Apples and Oranges: Understanding Lifetime Income Options

February 12, 2024

4 min read

Christopher Nikolich| Head of Glide Path Strategies (US)—Multi-Asset Solutions

Howard Li, CFA| Senior Research Analyst—Multi-Asset Solutions

Andrew Stumacher| Managing Director—Custom Defined Contribution Solutions

Secure lifetime income is a top wish-list item for defined contribution plan participants, and it has benefits for plan sponsors too. But there are very different ways to deliver it.

The first step in choosing a retirement-income solution is understanding the differences—which can be substantial—across the broad array of options. Let’s look at four categories of typical solutions, with a high-level view of how they work, as well as their costs and risks, summarized in the Display below.

1) Self-Insurance: The Non-Guaranteed Approach

One way to pursue retirement income is what many participants do today: they invest in a diversified solution, such as a target-date strategy, and forgo insurance—often managing withdrawals on their own. Participants keep full ownership of and liquidity in their retirement savings, have growth potential based on their asset allocations, and can pass remaining account balances to their beneficiaries at death.

The drawback of self-insurance is uncertain income, and participants tend to overestimate or underestimate their sustainable withdrawal rates. As a result, they may have to reduce the percentage of assets they withdraw, lowering their amount of income and their living standard as a result. Or they can continue withdrawing the same amount of income and risk running out of assets. Participants who don’t want these risks are more likely to favor income insurance—a feature of the next three solutions.

2) Single Premium Immediate Fixed Annuity (SPIA)

A SPIA, also referred to as an income annuity, is among the most well-known annuities. At retirement, participants surrender their assets to an insurance company (a decision that can’t be revoked). In exchange, they receive guaranteed fixed payments that start right away and continue for life. SPIAs have no explicit annual insurance premium or fees, because participants no longer own any assets.

Outcomes for participants depend heavily on their age of death; half will die before the median life expectancy, failing to reap the full income benefit. Adding death-benefit riders can reduce the loss from dying early, but at the cost of a lower income rate. Participants living longer receive bond-like returns for decades: they no longer risk outliving their assets, but they sacrifice the liquidity and growth potential of target-date funds.

Retirement-Income Solutions: Key Features

Comparing features of uninsured and insured income solutions, including risks and costs

For illustrative purposes only.
*Refers to managed payout funds, managed accounts, self-directed drawdown of target-date funds and systematic withdrawal programs. While each of these solutions functions differently and provides varying degrees of success and personalization, the features are essentially the same. Guarantees are based on the strength and claims-paying ability of each insurance company.
As of December 31, 2023

3) Deferred Fixed Annuity

A deferred fixed annuity, such as a qualified longevity annuity contract (QLAC), requires participants to surrender their assets up front, like the SPIA. But with a QLAC, income payments start many years later. A person surrendering their assets at age 65 might receive payments starting at age 80. In exchange for waiting, payment rates are higher than those of a SPIA. Participants must manage their own assets and avoid running out of money until guaranteed income payments start.

As with a SPIA, participants with QLACs forgo the liquidity and growth potential of the assets they surrender to the insurer. The deferred payments make outcomes more sensitive than a SPIA to the age of death. For example, a person who dies before payments start may get nothing. Adding death benefits can address this, but they reduce the income rate. QLACs also face more inflation risk: fixed payments are bought many years before they start, so rising prices will reduce their purchasing power. A QLAC’s income level is more sensitive than a SPIA’s to prevailing interest rates at the time of purchase, so participants face more market-timing risk and potential buyer’s remorse.

Fixed annuities like the SPIA and QLAC face significant risks and impose implicit costs that are neither transparent nor clearly visible at purchase. This sets up a potential unwelcome surprise for those who don’t fully understand them.

4) Guaranteed Lifetime Withdrawal Benefit (GLWB)

A GLWB is a lifetime income insurance contract on a participant’s investment portfolio. Participants keep ownership of all their assets and retain growth potential, because assets covered by the GLWB are typically invested in a well-diversified mix of stocks, bonds and inflation-sensitive assets.

