been offered as group contracts to fund benefits under defined contribution plans and as individual contracts in the retirement plan rollover as well as retail markets.

Fixed annuities are general account obligations of the issuing insurance company, and variable annuities are obligations of insurance company separate accounts which typically invest in underlying mutual funds.

Generally, variable annuities, but not fixed annuities, are considered securities and must be registered under the 1933 Act, and the separate accounts that fund them must be registered under the 1940 Act, unless they are issued to fund retirement plans qualified under Section 401 of the Internal Revenue Code ("IRC") ("Qualified Plans") or pursuant to some other exemption. Persons who sell annuity contracts must be licensed insurance agents, and if the contracts are securities, broker-dealer registered representatives.

Although traditional annuity contracts can provide guaranteed lifetime income payments, the commencement of those payments typically requires the beneficiary to give up future access to account value, and their continuation depends on the long-term financial strength of the insurance company issuing the contract. Concern with these aspects of annuity contracts may be reduced when funds and annuity contracts are offered in combination.

Longevity Insurance. Funds have been offered in combination with longevity insurance in order to provide lifetime income payments.6 Longevity insurance is an "advanced-life" deferred fixed annuity that provides guaranteed lifetime income payments that commence at a late age, typically 80 or 85. It is intended to provide assurance of continuing income if the contract beneficiary outlives other resources. Typically, at the time of retirement, a small portion of retirement assets is used as a single premium to purchase the longevity insurance, with the balance remaining invested in mutual funds to provide income payments prior to the annuity commencement date, protection against inflation and continuing access to fund account values.

The use of combined mutual fund and longevity insurance products in defined contribution plans has been inhibited by required minimum distribution ("RMD") rules providing that contract beneficiaries must begin account withdrawals by age 70 ½. However, as described in Josh Waldbeser's article in this newsletter, the Treasury Department in February 2012 released proposed regulations and Internal Revenue Service ("IRS") revenue rulings intended to facilitate and encourage the in-plan use of longevity insurance by providing special relief from RMD rules.7

Guaranteed Lifetime Withdrawal Benefits ("GLWBs"). To address in part the concern over lack of access to account values, insurance companies developed GLWBs.

A GLWB provides a contract beneficiary with continued access to the account (cash) value under the contract while receiving periodic payments for life equal to a specified percentage of a benefit base. The benefit base differs from the account value, which continues to be subject to both positive and negative investment performance. The benefit base may be increased by positive investment performance, but it is not reduced by negative investment performance. Withdrawals reduce the account value but do not reduce the benefit base (and payments made under the contract) unless they exceed the limits set forth in the contract. The insurance company continues to make payments based on the benefit base even if the account value is reduced to zero. Any account balance remaining at death is available to the contract beneficiary's heirs.

Insurance companies initially offered GLWBs only as riders to individual and group annuity contracts which meant that the benefits of the GLWB could not be obtained without purchasing an annuity contract and limiting investments to the options available under the contract. Recently, insurance companies have been developing contingent annuities, or "stand-alone GLWBs," which can provide greater flexibility for combined offerings of the guaranteed lifetime income they provide with a wider range of mutual funds.

Contingent Annuities. The principal difference between a contingent annuity and a GLWB is that the investments which support periodic income payments under the contingent annuity are owned by the contract beneficiary rather than the insurance company and are held in a separate investment account that is not managed by the insurance company issuing the annuity. Investment account balances remain accessible by the contract beneficiary and heirs. The benefits under a contingent annuity are conditioned on the investments in and the withdrawals from the investment account adhering to standards established by the insurance company. If the conditions are met, and if the assets in the account are exhausted through permitted withdrawals or negative investment performance, the insurance company begins making the payments specified in the contingent annuity and continues them for the life of the contract beneficiary.

Contingent annuities may be offered in arrangements that condition benefits on investment in one or more specified mutual funds or kinds of mutual funds. Under one arrangement, plan participants begin at midlife to invest in target date funds which gradually invest, and at retirement age are fully invested, in a stand-alone GLWB, and the lifetime income guarantees are provided by multiple insurers to mitigate the risk of dependence on the claims-paying ability of a single insurer.8

Contingent annuities that are offered outside the Qualified Plan context have been registered under the 1933 Act on Form S-1 or Form S-3. Registration subjects the insurance company to 1934 Act reporting requirements unless an exemption from these requirements is available pursuant to 1934 Act Rule 12h-7. For federal income tax purposes, the IRS has determined that contingent annuities qualify as "annuities" under the IRC. A number of regulatory issues continue to exist under state insurance laws. As Daniel Krane and James McMeen discuss in their article in this newsletter, a subgroup of the National Association of Insurance Commissioners has been considering these issues and recently recommended that contingent annuities be treated as life insurance rather than financial guarantee insurance for regulatory purposes. Contingent annuity offerings generally will be subject to the regulatory provisions governing the distribution of securities and insurance products.

