Can a Hybrid 401(k) Save Retirement?

The holy grail is a pension/401(k) mixture that pays out for the rest of your lifebut shaken administrators may not be ready for it

With Social Security on shaky ground and pension plans disappearing, more retirees will have to rely on their 401(k)s to support them in old age.

That's not very reassuring to anyone who has dared to tear open a recent statement and peek inside. The market meltdown is the chief culprit. But even if the economy were rock-solid, 401(k) plans would still be a problem. For years, most investors haven't saved enough, allocated their assets wisely, or figured out how to draw down those assets in ways that would make them last a lifetime.

If you're approaching retirement right now, there's no easy fix for your portfolio. But if you are in midcareer, you may soon have a chance to structure your 401(k) in a much different way. A dozen or so asset managers and insurers, including AllianceBernstein (AB), AXA (AXA), Barclays Global Investors (BCS), John Hancock (MFC), MetLife (MET), and Prudential (PRU), are designing a new breed of retirement instrument that combines elements of pensions and 401(k)s. These products—call them hybrid 401(k)s—have begun slowly rolling out. And while they differ in structure, all combine annuities—essentially, insurance contracts that provide periodic income payments—with an investment portfolio. The hybrids won't protect investors from violent market swings. But they'll guarantee a certain amount of monthly income for the rest of your life.

Among all the competitors, San Francisco-based Barclays Global Investors (BGI), one of the most successful units of Britain's troubled Barclays, is regarded as a trailblazer. BGI is the world's largest asset manager, with about $1.9 trillion under its control. It's a research-oriented shop that invented such now-familiar retirement products as index investment strategies and target-date funds, which shift their asset allocations as the owner approaches retirement. Its latest idea is to make 401(k)s more like pensions so participants receive income for their entire retirement. The result is SponsorMatch, a product that combines a target-date fund and an annuity.

Employees in SponsorMatch will end up with roughly half their assets in annuities by the time they reach retirement age. That's a potential lifesaver—and, of course, it helps BGI. The firm's business in 401(k)s and other defined-contribution plans has about $250 billion in assets. Not a puny sum, but it's a mere footnote to the company's massive pension operations at a time when 401(k)s have been growing and pensions shrinking. "This is a business opportunity, but it goes beyond that, to almost a moral calling," says BGI Chief Executive Blake Grossman.

The timing for this new hybrid product has proved tricky, however. With trauma spreading in the financial markets and corporate plan sponsors preoccupied, BGI has yet to find its first institutional client among the large corporate 401(k) plans it has targeted. Some of BGI's rivals have nabbed early adopters for their own hybrid products, but all have struggled. "We are in the same stage of development with these retirement products as we were with electronics 20 years ago. We are going to find out what the public likes," says Don Ezra, global director of investment strategy at Russell Investments and author of the forthcoming book, The Retirement Plan Solution. "Twenty years from now, there will be a clear winner."

Whichever product wins, retirement experts believe hybrids are the future. Consulting giant McKinsey figures defined-contribution plans will swell from $3.3 trillion today to $7.5 trillion or more between 2015 and 2020. At that point, McKinsey predicts, 401(k)s and other such plans will have roughly three times the assets of corporate pension plans and will be transformed from investment vehicles into platforms for providing lifetime retirement income. "This is the pensionization of the 401(k)," says J. Mark Iwry, a nonresident scholar at the Brookings Institution and an expert in retirement security. Retirement planning is "no longer just about waiting for the end of the line and thinking about the benefit as a lump sum," he says.

BGI's efforts to launch its hybrid 401(k) form a saga of stumbles and false starts. In the summer of 2006, as Congress was debating new retirement regulations, Matthew Scanlan, BGI's institutional chief, started thinking about the problems of 401(k)s. These retirement savings vehicles we've all come to accept as core benefits were designed to take advantage of a particular snippet of the tax code. They were never meant to be the primary way Americans paid for their retirement, and participants haven't exploited them intelligently. Faced with higher fees and their own poor investment choices, investors in 401(k)s have historically underperformed institutional investors by at least 2% a year. "It is a national emergency," says Scanlan.

