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Guaranteed Income: The Impact of the SECURE Act


EDITOR'S NOTE: This article first appeared in the Spring issue of NAPA Net the Magazine.

The SECURE Act has three sections that, taken together, should have a positive impact on the provision of retirement income products in defined contribution plans. While the focus of this article is on the Act’s fiduciary safe harbor, it summarizes the three provisions and then goes into detail on the fiduciary safe harbor for selecting an insurance company. But first, let’s look at why this matters. 

Retirement Challenge

Over the last 40 years or so, the retirement landscape has shifted from being focused on defined benefit plans—which guaranteed income for life—to mainly 401(k) plans, which generally provide a lump sum at retirement that workers need to manage for their remaining lifetime. This shift means that retirees and those preparing for retirement are facing a number of issues. They are living longer, so their money needs to last longer. The money needs to be invested, which subjects it to market fluctuations, more specifically “sequence of return risk,” which means that the markets can be sharply lower at the very point in time they need to withdraw funds. And as they get older, their ability to make financial decisions diminishes, so they need to have arrangements that protect them from bad advice and decisions. 

These are, of course, the same individuals who have struggled with the complexities of saving and investing for retirement—many of whom have, over the past decade and a half, been aided by plan designs that automatically set contribution rates and taken advantage of investment alternatives that establish and systemically rebalance diversified investment portfolios on their behalf. 

Unfortunately, many—perhaps most—participants and retirees are not prepared, by education or experience, to invest for long-term retirement security, to withdraw money from their IRAs at a sustainable rate, or to know their likely life expectancies to properly balance their needs and available resources. Retirees, who are essentially creating their own paycheck from their available resources, need the certainty of knowing just how much they have available to spend.

One solution is to invest a portion of their assets in guaranteed retirement income products. This is why the SECURE Act’s focus on retirement income is important.

Three Retirement Income Provisions

The Act has three provisions relevant to retirement income: 

  • Section 109 dealing with the “Portability of lifetime income options.” Generally, it permits special distributions of a “lifetime income investment” when the investment is no longer authorized to be held under the plan. This makes it possible for a participant to keep the investment even if the plan sponsor changes recordkeepers or decides to eliminate the investment from the plan lineup. This provision is effective now. It also addresses the concerns of plan sponsors reluctant to add these options to their plan menu for fear that a change in recordkeepers could be disruptive to participants who had invested in those options.  
  • Section 203 relates to “Disclosure regarding lifetime income.” This section requires plans to give participants projections of their current account balance as a monthly benefit using assumptions prescribed by the Secretary of Labor. This is designed to inform participants about how their accounts translate into income when they retire and to, at least partially, shut the focus from account balance to retirement income. This section goes into effect 12 months after the DOL issues guidance. It is hoped that this will help participants better understand what their projected retirement savings will produce in terms of monthly income in retirement.
  • Section 204 provides the fiduciary safe harbor for the selection of a guaranteed retirement income provider, which is effective now. 

The New Safe Harbor

While there are a number of different retirement income “solutions” (such as managed accounts and mutual funds designed to provide sustainable withdrawals), only insurance companies can offer a guarantee. However, the fiduciaries of some plans have balked at the prospect of selecting an insurance company that needs to be around in 20, 30 or 40 years to make payments to the retirees. The SECURE Act safe harbor addresses that. 

In essence, the safe harbor says that, when a plan fiduciary of a defined contribution plan selects a “guaranteed lifetime income contract” to be offered under its plan, the fiduciary will be deemed to have acted prudently if it follows the steps outlined in the law. The Act defines “guaranteed lifetime income contract” as an annuity contract or any other contract that provides guaranteed benefits for at least the remainder of the life of a participant in the plan. The new safe harbor means that the fiduciary will not be liable if the insurance company later defaults on its obligation to participants who invest in the contract. The requirement is that the fiduciary obtain specified representations from insurance companies about their financial soundness (and not have any information that contradicts those representations). 

