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.
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 Commission1 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.2 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.3
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.4
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.
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.
1 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.
2 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.
3 Dep't of the Treasury, Internal Revenue Service, "Longevity Annuity Contracts," 77 FR 5443 (Feb. 3, 2012).
4 See AllianceBernstein, "Secure Retirement Strategies – SRS – Lifetime Income" (2011), available at https://www.alliancebernstein.com/abcom/Opportunity/SRS/Content/AB_SRS_Brochure.pdf.
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.