The Pension Protection Act, passed in August 2006, was a call to action for Scanlan and Kristi Mitchem, whom he had just named as head of defined contribution. The legislation, the most significant retirement law in more than 30 years, closed loopholes on the underfunding of pension plans and encouraged increased participation in 401(k)s by offering legal protections for companies that provided automatic enrollment to their workers. Regulations that followed the new pension law identified certain investments, including target-date funds, as qualified default investments. That meant plan sponsors could put employees who didn't make specific choices into default options and not worry about liability. Those changes are important because, let's face it, people are lazy with their 401(k)s. But the plans still leave it up to participants to estimate how long they might live and how much money they'll need over a 20-odd year period. "It's too much to ask," Scanlan says. "Individuals just can't process it."

In early 2007, Scanlan and Mitchem brought in Chip Castille, who had previously helped develop BGI's target-date funds, as head of defined-contribution research. His team quickly encountered a conundrum. Academic research has long shown that retirees need monthly income and that annuities make sense in theory, but people don't like them—often for good reason. Many retail annuities sold to retirees are too complicated, too expensive, and too restrictive. The researchers wondered if they could design a product from scratch combining a target-date fund and an annuity.

This was a good starting point, given BGI's history with target-date funds, and since these were now qualified default investments. McKinsey estimates that target-date funds and other asset-allocation funds will make up more than one-third of all defined-contribution assets by 2015, up from 3% in 2006. "In six weeks of research, we knew we were onto something," says Peter Hand, lead researcher on the BGI team.

To build a computer model representing the retirement-planning concept in his head, Hand started with something called a happiness model. It calculates how to deliver the optimal level of happiness for the greatest number of people in retirement. People are much less happy if they have to cut their spending by 25%, but only somewhat more happy if they get to increase it by 25%, he argues. That simple behavioral insight shaped everything that followed. "I started seeing what the academics see," Hand says. That is, how important it is to know your spending won't have to drop below a certain level regardless of how long you live. "Equities are a bit of a longevity hedge, but annuities are the real longevity hedge."

But how to create that annuity? Hand plugged in certain scenarios and let the computer calculate whether they would make more people happy or fewer. For example, while most annuities don't include cost-of-living increases, Hand's model showed that one was needed and that 2.5% per year was the best level. If there's no cost-of-living increase and there's a very bad market, you'll see a large "tail" of people who are outliers because they live very long or because they retired at a point of market decline. These are the ones who end up with miserable retirements. Add the cost-of-living adjustment, and you lose a little upside, but you mitigate the horrific results for the tail. If you upped the cost-of-living increase to 3% a year or lowered it to 2%, Hand says, fewer people would be happy. "There are hundreds of tweaks like that, and they all interact with each other. It's all about managing the tail."

The structure BGI's finance wonks came up with embeds fixed deferred-income annuities (which provide a set amount of monthly income in retirement) into a target-date fund. A 401(k) participant who chooses SponsorMatch—or whose employer uses it for the matching contributions—would have part of each contributed dollar invested in the annuities and part in the investment portfolio. Essentially, the annuities replace the bonds that would normally be in your portfolio. If you're in your twenties or thirties, you'd have only a small portion in annuities; but as you age, that portion increases. As with a regular target-date fund, BGI would make those changes for you. Your investment portfolio, comprised of index-based investments, would also be automatically managed for you based on your age. You would simply pick SponsorMatch and sit back. When you received your 401(k) statement, you'd see two pieces: the amount of monthly income you'd have in retirement and the value of your investment portfolio. Says Mitchem: "People are not so good at converting asset numbers into a stream of income, so what we are doing is turning the 401(k) into something people can understand."


