By Christopher B. Tobe, CFA, CAIA
The burden of proof is on plan sponsors regarding their plan annuity qualifies for an exemption from being classified as a prohibited transaction. Likewise, they are also liable for proving that any annuity option or investment option that contains annuities qualifies for a prohibited ransaction Exemption,
I believe that most annuities in 401(k) and other ERISA plans do not fully qualify for a prohibited transaction exemption. [i] The primary basis for my opinion is that the single entity credit and liquidity risk in annuity contracts violates one of the most basic standards of care diversification.[ii] CFA Investment Standards lay out specific standards for 401(k) and other defined contribution (D.C.) plans. Diversification—each investment option, as a standalone investment, must be sufficiently diversified that plan participants, if they chose only that option would not be at serious risk of unsustainable investment losses because of a relatively small segment of the capital markets experiencing distress [iii]
Assuming that as plan sponsor that you can get over the single entity credit and liquidity risk, how can you justify any connection to annuities. Perhaps your advisors will talk you into smaller amounts buried and hidden in a target date fund or in a lifetime income option. It is common term in the financial world that “Annuities are sold not bought”.
I contend that annuities violate fiduciary standards in so many ways that it is very difficult for a plan sponsor to prove that these contracts qualify for a prohibited transaction exemption.
Fiduciary Transparency Tests of Care
As a plan sponsor you should put all products through these fiduciary transparency tests, I contend that annuities almost always flunk this basic level of care.
Is the annuity in a well-regulated transparent structure like a SEC registered mutual fund?
Most likely the answer is “no,” as annuities, with their lack of transparency around fees, are typically not allowed in SEC registered mutual funds. Many plans avoid this issue by using SEC registered mutual funds. SEC registered mutual funds have transparent fees and performances, have uniform federal regulations and are the gold standard for the 401(k). SEC registered mutual funds do not allow annuities for the same reasons that I think most annuities flunk prohibited transaction exemptions.
CFA Institute Global Investment Performance Standards (GIPS) also have transparency standards on performance and fees.[iv] Annuities typically do not comply with CFA GIPS standards. [v]
Another way for plans to have Transparency and fiduciary control are achieved in a plan by an Investment Policy Statement (IPS). However, plans with annuities avoid an IPS because they usually cannot comply with one. [vi]
Noted Morningstar analyst John Rekenthaler said in April 2022 that in selecting 401(k) investment options, “inappropriate are investments that don’t price daily. Annuities typically do not price daily and do not provide valuation transparency.[vii]
Annuities avoid transparency with poor state regulated structures which allow them to hide excessive risks and fees. Annuity providers fight hard to avoid any federal regulations, especially those imposing on them any type of true fiduciary standard and/or transparency, usually favoring state regulation in their home states where they are major employers and have higher political influence. Even industry insiders admit hidden fees are problematic to adopting annuities.[viii]
After the 2008 financial crisis several insurers were forced into federal regulation under SIFI (too big to fail) they did everything to get out of the higher transparency and higher capital requirements.[ix]
Fiduciary Conflicts Tests – Loyalty and Excessive Compensation
Plans need to put their loyalty to plan participants first, which is their fiduciary duty. They do not have loyalty to vendors such as money managers and annuity providers.
Annuities have an inherent conflict because upon annuitization, a common prerequisite to receiving the alleged benefit – guaranteed stream of income for life – investment dollars leave the ownership of the plan and participants, and become part of the balance sheet of the insurance company.
Annuity contracts are designed to avoid all fiduciary obligation with no loyalty to participants. Most annuity providers refuse to sign a “Fiduciary Acknowledgement Disclosure.”
DOL official Khawar said. “” Under the National Association of Insurance Commissioners’ model rule, for example, “compensation is not considered a conflict of interest,” [x]
Reasonable Compensation Limitation
Annuities have a total lack of disclosure of profits, fees and compensation. They have secret kickback commissions. How can a plan claim any of the compensation annuity provider receives is reasonable if it is secret and not disclosed?
Secret kickback and commissions place the financial interests of the insurers and their affiliates over those of retirement investors.[xi] In summer 2024 the GAO report on Self-Dealing [xii], and Senator Warrens reported on Annuity kickbacks.[xiii]
A number of lawsuits have settled with claims of excessive secret fees and spreads. An insurance executive bragged at a conference of secret fees r3agrding spreads of over 200 basis points (2%) in 2013. [xiv] Most observers of 401(k) plans do not feel that 200 basis points of compensation is reasonable.
