In the private sector, employers have been moving away from traditional pensions, known as defined benefit plans. These plans, funded by employer contributions, often pay long-time employees (and usually those employees’ spouses) lifelong regular cash flow.
Instead, many companies now provide defined contribution plans, such as 401(k)s, which are funded largely by workers’ salary deferrals. The actual retirement benefit will vary, depending on how the chosen investments perform.
Last year, the Treasury Department and the IRS took steps to encourage the use of substitute traditional pensions by retirees. Deferred income annuities (DIAs), which are mainly held in IRAs, were given favorable tax treatment, if certain requirements are met (see the CPA Client Bulletin, December 2014 issue). Later in 2014, the Treasury and IRS issued Notice 2014-66, which made it more likely that target date funds, mainly held in 401(k) plans, will purchase DIAs, which can offer pension-like cash flow to retirees.
Setting the date
Target date funds offer a predetermined asset allocation that gradually becomes less aggressive and more conservative, as its target date approaches.
Example 1: Fawn Grant, age 50, plans to retire in her mid-60s. She invests her 401(k) contribution in a 2030 target date fund. Now, that fund has a balanced mix of equities, for appreciation potential, and fixed income, for stability and cash flow.
As this fund approaches its 2030 target date, its asset mix will shift to fewer equities and more fixed income. Many plan participants like the idea of having professional investment strategists automatically make these asset allocation decisions.
Enter deferred annuities
Notice 2014-66 clarifies that target date funds in employer sponsored retirement plans can hold DIAs. A DIA is purchased today; the resulting income stream will not begin until years later. The longer the time between the investment and the start of annuity payments, the greater the amount of periodic cash flow an annuitant will receive.
Example 2: Hugh Jordan purchases a DIA at age 55. If Hugh defers lifelong income payments until age 65, he will get more monthly income than he would get by starting immediately. Hugh will get even larger annuity payments by waiting until age 70, or age 75.
The recent federal notice explains that target date funds offered through employer plans will be able to include DIAs among their fixed-income holdings for participants who are nearing retirement age. If those DIAs meet certain criteria, some technical issues won’t arise.
Similarly, target date funds are considered qualified default investment alternatives (QDIAs), which helps to explain their popularity in 401(k) plans. Employers who make the proper explanation can use QDIAs for the contributions of employees who neglect to make investment choices, while the employers generally avoid liability for any investment losses.
How 401(k) pensions might work
Here is an example of how DIAs could provide lifetime income from a target date fund offered by an employer-sponsored retirement plan. Such funds might be limited to participants of similar ages. A 2033 target date fund, for instance, might be available only to employees born in 1967, 1968, or 1969. In 2033, those employees will be 66, 65, or 64.
Beginning in 2023, when the fund participants are 56, 55, or 54, the target date fund can begin to purchase DIAs as part of its fixed income allocation. For the next 10 years, the fund will purchase more and more DIAs, increasing the allocation to such annuities. In 2033, the fund’s target date, the fund will dissolve.
At this point, the participants will learn what their DIA options are. They can start to receive lifetime income right away, or they can wait until a later time to start, in order to increase the annuity payments. Other assets of the now-dissolved target date fund, besides the DIAs, can be reinvested elsewhere in the company retirement plan.
The federal notice provides one example, so not all target date funds holding DIAs inside company plans will look exactly like that. However they’re structured, the idea is to provide employees with predictable cash flow after retirement through income annuities.
- It’s possible for target date funds in defined contribution plans to hold deferred income annuities and satisfy nondiscrimination requirements.
- Among other conditions, the deferred annuities cannot provide a guaranteed lifetime withdrawal benefit (GLWB) or a guaranteed minimum withdrawal benefit (GMWB).
- With a GLWB, the participant is guaranteed to receive a specified lifetime stream of income, regardless of the investment performance of the account, while still retaining access to the funds in the account.
- A GMWB is similar to a GLWB, but a stream of income is guaranteed for a specified period rather than for the lifetime of the contract owner or annuitant.
The Treasury Dept. and the IRS are considering whether to provide guidance relating to GLWB and GMWB features in defined contribution plans.