United States: Retirement Income Team Newsletter - October 2013

This newsletter is published by the Drinker Biddle Retirement Income Team - a group of attorneys whose combined focus is on retirement income investments and products - but whose individual specialties include employee benefits, securities law, investment management, insurance, income taxation and government relations.

The purpose of the newsletter is to inform our clients and friends about issues of interest to the investment managers and insurance companies that create retirement income vehicles, people in their organizations who deal with the compliance issues, advisers and consultants who assist in the distribution of those products and services, and retirement plan sponsors who evaluate and select them.

With the aging of the baby boomers and the ongoing retirement of the first generation of 401(k) participants, the issue of retirement income is gaining in importance. The question is: how will the average retiree invest and withdraw his or her money in a way that it lasts for a lifetime (and the lifetime of the retiree's spouse), regardless of whether that is 10, 20, 30 or more years? That is a complex and difficult task.

Because of these issues, we believe there is a need to focus on the laws and compliance issues of importance to retirement income products and services. That is the work of our Retirement Income Team. Because of our combined expertise, we are able to address those issues arising under insurance and securities laws, as well as those under ERISA that govern the use of those products and services in 401(k) and other defined contribution retirement plans. It is a unique combination that we believe offers value to our clients.

Before ending this introduction, I want to thank John Blouch for his leadership of our Team since its inception. John is an outstanding attorney and a good friend. But, at this stage of life, he has decided to become the object of our focus... that is, John has become a retiree. John, we will miss you.

Fred Reish
Chair, Retirement Income Team


By Fred Reish, Bruce L. Ashton and Joshua J. Waldbeser

In our last newsletter, we wrote about the DOL's Advance Notice of Proposed Rule Making (ANPRM) concerning the projection of retirement income on ERISA participant benefit statements. Since that article was published, a number of plan sponsor and service provider organizations have filed their comments with the DOL, and the comment period has now expired. This article contains a general summary of the comments and our view of the next steps.

The DOL will now begin its review of the comments filed by the private sector. Many of the comments were thoughtful and detailed... which will give meaningful input to the regulatory process. Different comments filed by a number of knowledgeable and credible organizations supported almost all of the alternative approaches suggested by the DOL, meaning that the comments often conflicted with each other. Also, many of the organizations noted significant disagreement on key issues even within their own membership. As a result, the DOL should find some level of support (and some level of dissent) for virtually any avenue that it decides to pursue. Examples of the alternatives discussed include whether the projections should be made mandatory or merely voluntary with a fiduciary safe harbor to encourage their use, and even whether the project should be abandoned entirely in favor of online calculators for plan participants.

Realistically though, we suspect that the DOL will, after reviewing the comments, draft a proposed regulation that mandates retirement income projections on participant benefit statements. While some employer organizations and service provider organizations argued against the mandate, organizations that represent employees, participants and retirees were nearly unanimous in arguing that mandated projections would provide value to plan participants.

Allowing for a reasonable period of time to review the comments and draft a proposed regulation, it is possible that a regulatory package could be sent to the Office of Management and Budget (OMB) in mid-first quarter 2014. It ordinarily takes the OMB three months for its review, which suggests that the proposed regulation would not be publicly available for comment until well into the second quarter. That would then be followed by a comment period and perhaps public hearings. Allowing time for that, together with the development of the final regulation and its review by the OMB, would add another seven to nine months to the process.

So, our "best guess" is that we could have a final regulation in the second quarter of 2015, but with a deferred effective date to allow time for system changes and other necessary implementation steps.

Once again, the DOL received comments from knowledgeable and credible organizations that would support almost any outcome. That said, based on our reading of the comments, we think that the following are "high possibility" outcomes:

  • The projection of retirement income on benefit statements will be mandated.
  • There will be a safe harbor... of sorts. Many of the commenters responded unfavorably to the safe harbors in the ANPRM, which consisted largely of fixed assumptions. These commenters suggested that fixed percentages are too rigid and would inhibit innovation and efforts to improve the quality of projections by adjusting assumptions over time to reflect "real life" shifts in the interest rate and capital markets. Instead, they recommended that the DOL provide retirement income projection guidelines similar to the investment education guidelines in Interpretive Bulletin 96-1. At a high level, this approach would ensure that plan sponsors could avoid having their projections deemed to be fiduciary "investment advice" (and avoid corresponding potential liability) so long as they are based on reasonable assumptions and do not steer plan participants toward specific investment products. We believe there is a significant possibility that the DOL will adopt this approach in developing the proposed regulation.
  • Most of the commenters suggested that plan sponsors should be able to select from among a variety of methods for projecting the payment of retirement income. For example, some of the commenters favor the withdrawal method, rather than the annuity method. Others prefer the annuity method, but with the calculations based on commonly accepted actuarial assumptions, rather than the specific annuity contracts offered by each particular plan. We believe that there is a significant possibility that the DOL will adopt the latter alternative.

Those are our thoughts. At best, it is a guessing game. So, we encourage readers to view this as our attempt to "handicap" the odds rather than make specific predictions.


By Diana E. McCarthy and David L. Williams

Managed payout funds are mutual funds designed to provide a steady stream of retirement income while still allowing retirees access to their money during their lifetime. Managed payout funds are of relatively recent vintage (2008). The launch of these products coincided with the economic downturn, which adversely affected their popularity and growth for a time. As the economy has rallied, however, managed payout funds are gaining more assets. Managed payout funds make periodic distributions at a specified annual or monthly rate, but because they are mutual funds and not insurance products, they cannot offer a guarantee that payments will continue for a specified period or the life of the retiree.

Managed Payout Funds vs. Annuity-Like Products

Managed payout funds are often compared to annuity products or annuity-like products such as guaranteed minimum withdrawal benefits (GMWBs). There are key differences, however. In particular, annuity participants generally relinquish their retirement account (and access to its value during life) in return for guaranteed payments. A GMWB is an insurance product, owned by the investor, that provides guaranteed income for a retiree's life as long as the retiree does not withdraw more than a specified percentage from the fund each year; if the retiree opts for larger withdrawals, the lifetime income guarantee is forfeited. Managed payout funds allow investors to withdraw more than the payout (or their entire investment) at any time, but this liquidity benefit is offset by the loss of the anticipated payout. While managed payout funds seek to provide steady income to investors, such payouts will generally rise and fall depending on market conditions. It is possible for a managed payout fund to suffer substantial investment losses and simultaneously experience additional asset reductions as a result of distributions to shareholders. Thus, managed payout funds are a useful investment tool when combined with more certain sources of retirement income. For example, it may be prudent for a retiree to buy an annuity or GMWB to cover fixed costs and invest in a managed payout fund for discretionary spending that can be scaled back if the fund underperforms.

Types of Managed Payout Funds

Managed payout funds generally fall into two categories: those that pay out indefinitely and those that pay out for a set term and then liquidate (i.e., reverse target date funds). A principal difference between these types of funds is that the income for the indefinite payout funds will tend to vary more than the reverse target date type funds.

Indefinite Payout Funds. Indefinite payout funds function as you would expect. They are designed to pay out monthly income for an indefinite period of time. Schwab Funds and Vanguard Funds typify this type of funds.

Schwab offers three types of monthly payout funds: moderate payout, enhanced payout and maximum payout. Each fund type has the same investment objective: to seek to provide current income and, as a secondary investment objective, capital appreciation. Each fund is also a fund of funds, meaning that its principal investment strategy is to invest in other Schwab funds, which are a mixture of equity, fixed income and money market funds. The main difference among the three funds is the target asset allocation used to achieve the investment objective suggested by the name of each fund. The funds' principal risks are linked to those of the underlying funds and the adviser's ability to manage the fund to produce the monthly payout goal. The Schwab maximum payout fund aims to provide monthly income in the ranges of 1-5% in a low interest environment and 5-8% in a high interest rate environment. The other two funds aim for progressively lower percentages.

Vanguard also offers three different managed payout funds. Their investment objectives are to make monthly distributions of cash while seeking to provide inflation protection and capital appreciation. Vanguard's managed payout funds operate similarly to that of the three Schwab funds in that they have different asset allocation strategies geared to their distribution goals. They, too, are funds of funds, and their principal risks are similar to that of the Schwab managed payout funds. The monthly distribution goals range from 3-7% depending on the fund.