This structure yielded certain advantages that were geeky but important. For one, the annuities would actually be held by the fund, rather than the individual, as annuities typically are. This meant the insurer didn't need to keep track of each person's details, which helped slash costs to a very low fee of 50 basis points, including both the cost of the annuity and the asset-management fee. Participants could also cash out of SponsorMatch without paying any fees until they turned 65; that's in sharp contrast to typical retail annuities, which charge surrender fees of between 4% and 10%. One more benefit: BGI buys annuities over time, which is an advantage because they're more expensive when interest rates are low, and cheaper when rates are high.

At first BGI had hoped to avoid working with an insurer. The researchers spent six months experimenting with something called a synthetic annuity, which would allow the company to do everything in-house. But the costs were prohibitive. Says Castille: "That was a dark period in the development of the product."

In the summer of 2007, Castille phoned MetLife, which had developed a hybrid 401(k) concept with Merrill Lynch. MetLife was interested in developing other partnerships to gain a bigger foothold in what it saw as a massive, expanding market. "It was like a meeting of the minds within minutes," says Jody Strakosch, MetLife's national director of institutional strategic alliances. "We've been focused on retirement income for quite some time, and it is going to be a really big topic in 2009."

On Sept. 21, 2007, Mitchem, Castille, and Hand appeared before BGI's global investment committee. Chief Executive Grossman was there, as was the firm's head of research, and every business division head and regional chief investment officer. For more than an hour, the 401(k) team made its pitch and fielded questions. What was the optimal mix between the investments and annuities over time? What might happen to someone who lived to 110? "It's like defending a dissertation," laughs Scanlan. "You come out bruised and battered." The product got unanimous approval.

BGI and MetLife announced their partnership in March 2008. Their deal is currently exclusive, but BGI eventually will be permitted to bring in other insurers—possibly holding auctions when it needs to purchase annuities.

SponsorMatch was formally launched last October, and over several months, BGI's salespeople held a total of 180 meetings with plan sponsors. With everyone fixated on the financial crisis and pensions sinking deeper into the red, nobody wanted to be the first to sign up. Management, however, is taking the setbacks in stride. "We knew that this was going to be missionary work," Mitchem says. Adds Al Goduti, managing director of BGI's institutional business: "Even people who aren't making changes in their plans still want to talk." BGI now hopes to have a client on board by the end of the first quarter.

Greg Williamson, chief investment officer and director of trust investments at BP America, says he was intrigued when BGI briefed him on the new product. BP itself has a strong pension and isn't looking to make a change. Still, says Williamson, who runs BP's $7 billion 401(k), "For those looking at guaranteed income in retirement, this is one of the simpler and easier ways to do that."

As to why many plan sponsors are hanging back, William A. Schneider, a principal at pension consultants DiMeo Schneider & Associates in Chicago, blames a short-term view. "They've had other issues with the markets cratering and their in-house counsels saying, 'Maybe we don't want to roll out new things at this moment,' " Schneider says.

Other companies experimenting with hybrid 401(k)s have encountered obstacles. Players such as Prudential and MetLife-Merrill jumped in early and attracted a few clients. None of their products has gained a big following, but the instruments continue to evolve. AllianceBernstein, for example, plans to launch its own hybrid product with a target-date structure and multiple insurers offering guarantees.

It's too early to say who will win this lucrative competition, but the momentum behind hybrids is building. "This is the next battleground," says Onur Erzan, a McKinsey consultant and co-author of its report on the topic. "I think there's going to be a lot of demand."

When pensions and Social Security provided a safety net for retirees, 401(k)s made sense as add-ons. But with that safety net frayed, it's clear 401(k)s in their current state can't provide a secure retirement for most Americans. For plan sponsors looking to freeze pensions; for asset managers and insurers looking for the next new thing; and especially for employees worried about how they'll pay for their nonworking years, adding guaranteed lifetime income to a 401(k) is one answer. Says Moshe Milevsky, a professor at York University in Toronto: "This is the very beginning of a new way to approach retirement financing."

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