What Does The Sample Annuity Calculation On Your 401(k) Statement Really Mean? | Trust Point
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What Does the Sample Annuity Calculation on your 401(k) Statement Really Mean?

Updated September 13, 2022

Jon Marquet, Retirement Plan Consultant

Find out how the new Lifetime Income Illustrations(LII) requirement can help with retirement planning.

The SECURE Act of 2019 requires that plan administrators provide plan participants hypothetical illustrations of a participant’s retirement plan account balance if it were annuitized using a Single Life Annuity (SLA) and a Qualified Joint and Survivor Annuity (QJSA). The SECURE Act also requires that these annuitized illustrations (known as Lifetime Income Illustrations (LIIs) or Lifetime Income Disclosures) be included on participant benefit statements at least once a year. The Employee Benefits Security Administration (EBSA) has stated that these illustrations are meant to “help workers…better understand how their account balance translates into monthly income in retirement and therefore to better prepare for retirement” and to strengthen “retirement security by encouraging those currently contributing too little to increase their plan contributions.”

To effect these SECURE Act requirements, the Department of Labor (DOL) issued an Interim Final Rule (IFR) on September 18, 2020. It became effective one year later.[1] Pursuant to the IFR, and related DOL documents, at the latest, participant-directed, calendar-based plans had to include their first-ever LIIs on Q2 2022 (June 30) participant benefit statements. (Non-calendar based plans will need to issue their first-ever LIIs in advance of the September 2022 deadline.)

LIIs are new. And plan participants have likely just received, or will soon receive, their first retirement plan benefit statement that includes these illustrations. Accordingly, retirement plan sponsors can expect questions and concerns from their participants and need to be prepared to explain what the LIIs are – and are not. In addition, plan participants should educate themselves about what this new information means.

LII Assumptions

Because LIIs are required across the universe of plans and plan participants, the IFR instructs that they should incorporate a number of assumptions. These assumptions are generally designed to promote simplicity and consistency. They are not generally designed to account for each individual participant’s particular personal, financial, or retirement situation. Thus, the LIIs will likely be different than other retirement projections provided by other sources, e.g., plan advisors or plan sponsors. Understanding the assumptions that underlie the LIIs can help to allay any concerns and explain any such differences.

  • Commencement Date: The start date for the illustrated annuity payments is not projected forward to an assumed retirement date. Instead, annuity payments are assumed to begin on the last day of the benefit statement period and are based upon the account balance as of that date. Thus, for example, for calendar Q2 2022 participant benefit statements, the LIIs assumed that annuity payments began on June 30, 2022 and were calculated based on the participant’s account balance as of that date.

This assumption presupposes and incorporates an immediate annuity scheme into the LIIs.

  • Age: All participants are assumed to be sixty-seven years old on the last day of the statement period (i.e., on the assumed commencement date). The only exception is that for participants who are older than sixty-seven their actual age is used. Thus, for example, for calendar Q2 2022 participant benefit statements, the LIIs assumed that all participants under age sixty-seven, regardless of their actual age, were sixty-seven years old as of June 30, 2022.

Like most of the assumptions made in connection with the LIIs, the DOL’s decision to use sixty-seven years old was made because the DOL placed a premium on making the LIIs simple and consistent. Moreover, sixty-seven years old aligns with full or normal retirement age for MOST workers, as well as with Social Security’s full retirement age for MOST workers.

However, this assumption may have significant implications. For example, twenty-four year old participants who have only recently begun using their retirement plan are fast forwarded to age sixty-seven for the purposes of the LII. But their “retirement balances” are their actual account balances as of the assumed commencement date. And those balances are not fast forwarded or in any way projected forward like with their age. Thus, their “retirement balances,” on which their LII annuity projections are based, do not include, and will not account for, their anticipated lifetime of additional deferrals, additional employer contributions, and/or investment returns. Accordingly, their illustrated lifetime income may be significantly less than they might otherwise expect, potentially based on information and projections they receive from other sources.

The DOL presumably hopes that this potential underestimating of lifetime income will jolt plan participants and will encourage “those currently contributing too little to increase their plan contributions.” But certainly the opposite reaction – i.e., withdrawal from a seemingly ineffective plan after years of savings – is also a real possibility.

  • Interest: The assumed interest rate is the variable 10-year Constant Maturity Treasury rate (10-year CMT) as of the first business day of the last month of the statement period. Thus, for example, for calendar Q2 2022 participant benefit statements, the LIIs assumed that the applicable interest rate for both the SLA and QJSA projections was the 10-year CMT as of Wednesday, June 1, 2022.

Notably, during the IFR public comment period, one commenter “with members representing more than 90% of assets and premiums in the US life insurance and annuity industry” stated that the 10-year CMT best represents the interest rates that are reflected in the actual pricing of commercial annuities. Thus, the use of the 10-year CMT in the LIIs may be a reasonable proxy for the interest rates available in the commercial annuities the LIIs are supposed to illustrate. But, of course, generally speaking, the 10-year CMT is unrelated to the actual investments, and returns that may (or may not) be achieved, in a retirement plan participant’s account. In other words, the actual investments, e.g., mutual funds, in a plan participant’s account and returns that may (or may not) be achieved from those investments can and will vary widely between plans and plan participants.