Conclusion

Mutual funds have responded creatively to retirement income needs by joining with insurance companies to develop offerings of investment and insurance products that together can both enhance and guarantee the lifetime income available to retirees. These efforts require careful attention to multiple regulatory schemes, including the federal securities laws, FINRA regulations, ERISA, federal tax laws and state insurance laws, not only as they affect mutual fund and insurance company providers, but also investment advisers that manage fund and plan assets, broker-dealers and insurance agents that distribute the products, and plan sponsors and participants who use them.

USE OF LONGEVITY ANNUITY CONTRACTS IN DEFINED CONTRIBUTION PLANS

By Joshua J. Waldbeser

On February 3, 2012, the IRS issued a proposed regulation9 that would encourage the use of longevity annuity contracts under 401(k), 403(b), and other defined contribution retirement plans, as well as governmental 457(b) plans. The regulation would exempt certain such contracts from requirements of the Internal Revenue Code (the "Code") that might otherwise prevent them from operating as intended.10 The regulation is one of several recent IRS pronouncements that are designed to help retirees deal with the risk of running out of money by facilitating their use of products that pay lifetime income benefits.

Longevity annuity contracts pay retirees a lifelong stream of income commencing at an advanced age, if the retiree lives to that age. Accordingly, they are a potentially valuable tool to help retirees protect themselves against the risk of exhausting their retirement savings while still alive.

Absent the relief proposed in the regulation, the use of using longevity annuity contracts in tax-advantaged retirement plans may create a problem under the "required minimum distribution" ("RMD") rules in Code Section 401(a)(9). These rules require retirees to receive their plan benefits in installments after reaching the age of 70 ½, and the value of an annuity must be taken into account in determining the amount of RMD payments. As a participant makes withdrawals from his or her plan account in retirement, and depending on how much of the account value is attributable to the annuity contract, these rules could require contract distributions to commence earlier than the intended advanced age, thus defeating the purpose of the contract.

The regulation would provide relief by allowing longevity annuity contracts that meet certain requirements, referred to as "qualifying longevity annuity contracts" or "QLACs," to be excluded in determining the amount of a retiree's RMD payments prior to the commencement of annuity payments.11 QLACs eligible for this relief would be limited to non-variable contracts that satisfy certain reporting and disclosure obligations and certain other requirements, including that:

  • Benefits must commence no later than the retiree's attaining age 85;
  • No cash surrender value or similar feature may be included;
  • After the retiree's death, no benefit other than a life annuity to a designated beneficiary may be provided;
  • The total premiums paid for the contract cannot exceed the lesser of (i) $100,000 or (ii) 25% of the participant's plan account balance on the date of the payment. On and after January 1, 2014, the $100,000 figure could be increased by cost-of-living ("COLA") adjustments in $25,000 increments.

Industry response to the proposed relief has been very positive. However, there have been a number of public comments raising concerns about specific requirements.

Many of the comments relate to the premium limits. As drafted, the regulation provides that a contract fails to be a QLAC if and at the time those limits are exceeded. This would cause a QLAC to lose its favorable RMD treatment if, for example, the premiums paid exceeded 25% of the participant's account balance due to a decrease in the account value between the time the contract is applied and paid for, or because of other account withdrawals where the contract is paid for in installments over time. Some commentators have suggested that the IRS provide a de minimus exception or other flexibility that would apply in such a circumstance, or "disqualify" a contract as a QLAC only with respect to the excess premium. Another commentator has suggested that the percentage limitation be increased to 35% or 40% percent to enable retirees with account balances of less than $400,000 to take advantage of the full $100,000 limitation, and that the dollar limitation should be increased to $150,000 or $200,000.

It has also been suggested that the COLA adjustment increments be decreased from $25,000 to a lower figure that would permit more frequent adjustments.

Commentators have also suggested that certain prohibitions in the regulation should be removed to encourage QLAC use. One commentator noted that the current low interest rate environment may discourage their purchase, and that permitting some use of variable contracts might be beneficial. Others have pointed out that the prohibition on including a cash surrender feature could discourage their use and that a "refund of premium" or similar feature would help address retiree concerns over becoming "locked in."

We anticipate that the IRS will review these comments and perhaps make adjustments in response. In any event, we believe that a final regulation will be issued in the next six months or so and, as proposed, would generally apply to contracts purchased after the date of the final regulation and with respect to RMDs for years commencing on and after January 1, 2013. Upon issuance of the final regulation, defined contribution plan sponsors and participants will then determine whether use of QLACs is appropriate in their plans.

CONTINGENT DEFERRED ANNUITIES: NAIC UPDATE

By Daniel W. Krane and James C. McMeen

This update provides a brief overview of recent activities of the National Association of Insurance Commissioners ("NAIC") in connection with the issuance and regulation of contingent deferred annuities ("CDAs").