Reverse Target Date Funds. Fidelity's and PIMCO's fund offerings are examples of reverse target date funds. Essentially, these funds aim to pay out all of their principal and earnings by a date certain, thus the monthly income paid to investors is a combination of both principal and earnings. Fidelity has at least 14 of these funds with target liquidation dates ranging from 2016 to 2042. The allocations become more conservative over time. The Fidelity funds invest in all types of affiliated funds, in contrast to PIMCO's two managed income funds that liquidate in 2019 and 2029, respectively, and seek to invest at least 90% of their assets in "laddered" inflation-indexed Treasury bonds. PIMCO's investment objectives are to provide "consistent real (inflation-adjusted) distributions" through the maturity of the fund. The Fidelity managed payout funds' investment objectives seek total return through a combination of current income and capital growth, but their returns are not inflation adjusted like the PIMCO funds. Each of these reverse target date funds aims to make distributions that gradually increase over time to the date of maturity of the fund.

A main difference between the reverse target date funds and traditional target date funds is that the former seeks to provide monthly income for the investor through retirement, whereas traditional target date funds are designed to provide the investor with assets by the time of retirement.


Managed payout funds are relatively new and are only starting to gain traction in the market as investors and their advisers become more knowledgeable about how to use them. Generally, they are not necessarily intended to be an investor's sole source of income because their monthly income is not guaranteed. They are probably most useful for investors who have other sources of steady income, whether they be annuities, GMWBs, pensions or other sources.


By Joan M. Neri and Mark F. Costley

The Variable annuity contract ("Contract") sales practices were again included in the Financial Industry Regulatory Authority's ("FINRA") 2013 Regulatory and Examination Priorities Letter as among the "key investor protection and market integrity issues" that it will focus on in the coming year. This article discusses two potential risk areas that broker-dealers should consider in connection with the Contracts that their registered representatives ("Advisors") sell, and steps that they can consider to mitigate these potential risks.

Contracts often contain provisions permitting the annuity provider to implement future changes or require action by the policyholder (the "Client") as a condition to receiving the guaranteed payment. Broker-dealers whose Advisors recommend Contracts to Clients that include these provisions should consider whether those Contracts should be monitored on an on-going basis to ensure continued suitability, and to determine whether future Client communications would be prudent.

Broker-dealers whose Advisors recommend Contracts have an obligation under FINRA rules to ensure that recommended products are "suitable" in light of the Client's financial needs, investment objectives, and other relevant information. As a general matter, to carry out this obligation, the broker-dealer and/or Advisor will evaluate the Contract's terms, asset allocation and investment line-up and determine whether those characteristics align with the Client's financial needs, objectives and circumstances. What if - after undertaking this analysis and recommending a Contract that is suitable for the Client - the Contract's terms, asset allocation and/or investment line-up is significantly modified?

Recently, annuity providers have exercised their contractual right to make changes to existing Contract terms, including investment line-up changes, shifts in asset allocation and the imposition of investment restrictions. These changes have presented a challenge for Advisors because a Contract as modified in this way may no longer be suitable for the Client. In addition, Contracts may contain provisions that require the Client to take action in order to avoid lapse of the guaranteed payment. If a Client fails to take such required steps, and as a result loses the guaranteed benefit, the Client may try to claim that the Advisor had an obligation to remind them of the required action. These provisions create risk that broker-dealers may want to consider mitigating.

How can broker-dealers address these challenges? One of the most effective ways to address these issues, at least as a first step, is Advisor training. Broker-dealers can review their Advisor training materials to ensure that the issues discussed above are addressed in an appropriate manner. Secondly, broker-dealers may want to consider a specific suitability review process for Contracts, to ensure that these issues are considered by the Advisor at the time the Advisor is making a recommendation of a specific Contract to a specific Client. Finally, broker-dealers may want to consider whether specific compliance/supervisory procedures that monitor changes to Contracts purchased by Clients are feasible.

Broker-dealers also should consider whether proactive steps for existing Contracts are warranted as a risk mitigation tool. These steps could include identifying those Contracts held by Clients that contain these provisions and determining whether monitoring of these Contracts is warranted and feasible. Where an existing Contract requires policyholder action to avoid lapse of the guarantee, broker-dealers should consider whether a communication to Clients about the lapse and the steps the Client needs to take to avoid the lapse is feasible. We can assist broker-dealers in developing specific compliance and supervisory procedures to help address these issues.


