Even before the current market meltdown, employees with 401(k)s weren't well prepared for retirement. Now, with the Social Security safety net frayed and corporate pension plans disappearing, asset managers and insurers are trying to transform the 401(k) into something that will save future generations of retirees—and provide a new, lucrative business opportunity for themselves. These new products—call them hybrid 401(k)s—combine guaranteed income in retirement with an investment portfolio. There's no simple way to do that, and the products vary greatly in their structures, features, and costs. We spoke with retirement and insurance experts about what they think are the best features for these pension-like 401(k)s to include, as well as potential pitfalls in their construction. Here's their thinking on six key criteria.
SIMPLICITY AND FLEXIBILITY. The black box that makes any of these products work gets complicated, but whatever wins will need to be simple enough for employees without PhDs in finance or insurance to understand. At the same time, investors in 401(k)s like having access to their money if they need it, and may expect similar flexibility from hybrid 401(k)s. "People become concerned that they've locked up money with no upward potential," says Phil Suess, a worldwide partner in the defined contribution consulting practice at Mercer.
PORTABILITY. Workers switch jobs often, and in today's economy many are being laid off. If you are in one of these hybrid plans, what will happen to your guarantee if you leave your job? It's important to know that you won't lose out on your savings as you make career moves—in retirement lingo, portability. "From an administrative perspective, it's a big challenge if you are going to have annuities in the plan," says Robyn Credico, national director of defined-contribution plans at WW. "If you leave the plan before you retire, what happens to your annuity? If the company doesn't like the annuity solution anymore, what happens? The providers are trying to work out those issues."
LIFETIME INCOME. One of the biggest issues in retirement planning is that people don't know how long they'll live, and they don't know how to plan around that uncertainty. Even if you have $1 million when you retire at 65, if you think it needs to last 15 years, but you luck out and live to 95, you could be sunk. Similarly, if you've purchased a guaranteed income product that covers you only from 65 to 80, what will happen to you after that age? If the guaranteed income doesn't last your lifetime, "there's really no point," says Moshe Milevsky, a professor at York University in Toronto and author of the book, Are You a Stock or a Bond?
COST OF LIVING ADJUSTMENT. Because you'll, with luck, be spending many years in retirement, you'll need to think about your purchasing power from that monthly income. After all, over a long period of time, inflation matters. Even if the economy isn't in an inflationary period, elderly people's cost of living typically increases, Milevsky says. "I would like to see a 1-2-3% increase in the income stream, even if early on you get less," he says. "If you tell me that I am getting a nominal amount of income each month, that doesn't really help me manage the risk.":
SAFETY. With financial institutions in crisis, you want to be certain that the guarantee you're paying for is safe—and will be for a long time. How do you structure a product where the guarantee isn't at risk regardless of what happens to the insurer behind it? One way to reduce credit risk is for multiple insurers to offer guarantees on a single product so that even if one should fail, the others will be able to fill the gap.
COST. One big problem with annuities historically has been their costs. Many not only have hefty regular fees, but also high surrender charges (what you'll pay to get out if you need to). What prices is fair for a hybrid product in a 401(k) depends on what features you want, says Onur Erzan, a McKinsey consultant and coauthor of a report on redefining defined contribution. "It's a question of value for money,"Erzan says. A fair price for a plain-vanilla product might be 100 basis points, he says, but a more sophisticated product might be worth 150 to 200 basis points for a wealthier, more sophisticated individual who will use the features it offers. To know whether the cost is right for you, you'll want to pay attention to whether you'll actually use the features offered and, if you think you might, whether some of them might be available less expensively outside your retirement plan.