Guaranteed income is initially withdrawn from the participant’s insured portfolio. If that portfolio runs out of funds, an insurer (or insurers) steps in to pay guaranteed income for the rest of the participant’s life. The GLWB also includes “step up” provisions that may boost income if the insured portfolio grows with rising markets. If there’s a balance left when the participant dies, it’s transferred to beneficiaries.

A GLWB contract charges an annual insurance premium—typically a percentage of the insured portfolio balance. Insurance can be bought before or at retirement, and participants can cancel some or all of it at any time with no restrictions, so they benefit from liquidity and flexibility.

The specific features, costs and risks of these representative retirement-income solutions vary quite a bit, and some risks and costs aren’t obvious on the surface. Understanding the distinctions is a vital step for plan sponsors to take in assessing which one is best suited to meet the individual needs of each plan participant.

“Target date” in a fund’s name refers to the approximate year when a plan participant expects to retire and begin withdrawing from his or her account. Target-date funds gradually adjust their asset allocation, lowering risk as a participant nears retirement. Investments in target-date funds are not guaranteed against loss of principal at any time, and account values can be more or less than the original amount invested—including at the time of the fund’s target date. Also, investing in target-date funds does not guarantee sufficient income in retirement.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to revision over time.

About the Authors

Christopher Nikolich

Christopher Nikolich joined AB in 1994 and is the Head of Glide Path Strategies (US) in the Multi-Asset Solutions business, leading research efforts relating to effective target-date and lifetime income fund construction. He is an author of defined contribution–related research, such as Designing the Future of Target-Date Funds: A New Blueprint for Improving Retirement Outcomes and Leveling the Retirement Income Playing Field: A Comprehensive Framework for Evaluating Diverse Lifetime Income Solutions. In addition, Nikolich has authored thought leadership focused on a variety of topics, such as plan design, asset allocation and inflation. He works closely with clients in the structuring of their customized target-date and lifetime income funds. From 2002 to 2008, Nikolich worked in both New York and London as a senior portfolio manager on the Blend Strategies team, collaborating with clients on the creation and implementation of multi-asset class solutions. From 1996 to 2002, he was a portfolio manager in the Index Strategies Group, where he managed risk-controlled equity services. Nikolich holds a BA in finance from Rider University, an MBA in finance from New York University. He is a member of the Board of Trustees of Rider University, the Vice Chair of Rider University’s Investment Subcommittee and is a former member of the Executive Committee of the Defined Contribution Institutional Investment Association (DCIIA). Location: New York

Howard Li, CFA

Howard Li is a Vice President and Senior Research Analyst for AB’s Multi-Asset Solutions division. He works in the US Defined Contribution Research and Investment Management team, where he is responsible for custom glide path construction, asset allocation and portfolio management of target-date solutions for US defined contribution (DC) plans. Li works with plan sponsors to develop custom glide path strategies that are tailored to DC plan sponsors’ objectives and participants’ demographics. He joined the firm in 2006 as a quantitative research analyst. Since 2008, Li has focused his research on asset allocation and investment management of custom target-date and lifetime income strategies. He holds an MSc in computer science from Boston University and an MBA in finance and economics from Columbia Business School. Li is a CFA charterholder. Location: New York

Andrew Stumacher

Andrew Stumacher is a Senior Vice President and Managing Director for AB’s Customized Defined Contribution Solutions. He is responsible for developing, implementing and driving the growth of custom target-date, model portfolio and retirement income strategies for the large and mega-size institutional plan market, in which AB serves as one of the largest managers in the US. Stumacher works in close collaboration with plan sponsors, consultants and external business partners to develop innovative and flexible products to improve outcomes for DC plans and participants. He joined the firm in 2004 as a marketing analyst, focusing on strategy and development for new institutional products. From 2011 to 2017, Stumacher managed the integration of AB’s DC products with recordkeepers, trustees, custodians, insurers and investment managers as the DC partner relationship officer. He holds a BS in applied economics and management from Cornell University and an MBA from Wagner College as well as the Certified Annuity Specialist™ designation from the Institute of Business & Finance. Location: New York

Apples and Oranges: Understanding Lifetime Income Options

1) Self-Insurance: The Non-Guaranteed Approach

2) Single Premium Immediate Fixed Annuity (SPIA)

3) Deferred Fixed Annuity

4) Guaranteed Lifetime Withdrawal Benefit (GLWB)

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