By Fred Reish and Bruce L. Ashton

In earlier newsletters, we discussed two of the key issues for selecting an insurance company to provide guaranteed income for retirees under 401(k) and other defined contribution plans. We explained that the process is not inherently different from - or more difficult than - other fiduciary decisions (for example, selecting investment products or providers). We pointed out that the DOL safe harbor regulation is helpful, but does not give specific guidance on what information should be reviewed. We described some of the information a plan committee or other fiduciary should consider, noting that a plan committee does not need to predict the future, but instead just needs to make an informed, prudent decision.

In this article, our focus is again on the fiduciary process of selecting an insurance company.

But first, why should a plan consider offering a lifetime income guarantee? By "lifetime income guarantee," we mean an annuity (or other product provided by an insurance company) that guarantees a stream of payments for the life of a retired participant, and possibly his or her spouse. The reason to offer a guarantee is to eliminate, or at least reduce, the risk that a retiree will outlive the money in his or her plan account or rollover IRA. Elements of this risk include the possibility of living longer than expected, market downturns at the "wrong" time, the impact of withdrawing retirement funds too quickly and the erosion of critical decision-making capacity as the retiree ages. A guarantee of payment for life addresses those risks.

How should a committee select an insurance company? ERISA requires fiduciaries to engage in a prudent process, which entails gathering and assessing relevant information and making a rational decision based on that information. But what if the committee just selects a well-regarded insurance company that has a long history of providing annuity benefits to thousands of annuitants? In one case, then Appeals Court Judge Antonin Scalia (now Supreme Court Justice Scalia) said that "[e]ven if a trustee failed to conduct an investigation before making a decision, he is insulated from liability if a hypothetical prudent fiduciary would have made the same decision anyway."1 In other words, if other fiduciaries would have chosen that insurance company after engaging in a prudent process, the committee making the same choice - but without conducting an investigation - would not be exposed to liability.

We are not advocating that fiduciaries avoid engaging in a prudent process. However, it may help a committee feel comfortable with its decision if it knows that many others have chosen that insurance company to provide guaranteed retirement income.

With that in mind, what information should a committee consider? Among other factors, some key issues for evaluating insurance companies include the following:

  • Whether the company is regulated by all, or almost all, of the states. The degree of scrutiny by state regulators varies from state to state, but many state agencies conduct thorough, detailed and rigorous investigations; fiduciaries can take comfort in their findings of soundness.
  • The company's commitment to the annuity or guaranteed income business assessed by the number of guaranteed income contracts and total assets in guarantees.
  • The quality and consistency of the company's ratings across all of the major rating agencies.
  • The consistency of the ratings over an extended period (generally, at least one economic cycle). The long-term financial stability of an insurance company - expressed by uniformly high ratings over extended periods of time - is particularly important for selecting a provider that will pay benefits many years in the future.

For further information regarding the issues discussed in this article, see the White Paper we published in May 2012 (co-authored with Joe Faucher) titled "Lifetime Income in Defined Contribution Plans: A Fiduciary Approach" at www.drinkerbiddle.com/resources/publications/2012/Lifetime-Income-in-Defined-Contribution-Plans?Section=Publications.


1 Roth v. Sawyer-Cleator, 16 F.3d 915, 919 (8th Cir. 1994); Herman v. Mercantile Bank, N.A. 143 F.3d 419, 420 (8th Cir. 1998). See also, Bussian v. RJR Nabisco, Inc., 223 F.3d 286, 300 (5th Cir. 2000): "ERISA's obligations are nonetheless satisfied if the provider selected would have been chosen had the fiduciary conducted a proper investigation." Note, however, that while the "hypothetical prudent fiduciary" standard may protect a fiduciary that engaged in an imprudent search from being liable for damages, it may not prevent an injunction against the fiduciary from acting on behalf of the plan in the future. See, Brock v. Robbins, 830 F.2d 640, 646-647 (7th Cir. 1987).

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.

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Frederick Reish
Bruce L. Ashton
Diana E. McCarthy
Joan M. Neri
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