A CDA is a type of annuity contract that provides guaranteed lifetime income payments if the assets in an investment account are exhausted during the life of the contract holder through allowable withdrawals and/or poor investment performance. The investment account contains the covered assets (often mutual funds or assets in a managed account). These assets typically are not owned by the insurance company that issues the contract and remain under the control of the contract holder.

A CDA in many ways resembles a traditional annuity with a guaranteed lifetime withdrawal benefit ("GLWB") rider, which typically guarantees a minimum income or withdrawal amount for the life of the annuity contract holder. With a traditional annuity, however, the insurer holds and controls the underlying assets, whereas with a CDA a third party typically holds the underlying assets.

CDAs are currently subject to regulatory oversight by state insurance regulators, and in many cases the Securities and Exchange Commission and the Financial Industry Regulatory Authority. In 2011, the NAIC established the Contingent Deferred Annuity (CDA) Subgroup to review issues concerning CDAs. On February 22, 2012, a majority of the Subgroup concluded that CDAs resemble and raise the same regulatory issues as GLWBs and are best written as annuities though life companies, and not as financial guarantee insurance written through property and casualty companies. The Subgroup recommended the formation of a new working group to evaluate the solvency and consumer protections appropriate for CDAs. On March 4, 2012, the NAIC established the Contingent Deferred Annuity Working Group as part of the Life Insurance and Annuities (A) Committee.

In recent months, the Working Group has held several meetings and conference calls to discuss the regulation of CDAs. At a June 27, 2012 meeting, the Working Group heard comments from a number of regulators and industry and trade groups. Among other comments:

  • a representative of the Actuarial Resources Corporation observed that CDAs would require insurers to maintain strong, comprehensive risk-management practices, with complementary regulatory oversight, and that current NAIC model laws for reserves and risk-based capital were appropriate for regulating CDAs;
  • regulators expressed a common concern that poor market performance could result in a large number of CDA benefits being triggered at the same time; and
  • representatives from industry and trade groups observed that insurers must properly reserve for risks inherent in CDAs, and that the existing regulatory framework, including enterprise risk management principles, was appropriate and sufficient for regulating CDAs.

In addition, a representative from the Government Accountability Office explained that it had commenced a study of the regulatory structures applicable to CDAs and other lifetime retirement income products and planned to release a report in the fall of 2012.

The Working Group heard further comments from consumer and industry representatives as well as the Department of Labor on August 11, 2012 and on August 29, 2012, discussed, among other matters, the application to CDAs of the NAIC Standard Nonforfeiture Law for Individual Deferred Annuities. The Working Group will meet again during the NAIC Winter Meeting in Washington, D.C.

Footnotes

1 29 C.F.R. §2550.404a-4

2 29 C.F.R. §2550.404a-4(a)(2).

3 29 C.F.R. §2550.404a-4(b).

4 In recent testimony before the DOL's Advisory Council on Employee Welfare and Pension Benefit Plans, industry representatives have suggested – and sought clarification -- that the safe harbor with respect to assessing the long-term financial strength of annuity providers, a particular concern for plan fiduciaries, should be deemed satisfied if an insurer meets stringent state insurance licensing and solvency requirements. See Elizabeth Festa, "DOL Safe Harbor Clarification for Lifetime Guarantees Sought by NAIC, Life Insurers," LifeHeathPro (Sep. 7, 2012), available at http://www.lifehealthpro.com/2012/09/07/dol-safe-harbor-clarification-for-lifetime-guarant.

5 See, e.g., Merrill Lynch Principal Protected Trust, et al., 1940 Act Release Nos. 26164 (Aug. 30, 2003) (Notice) and 26180 (Sep. 16, 2003) (Order). Conditions to the grant of exemptive relief included a competitive bidding process to obtain the guarantee and fund board approval and oversight of the guarantee arrangement.

6 For example, Pimco and MetLife have begun co-marketing Pimco income funds with MetLife longevity insurance. See Mariana Lemann, "Pimco, MetLife Join Forces on Retirement Income Push," Ignites (Mar. 2, 2011); and MetLife, "Longevity Income Guarantee – A 'Safety Net' of Lifetime Income for Later in Life" (2011), available at https://www.metlife.com/assets/investments/products/annuities/Longevity-income-guarantee.pdf.

7 Dep't of the Treasury, Internal Revenue Service, "Longevity Annuity Contracts," 77 FR 5443 (Feb. 3, 2012).

8 See AllianceBernstein, "Secure Retirement Strategies – SRS – Lifetime Income" (2011), available at https://www.alliancebernstein.com/abcom/Opportunity/SRS/Content/AB_SRS_Brochure.pdf.

9 77 FR 5443 (Feb. 3, 2012).

10 The regulation also applies to IRA accounts.

11 Contract payments have to satisfy the RMD rules after payments commence.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.