Plan sponsors add income replacement funds to meet a demand for simplifying 401(k) choices.

aNow that workers have large amounts in 401(k) and 403(b) defined contribution pension plans, plan sponsors want employees to draw a stable source of retirement income from them.  But it's a daunting task to manage a portfolio of mutual funds while withdrawing money, based on government-mandated minimum distribution rules.
A few plan sponsors already have begun adding income replacement funds to solve this problem.
CDI Corp., a Philadelphia provider of engineering and information technology, is among six companies with at least $200 million in 401(k) assets using Genworth Financial's ClearCourse product. It is a participating annuity, which provides employees with a guaranteed source of retirement income for life.
Kristen Olsen, CDI Corp.'s vice president of human resources, says that employees for years have been saying they want a better way to understand the income they can expect from their 401(k) investments when they retire.
Under the Genworth Financial program, every 401(k) contribution purchases a specific amount of retirement income for life. Contributions are invested in a balanced mutual fund, split between stocks and bonds. The annual cost is 85 basis points plus fund management fees.
"It takes the stress out of the unknown," Olsen says. "We have been looking for 'cutting edge' products that would allow the CDI 401(k) plan to be the best in our industry." With the ClearCourse product, she says, employees can see on paper what they will have for income when they retire.
Lori Thielen, chief financial officer of the Durrant Group Inc., an architectural engineering company in Minneapolis, recently added Prudential's "IncomeFlex." This pilot investment option is a guaranteed lifetime minimum withdrawal benefit, based on an employee's investment in a 401(k). It's not a variable annuity, so there is no mortality and expense or surrender charge.
Since April, $1 million has been invested in this guaranteed lifetime income option, which was added to Durrant Group's stable of 401(k) investments. Durrant Group is one of three piloting the Prudential program in 401(k) plans.
Under the program, an employee over 50 can select from five different investment portfolio funds, ranging from conservative to more aggressive. Starting at age 65, employees can obtain a guaranteed yearly paycheck equal to a minimum of 5% of the "income base," or the amount invested in Prudential's portfolios.
Defined contribution plan assets, as well as future contributions, can be transferred into chosen funds so that the employees can take advantage of the minimum 5% guarantee. But withdrawals in excess of the guaranteed amount can proportionately reduce future withdrawals. The annual cost of this investment option is 95 basis points, including fund management fees.
"It is a solution that bridges the gap between the accumulation and distribution phases of retirement planning," Thielen says.
Plan sponsors may be on the right track. Research indicates that retirees may have a tough time managing retirement income portfolios, particularly if they experience large losses. A 2006 study by Ibbotson Associates, an affiliate of Morningstar Inc., found that systematic withdrawals from retirement savings plans can be problematic if individuals withdraw more than 3% to 4% annually.
The study found that, based on historical rates of return of a balanced stock and bond mix, a 7% annual withdrawal rate lasts just nine years. At a 5% withdrawal rate, the money lasts about 22 years. And individuals would have to reduce their withdrawal rates to 4% or less to make portfolios sustainable for at least 30 years.
Research also reflects employee concerns. A 2006 study conducted by EMI, a Boston-based survey firm, shows that 88% of those investing in 401(k)plans indicated they were interested in an investment option that would provide them with guaranteed monthly income.
The actions by a fistful of companies to give employees the option of getting guaranteed income from a defined contribution plan could be a harbinger of things to come. Numerous studies have found that the typical worker saves too little, often invests too conservatively and doesn't manage the nest egg well after retiring, says Marshall Blume, finance professor at the Philadelphia-based Wharton School of Finance of the University of Pennsylvania. The solution is for employers to improve their defined contribution plans through automatic enrollment, minimizing the use of the employer's stocks, expanding the use of annuities and improving employees' financial knowledge.
Several other corporate plan sponsors besides the Durrant Group and CDI are giving employees retirement income options in their defined contribution plans. The Retirement Group at Merrill Lynch has about two dozen smaller companies offering MetLife's "Personal Pension Builder," in 401(k) plans, according to Merrill Lynch spokesperson Thomas Applegate.       
"Personal Pension Builder" is a deferred fixed annuity that changes into an immediate fixed annuity when a worker retires. Each regular investment made by the employee locks into an interest rate and a sum that is paid out during retirement. When the worker retires, the investment is converted to an immediate annuity. The annual cost is just 70 basis points.
