Annuity Investment Option in 401(k) Plans

Take-Away: If passed, the SECURE Act 2.0 may contain a more liberal qualified longevity annuity contract (QLAC) option for plan participants. Qualified retirement plan sponsors need to proceed with caution if they offer an annuity option within a 401(k) or defined contribution pension plan in light of their ERISA-imposed fiduciary duties.

Background: The pending SECURE Act 2.0 reportedly will allow for an expanded offering of qualified longevity annuity contracts (QLAC) held in a 401(k) or other retirement account. This legislation is currently under serious consideration by Congress and it might (stress might) be adopted before the end of 2022.

SECURE Act 2.0: A qualified longevity annuity contract, or QLAC, is a deferred annuity purchased by a qualified retirement plan participant. Because the purchase is at retirement and payments do not start until the plan participant attains age 80 or 85 years, QLACs are much cheaper than immediate annuities, and they arguably provide a fail-safe against the participant running out of money in the participant’s retirement years.  Treasury has provided some guidance that explains what deferred annuities will satisfy the required minimum distribution (RMD) requirements and thus can be QLACs. However, the Treasury was limited in what it could do without a statutory change. The three retirement plan distribution bills that are currently floating around Congress (collectively referred to for convenience as SECURE Act 2.0) would eliminate the current Regulation’s limit of 25% of the participant’s retirement account balance invested in a QLAC, and increase the dollar limit invested from $100,000 to $200,000 and make other changes, such as including a 90-day look-free provision. In addition, current Regulations require QLACs to be, practically speaking, non-increasing except for cost-of-living, in order to satisfy the required minimum distribution (RMD) rules. The SECURE Act 2.0 would provide additional exceptions to this non-increasing limit, such as allowing annuity payments that increase by less than 5% and accelerations of future annuity payments. But who really knows what the final legislation will actually contain?

Fiduciary Duties: The harder question is how this annuity investment option stacks up against the plan sponsor’s fiduciary duties of prudence and loyalty in light of an annuity which is marketed with a promise of “guaranteed income for life” when the conditions required to obtain such lifetime guaranteed income is often not fully explained or understood by the plan participant. Moreover, often overlooked or glossed over is the cost of annuity ownership, and the contractual limitations that are imposed in order to receive the promised life-income stream. Recall that the plan sponsor selects the investment options for the plan participants to choose from, so the plan sponsor has a role if an annuity is an investment option in a qualified plan.

Duty of Loyalty: One of the costs of the annuity is the requirement that the annuity owner must give up ownership of the annuity and control of the balance in the annuity, with no guarantee of recovering either the principal or any other kind of return of the investment made in the annuity. The Employee Retirement Income Security Act [ERISA} and the Restatement (Third) of Trusts both describe a fiduciary’s duties of loyalty as follows:

“The duty of loyalty requires a plan fiduciary to discharge his duties with respect to a plan solely in the interest of the participants and beneficiaries with the exclusive purpose of providing benefits to participants and their beneficiaries.” [29 U.S.C. 1104(a)(1)(A).]

Many annuities are structured so that the likelihood that the annuity owner will ever break-even on their investment is slim, and the annuity issuer stands to recover a windfall at some point, the windfall being the balance, if any, remaining in the annuity contract as some point in time, usually upon the death of both the annuity owner and their spouse.

How does a plan sponsor or investment fiduciary justify offering any investment option that requires the owner to possibly forfeit ownership of the investment, without any assurance of a commensurate return? How does that forfeiture (or windfall) stack up with the sponsor’s duty to act solely in the interest of the participant and the participant’s beneficiaries?

While many annuities can guarantee a commensurate return, or a recovery of the balance forfeited by the annuity owner, that assurance is only if the owner is willing to  pay an additional fee for that guarantee.

A qualified plan sponsor has a responsibility to conduct an independent, objective and thorough investigation and analysis of each investment option offered within their qualified plan. Accordingly, it needs to be fully aware of, and communicate, the disadvantages of offering an annuity as an investment option under the plan.

Duty of Prudence: The plan sponsor also has a fiduciary duty of prudence under ERISA:

“The duty of prudence requires a plan fiduciary to discharge its duties with the care, skill, prudence and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use.” [29 U.S.C. 1104(a)(1)(B).]

One of the basic principles that underlies the fiduciary duty of prudence is that “equity abhors a windfall.” Consider that a portion of an annuity, other than reasonable fees and costs, that could potentially inure to the benefit of the annuity issuer at the cost of the original annuity owner and his/her beneficiaries.  Including an annuity within a 401(k) plan as an investment option could be viewed a breach of the plan sponsor’s duty of prudence.

In short, fiduciary law is not simply a balancing of advantages versus disadvantages. Under fiduciary law, there is only one chance to get it right. No ‘do-overs,’ no ‘mulligans,’ when it comes to carrying out the fiduciary duties of loyalty and prudence.

Conclusion: When selecting an investment option for a qualified plan, the plan sponsor needs to ask three questions as part of the required fiduciary investigation and evaluation process: (i) Is the investment expressly required by ERISA? (ii) Is the investment consistent with the required fiduciary standards set forth in the Restatement (Third) of Trusts? (iii) Could (or would) the investment potentially expose the qualified plan and the qualified plan sponsor to unnecessary fiduciary liability? When making this selection investment options, a plan sponsor (or its investment fiduciaries) need to answer these questions themselves and not listen to the advice of ‘conflicted’ advisors who  push annuities as a plan investment option “selling the sizzle but not the steak.”