Four Steps

A plan fiduciary needs to follow four steps to obtain the safe harbor protection for selection of a “guaranteed lifetime income contract.” It must: 

  • engage in an objective, thorough and analytical search for the purpose of identifying insurers from which to purchase such contracts; 
  • consider the financial capability of the insurer to satisfy its obligations under the contract;
  • consider the cost (including fees and commissions) of the contract in relation to the benefits and product features of the contract and administrative services to be provided under the contract (a subsection says this need not be the lowest cost, but it cannot exceed a reasonable cost); and 
  • conclude, on the basis of these factors, that, at the time of the selection, the insurer is financially capable of satisfying its obligations under the contract and the relative cost of the contract is reasonable. 

The key to the safe harbor is the process for considering the financial capability of the insurer. The safe harbor requires that the fiduciary obtain specified information from the insurer. If a fiduciary obtains that information, the fiduciary will be deemed to have satisfied the “consider” and “conclusion” requirements relative to financial capability. Specifically the fiduciary must obtain written representation from the insurer that:

  • the insurer is licensed to offer guaranteed retirement income contracts; 
  • the insurer, at the time of selection and for each of the immediately preceding seven plan years meets the following requirements:
    • operates under a certificate of authority from the insurance commissioner of its domiciliary state which has not been revoked or suspended; 
    • has filed audited financial statements in accordance with the laws of its domiciliary state under applicable statutory accounting principles; 
    • maintains (and has maintained) reserves which satisfies all the statutory requirements of all states where the insurer does business; and 
    • is not operating under an order of supervision, rehabilitation, or liquidation (an “adverse order”); 
  • the insurer undergoes, at least every five years, a financial examination (within the meaning of the law of its domiciliary state) by the insurance commissioner of that state (or by a representative, designee, or other party approved by such commissioner); and 
  • the insurer will notify the fiduciary of any change in circumstances occurring after the provision of the representations which would preclude the insurer from making the representations at the time of issuance of the contract.

After receiving these written representations, and before making its decision, the fiduciary must not have received notice of an adverse order affecting the insurer and must not have any other information that would cause it to question the representations.

‘Reasonable Cost’ Reminder

Note that a fiduciary is not required to verify any of the information provided by the insurer or to dig deeper into the insurer’s financial condition or regulatory status. It is only required to obtain the insurer’s representation as to these facts and not have any information to the contrary. 

There is a limitation in Section 204 that fiduciaries need to be aware of, however. The section (only) protects the fiduciary against liability “due to an insurer’s inability to satisfy its financial obligations under the terms of such contract.” The fiduciary must still determine if the costs are reasonable. This means that, in selecting a guaranteed retirement income contract, a fiduciary will need to engage in a prudent process to conclude that the costs are reasonable (e.g., obtain and review data about costs for similar products in similarly-situated plans). This requirement—the same standard that applies to the selection of any other investment or service to the plan—should be manageable with assistance from the plan advisor, assuming you have access to industry benchmarking data on costs.

What This Means

The three provisions in the SECURE Act are intended to facilitate the provision and acceptance of retirement income options in defined contribution plans. (Many recordkeepers currently provide an illustration of an income stream and/or calculators for participants to determine this for themselves.) 

Some fiduciaries have been reluctant to offer guaranteed retirement income products because of the difficulty in assessing the financial stability of the insurance company (and also due to a concern that participants would lose their guarantees if the plan switched providers). The SECURE Act provides solutions for both of those fiduciary concerns. 

It is likely insurance companies will now provide institutionally priced products to 401(k) plans. To be consistent with existing fiduciary practices, those products should be transparent in their pricing. The next steps will be for recordkeepers to add these products to their platforms. Then plan fiduciaries will need to decide whether to include the products in their lineups in view of the new safe harbor and their plan needs, and, ultimately, participants—perhaps with the assistance of their trusted plan advisor—will need to decide whether to use them.

Fred Reish and Bruce Ashton are partners at Faegre Drinker Biddle & Reath in Los Angeles. This article was puiblished in the Spring 2020 issue of NAPA Net the Magazine.