One large investment firm has already dropped annuities from its TDF series due to suboptimal investor behavior.
With the aging of the baby boomer generation and the growing importance of the defined contribution retirement plan system, investment management firms have recognized the need to create products dedicated to solving the retirement income challenge, including by adding annuities to the highly popular target-date fund vehicle.
A new report published this week by Mornignstar seeks to assess their progress, and the findings are decidedly mixed.
While at least 10 target-date series incorporating some form of annuity have launched since 2020, investor demand for these strategies has been muted, and one big investment management firm has already dropped annuities from its TDF series because of “suboptimal investor behavior.”
The report authors find target-date funds with annuities are an appealing idea to many, given that they offer investors familiarity with the TDF vehicle while baking the longevity hedge of annuities right in. For investors who plan to annuitize some or all their retirement savings, experts think they may be a good option.
But as the report emphasizes, the annuitization decision shouldn’t be taken lightly. Annuities can help with many retirement spending decisions, but they still may not be the right choice for everyone. Ultimately, it seems that the products’ perceived complexity and related investor behavior issues will remain a hurdle to widespread adoption of annuities — at least for now.
“Education remains these products’ biggest hurdle to success,” the authors conclude.
The Income Challenge
As the report details, retirees tend to fall into two camps, comprised of those who spend too little of their retirement savings and never enjoy the fruits of their labor and those who spend too much (and too quickly) and risk running out of money.
“Some investors struggle with self-control due to temporal discounting and availability bias,” the authors suggest. “They allow immediate wants to win over long-term needs and overspend in retirement. Other retirees fall on the opposite side of the spectrum and hoard their savings.”
Such investors are plagued by doubts that all stem, in their own way, from the perception of longevity risk. The questions they ask range from what if they outlive their assets to what if the markets go haywire and they lose money? What if they are confronted with a big expense somewhere down the line?
“Although these questions have merit, many investors let their biases — such as risk aversion, loss aversion and the endowment effect — cloud their judgment,” the authors explain. “Research suggests guaranteed income sources can help retirees manage these and other psychological obstacles.”
The Promise of TDFs
Having spelled out the income challenge in this way, the report authors note that the target-date fund vehicle has been a powerful tool that has helped solve other difficult retirement challenges stemming from novice investors’ behavioral tendencies.
So, it’ only natural that the investment management industry, buoyed by supportive legislation and regulation, has sought to use the TDF as a means of distributing annuities to those who could benefit from some income guarantees in retirement.
There are advantages to bundling TDFs and annuities, the authors suggest. For investors who plan to annuitize some of their assets, this “package deal” eliminates having to sort through myriad complicated options. Target-date providers choose the type of annuity, which varies by series, and then performs the due diligence on insurance companies.
Since 2020, the report finds, around a dozen new target-date series including a form of guaranteed income have launched or have planned to launch.
As of the end of the study period, the AB Lifetime Income TDF is the largest such series, with roughly $10 billion in assets as of the end of 2023. Its assets more than doubled to $5 billion in 2021 after the passage of the Secure Act eased the provision of annuities in TDFs, and it has continued to grow.
The authors suggest BlackRock’s forthcoming LifePath Paycheck series likely will surpass AB’s series after its April 2024 launch, because more than a dozen big plan sponsors have committed about $25 billion to its launch.
Most of those sponsors are converting from BlackRock’s LifePath Index series, which is identical to LifePath Paycheck, until the latter starts building up a guaranteed income allocation around 10 years before retirement.
Are Investors Buying In?
While these products’ asset levels sound impressive, they’re still a “drop in the ocean” of target-date assets, says Morningstar, and it’s unlikely that individual investors will propel these products to massive success. In that sense, the report finds, it will be up to financial professionals and employers to either push for or pass on the use of annuities in TDFs.
Is this likely? The outlook is as-yet unclear, for a few big reasons, the authors note.
To begin with, defined contribution plans have been lightning rods for excessive-fee lawsuits over the past several years. There were 48 such cases in 2023 alone, and while that’s fewer than the 88 filed in 2022, the more than 300 suits filed since 2019 have kept plan sponsors vigilant.
Most simply want to “keep their heads down,” meaning the adoption of new or innovative products can be seen as overly risky — especially when their plan participants aren’t clamoring for a change.
“Fees are a big obstacle for target-dates with annuities,” the repot notes. “Income annuities, for example, don’t have an explicit fee attached to them. Instead, the fee is baked into the guaranteed payment. That makes comparing the fees of target dates with income annuities with traditional target dates difficult.”
Annuities used as savings and accumulation vehicles, on the other hand, may have both explicit and implicit fees. The former can range from 50 to 100 basis points on top of the underlying funds’ fees and any management fee on top of those.
“It’s easier to compare these costs with traditional target dates, but they look more expensive in almost all cases,” the authors explain. This leaves plan sponsors hesitant to take up such options, for fear of scrutiny from litigators who fail to appreciate the value participants are getting for the higher costs.
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