Fixed Annuity Applications
In 1992, The Federal Reserve exposed the weak state regulatory and reserve claims of fixed annuities in retirement plans.[xv] In 2008, Federal Reserve Chairman Ben Bernanke said about these annuity products “workers whose 401(k) plans had purchased $40 billion of insurance from AIG against the risk that their stable-value funds would decline in value would have seen that insurance disappear.”[xvi]
The version of annuity that is most common in DC plans larger than $100mm in total assets or 1000 employees is the Immediate Participation Guarantee (IPG) which is a group annuity contract (GAC) written to a group of investors in a defined contribution (DC) plan, not to individuals.[xvii] The largest IPG is the TIAA Traditional Annuity with over $290 billion in assets, making it one of the largest options in DC plans in the United States. [xviii]
These IPG contracts have been characterized by DC plan group NAGDCA as having serious fiduciary issues. “Due to the fact that the plan sponsor does not own the underlying investments, the portfolio holdings, performance, risk, and management fees are generally not disclosed. This limits the ability of plan sponsors to compare returns with other SVFs [stable-value funds]. It also makes it nearly impossible for plan sponsors to know the fees (which can be increased without disclosure) paid by participants in these funds—a critical component of a fiduciary’s responsibility “ [xix]
The industry defense on prohibited transactions is a bait and switch around a hyped politically popular concept of lifetime annuities which, in reality, do not hold material assets in DC plans. The industry also uses language realtive to Pension Risk Transfers that apply to DB plans not DC plans.
My estimates, based on looking at 100s of DC plans over $100mm in assets, is that overall around 12% of plans currently have any type of annuity. Of those with an annuity, less than 1% is in lifetime annuities and variable annuities, 5% is in miscellaneous insurance company Separate Account products, 83% in Fixed Annuities IPG General account accumulation group annuity contracts, and 11% in Fixed Annuities IPGs Separate account accumulation group annuity contracts
While I believe that lifetime income and pension risk transfers in DB plans have fiduciary issues, plan sponsors do not really have any defense for the IPG type fixed annuities that make up the bulk of prohibited assets in larger Defined Contribution plans. https://www.metlife.com/retirement-and-income-solutions/insights/final-clarification-annuity-selection-safe-harbor/
Plan sponsors who choose to use IPG annuities in their 401(k) plans clearly need to document why they believe it deserves a prohibited transaction exemption.
[i] https://commonsense401kproject.com/2024/10/10/annuities-exposed-as-prohibited-transaction-in-401k-plans/
[ii] https://commonsense401kproject.com/2022/05/11/annuities-are-a-fiduciary-breach/
[iii] https://rpc.cfainstitute.org/-/media/documents/book/rf-publication/2017/rf-v2017-n3-1.pdf
[iv] https://www.cfainstitute.org/en/membership/professional-development/refresher-readings/gips-overview
[v] https://commonsense401kproject.com/2023/02/01/401k-plan-sponsors-should-look-to-cfa-code-for-investment-governance/
[vi] https://commonsense401kproject.com/2023/03/12/investment-policy-statements-crucial-to-fiduciary-duty/
[vii] https://www.morningstar.com/articles/1090732/what-belongs-in-401k-plans
[viii] https://riabiz.com/a/2024/5/11/fidelity-voya-and-boa-smooth-blackrocks-launch-of-guaranteed-paycheck-etfs-but-401k-plan-participants-may-yet-balk-at-high-unseeable-fees-and-intangibility-of-benefits
[ix] https://www.stanfordlawreview.org/online/the-last-sifi-the-unwise-and-illegal-deregulation-of-prudential-financial/
[x] https://www.thinkadvisor.com/2024/10/07/top-dol-official-sees-a-nonsensical-reality-at-heart-of-fiduciary-fight/
[xi] https://consumerfed.org/annuity-industry-kickbacks-cost-retirement-savers-billions/
[xii] https://www.gao.gov/products/gao-24-104632
[xiii] https://www.warren.senate.gov/imo/media/doc/senator_warrens_annuity_report_-_sept_2024.pdf Secret kickback commissions
[xiv] https://www.bloomberg.com/news/articles/2013-03-06/prudential-says-annuity-fees-would-make-bankers-dance?embedded-checkout=true
[xv] Federal Reserve Bank of Minneapolis Summer 1992 Todd, Wallace SPDA’s and GIC’s http://www.minneapolisfed.org/research/QR/QR1631.pdf
[xvi] http://www.federalreserve.gov/newsevents/testimony/bernanke20090324a.htm
[xvii] https://www.dfs.ny.gov › ipgdac_word_20121214
[xviii] https://www.tiaa.org/public/plansponsors/investment-solutions/lifetime-income/tiaa-traditional-overview
[xix] http://www.nagdca.org/documents/StableValueFunds.pdf_ The National Association of Government Defined Contribution Administrators, Inc. (NAGDCA) September 2010.
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