  • Mortality: Mortality is determined using the gender neutral mortality table in IRS Code § 417(e)(3)(B).

The DOL used a gender neutral table to determine mortality because doing so is administratively easier. However, mortality rates do differ by gender, with women generally skewing lower.

Illustrated Benefits

Incorporating these assumptions, the LIIs must illustrate hypothetical annuity benefits from a Single Life Annuity (SLA) and a Qualified Joint and Survivor Annuity (QJSA). Notably the illustrated annuities do not actually exist, cannot be purchased on the open market, and the illustrated payouts are not guaranteed by any employer or employer-based retirement plan. [2]

  • Single Life Annuity: The illustrated SLA pays a fixed monthly amount for the life of the participant.
  • Qualified Joint and Survivor Annuity: The illustrated QJSA is a Qualified Joint and 100% Survivor Annuity. Thus, it pays a fixed monthly amount for the life of the participant and the same fixed monthly amount for the life of the surviving spouse.

The use of a QJSA requires additional assumptions. The QJSA illustration assumes that the participant is married. And assumes that the spouse is the same age as the assumed age of the participant. In other words, both the participant and the (potentially hypothetical) spouse are assumed to be sixty-seven years old as of the commencement date. (If the participant is older than sixty-seven years old, then the spouse is assumed to be the participant’s actual age on the commencement date.) Again, this is regardless of the participant’s or spouse’s actual age and it ignores the potential wide variety of such ages and potential wide variety of age differences between participants and their spouses.

Notably, the DOL chose to illustrate a SLA and a 100% QJSA to fully demonstrate the spread of possible monthly payments if the retirement plan balance is annuitized. In other words, the SLA is included to illustrate the highest monthly payment amount and the 100% QJSA is included to illustrate the lowest monthly payment amount. Other options (e.g., 25% QJSA, 50% QJSA, etc.) would likely illustrate a monthly payment amount in between those two boundaries.

A Couple of Important Issues That Are Not Addressed

Although the LIIs incorporate a number of assumptions, there are a couple of important issues that they do not address.

  • Insurance Loads: The LIIs do not assume or incorporate any insurance loads.

In simple terms, insurance loads are the fees associated with purchasing and using annuity products. The LIIs do not make any assumptions concerning such fees or otherwise address or incorporate them in any way into the SLA or QJSA illustrations. This may be a significant omission, as annuity fees can sometimes have a meaningful impact on the actual monthly payments available to annuity purchasers. Thus, the complete omission of any assumptions concerning such fees may give some plan participants an inflated sense of the monthly payments available if they choose to annuitize their retirement balance.

  • Inflation: The LIIs do not account or adjust for inflation.

Obviously inflation can have a significant effect on any retirement plan or investment strategy. But the decision not to model or include inflation adjustments in the LIIs assumptions was made, like many of the other decisions concerning these illustrations, in an effort to keep these hypothetical illustrations as consistent and simple as possible across the universe of plans and plan participants. Regardless of the reason, particularly now, when inflation is running at historically high levels, plan participants may have questions and concerns surrounding this omission.

Example LII

This example is taken directly from an EBSA press release dated August 18, 2020.

  • Example Illustration: Participant X is age 40 and single. Her account balance on December 31, 2022, is $125,000. The 10-year CMT rate is 1.83% per annum on the first business day of December.
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In addition to information similar to the information in this chart, the IFR requires that additional explanations, statements, and disclosures be provided to plan participants. The idea is that the additional explanations, statements, and disclosures will help plan participants understand their annuity illustrations and also understand that they are only hypothetical illustrations and are not guarantees of payment.

The IFR provides model language for the required, additional statements, explanations, and disclosures. Generally speaking by adopting the assumptions and model language, or language substantially similar to that language, plan sponsors may qualify for some liability protection associated with the possibility that plan participants might sue if actual monthly payments are less than illustrated.

Final Thoughts

In general, the assumptions made in an effort to keep LIIs consistent and simple across the entire universe of plans and plan participants are also what may lead to specific plan participant questions and concerns.

Moreover, while the purposes behind implementing LIIs seem noble, their actual effect on plan participants and retirement preparedness is currently unknown.

Understanding the assumptions that underpin the LIIs and what the LIIs are – and are not – is important for plan sponsors and plan participants. Similarly, it is critical to understand the significant differences between annuities and the mutual funds that are often held in employer-based retirement plan accounts.

With all this in mind, trusted and knowledgeable financial professionals should be consulted when interpreting LIIs and throughout the retirement planning process.

Contact the Trust Point team if you have any questions on the new Lifetime Income Illustrations requirements.

[1] To date, no “final-final” rule has issued and there is no clear timeline for a “final-final” rule. The July 2021 Temporary Implementing FAQs stated that it would be issued “as soon as practicable based on feedback from comments received during the public comment period on the IFR.” Other statements indicated that the intent was to issue it before the now-passed IFR effective date.

[2] There are additional, special rules related to LIIs and in-plan annuities. TPI plans intentionally do not offer in-plan annuities. Thus, that possibility and those rules have not been analyzed and are not addressed in this article.

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Jon Marquet, Retirement Plan Consultant