The annuity lets employees dollar cost average to create a future income stream. As a result, when inflation and interest rates are high, the employee purchases more future income. For example, a 40-year-old employee contributing $200 a month for 25 years would buy $11,262 in annual income for a lifetime, based on current rates, according to MetLife.
The product also addresses the problem workers face if they roll 401(k) money into an immediate annuity. Monthly payouts are based on the interest rate at the time the annuity contract is signed. This can be a problem in a low-rate environment because monthly payments will be lower.
Fortune 500 companies have been in discussion with The Hartford companies about a deferred fixed annuity that converts into an immediate annuity within a 401(k) plan. With the "Hartford Income Builder," each employee contribution to the annuity purchases shares. Each share provides the employee with a guaranteed income stream of $10 per month for life starting at age 65. The cost per share will change, based on current interest rates and the age of the employee. The guaranteed monthly income payment, beginning at age 65, is determined by multiplying the total number of accumulated shares by $10. If an employee accumulates 50 shares of lifetime income, for example, he or she will get $500 of monthly income for life, starting at age 65.
The cost of the product is built into each share purchased. The idea behind this investment option is that an employee can invest part of his or her 401(k) in mutual funds for growth. The rest goes into the annuity, which buys, for example, future guaranteed sources of income to cover basic expenses such as food, clothing, housing and medical expenses.
There is no free lunch with the new hybrid type of immediate annuities being offered by 401(k) plan sponsors to their employees. Lance Wallach, CLU, ChFC, a Plainview, N.Y.-based financial planner, is concerned that employees may lose control of their assets if they invest in these annuity-type 401(k) investments.
"The income investment options are too complicated for most people to understand," he says. "There is the potential to put too much into the annuity and not have enough liquid assets during retirement."
Jeffrey Dellinger, an actuary and publisher of Retirement Income Solutions in Fort Wayne, Ind., says there are pros and cons to the annuity-type products now offered in some 401(k) plans.
The benefit is that it lets workers purchase future amounts of guaranteed income during the accumulation phase with the opportunity for additional nonguaranteed income through investments in mutual funds. They strike a balance between a 100% fixed-payout annuity and a 100% variable immediate annuity, he says. The big drawback: The employee needs to be sure to purchase enough guaranteed future income to cover his or her retirement years.
Products that let employees accumulate money into a fixed immediate annuity, which pays guaranteed lifetime income, may not protect employees from purchasing-power risk when they retire, Dellinger says.
"While the guaranteed income guards against longevity risk, if the benefit remains level it fails to allow a retiree to maintain his or her standard of living," he says. "Even at a modest 3.5% annual inflation (rate), a 60-year old with $70,000 of pretax income will need $140,000 at age 80 and $210,000 at age 92 to cover the cost of goods and services."
Products that provide guaranteed minimum withdrawal benefits are an alternative to immediate annuities. But they may not provide the retiree with enough income compared with a fixed or variable immediate annuity, because immediate annuities pay a higher level of income than identically invested guaranteed minimum withdrawal benefits. That's because their lifetime income is funded by three elements: principal, appreciation and survivorship credits.
"The [guaranteed minimum withdrawal benefit] is essentially a minimum investment performance guarantee-that is, the embedding of a lengthy series of put options, which creates a floor level of withdrawals that can be taken without risk of fully exhausting the account value," Dellinger says.
Although the idea of offering retirees a secure source of income from their defined contribution plan seems enticing, just a handful of plan sponsors have adopted the concept.
Jody Strakosch, national marketing director of MetLife Institutional Income Annuities, says MetLife has been talking with a number of plan sponsors. But she says it could take time for a 401(k) guaranteed income option to take hold in the marketplace.
"It is slow going," she says. "A new fund has to be introduced to the pension's investment committee and due diligence is conducted. It is a long road, but we are optimistic."
In the long term, however, the choice of a guaranteed income component in a defined contribution plan could be the wave of the future.
"I believe this is the tip of the iceberg," says Olsen of CDI. "The pendulum is swinging back. Employees want more help and fewer choices in planning for retirement. They don't want to give up the ability to make some decisions, but they want more concrete assistance in making their retirement a reality."