Fund Democracy

Consumer Federation of America

Consumer Action

May 3, 2010

FILED ELECTRONICALLY

Office of Regulations and Interpretations

Employee Benefits Security Administration

Room N-5655

Department of Labor

200 Constitution Avenue, NW

Washington, DC 20210

Re: Lifetime Income Options for Participants and Beneficiaries in Retirement Plans

Dear Ms. Ward, 

We are writing on behalf of Fund Democracy, Consumer Federation of 

America and Consumer Action in response to the Department’s request for 

information on Lifetime Income Options for Participants and Beneficiaries in 

Retirement Plans (collectively, “401(k) plans”). We support the Department of 

Labor’s efforts to improve Americans’ retirement security and its recognition of 

the changing structure of our retirement system. Lifetime income options should 

be a core component of Americans’ 401(k) plans.

We believe that the consideration of lifetime income options, which we 

will refer to as “annuities,” is the kind of foundational inquiry that requires the 

Department to revisit the key principles that define its role in regulating 401(k) 

plans. The answers to virtually all of the Department’s questions regarding 

annuities depend on fundamental assumptions about the Department’s regulatory 

role. Our letter presents our views regarding what these fundamental assumptions 

are and, to a limited extent, provides initial answers to some of the Department’s 

questions on the basis of these fundamental assumptions. 

We cannot emphasize strongly enough the importance of the Department’s 

developing a coherent conception of its role before developing policies and 

making detailed proposals regarding annuities in 401(k) plans. Regardless of 

whether the Department’s conception of its regulatory role conforms to our 

understanding, it is imperative that whatever policies it implements reflect a 

coherent, sustainable approach. We believe that America’s current and future 
2

retirees are at risk1 and that this risk results as much from the government’s 

ambivalence in developing and implementing coherent policies as from the 

current structure of our retirement system itself. 

The fundamental assumptions regarding the Department’s role in the 

regulation of 401(k) plans that we believe should guide the Department’s 

consideration of annuities are summarized as follows:

• Investment Theory. The Department’s role in regulating 401(k) 

plans requires as a matter of law, practice and policy that it ensure 

that 401(k) plans operating under the Section 404(c)’s fiduciary 

safe harbor reflect generally accepted investment theories. The 

Department should ensure that any policies relating to annuities in 

401(k) plans fulfill this role by expressly reflecting articulated 

general investment theories on which the policies are based.

• Low Income, Less Sophisticated Plan Participants. The 

Department should tailor is treatment of annuities in 401(k) plans 

to reflect the needs of less sophisticated, low income plan 

participants. These participants are most susceptible to sales 

abuses, are at greater risk of committing planning errors, and are 

most vulnerable to losses that leave them unprepared for retirement 

and dependent on government transfer payments.

• Variable Annuities. Variable annuities are more frequently the 

subject of abusive sales practice than any other investment. They 

impose higher fees and provide additional benefits of questionable 

value. We strongly encourage the Department to require 

heightened scrutiny by employers and/or product providers of 

variable annuity investment options. 

We have also provided initial recommendations regarding the role of 

annuities in 401(k) plans that generally flow from the fundamental assumptions 

discussed above. We expect that we and other commenters will revisit detailed 

aspects of this issue as the Department’s overall policy direction unfolds, and that 

our recommendations will evolve as well. Our initial recommendations are as 

follows: 

• Employers should be required to provide standardized Simple Annuities, 

as defined infra; 

• State guarantees of annuities should be strengthened and a federal role in 

this respect considered; and 

 1 See Christine Dugas, Retirement Overhaul: 401(k)s May Not be the Answer Now, USA Today 

(Oct. 20, 2009).
3

• Employers and/or product providers should be required to demonstrate the 

net benefit provided by variable annuities relative to other investments.

The remainder of this letter is organized as follows:

I. Investment Theory . . . . . . . . . . . . . . . . . . . 3

II. Low Income Participants . . . . . . . . . . . . . . . 11

III. Least Sophisticated Participants . . . . . . . . . . . . 14

IV. Variable Annuities . . . . . . . . . . . . . . . . . . . 15

V. Initial Recommendations . . . . . . . . . . . . . . . . 18

I. Investment Theory

We believe that the Department is required by law to incorporate 

substantive investment theory into its rules regarding the operation of 401(k) 

plans. This assumption is based on explicit directions from Congress, the 

consistent evolution of the law since ERISA was enacted over thirty years ago,

and the Department’s rulemaking under that Act.

The most important element of the legal structure under which the 

Department has promulgated numerous 401(k)-related rules is the fiduciary duty 

to which plan sponsors, referred to herein as “employers,” are subject under 

ERISA. The scope of an employer’s fiduciary duty is set forth in Section 404(a) 

of ERISA, which incorporates a “then-prevailing” prudent person standard. The 

term “then-prevailing” means that this standard is to be applied consistently with 

evolving notions of prudential investment management. Congress also 

incorporated a specific requirement that the employer “diversify the investments 

of the plan so as to minimize the risk of large losses, unless under the 

circumstances it is clearly prudent not to do so.” Congress chose to embed a 

specific, albeit somewhat crude, statement of investment theory in the statutory 

fiduciary duty that applies to employers under ERISA.

In Section 404(c), Congress also chose to insulate employers from liability 

with respect to participants’ investment decisions, however, when participants 

exercise control over the assets in their accounts. It expressly delegated to the 

Department the responsibility for determining when participants would be 

deemed to “exercise control.” Toward this end, the Department adopted Rule 

404c-1, which provides that a plan does not qualify under Section 404(c) unless, 

among other things, the participant has “an opportunity to choose, from a broad 

range of investment alternatives, the manner in which some or all of the assets in 

his account are invested.” 
4

Thus, the Department interpreted the “exercises control” standard to mean 

more than merely the participant’s authority to choose the options in which his 

assets are invested. The Department incorporated a specific “diversify the 

investments” requirement, which Congress had included in Section 404(a), as a 

component of an employer’s fiduciary duty under that provision.2 The conditions 

that the Department deemed necessary to absolve employers of fiduciary 

liability for participants’ investment choices included not just the employees’ 

unrestricted freedom, but also the incorporation of general investment theory.

The Department actually gave much greater content than that to Section 

404(a). Rule 404c-1 also states that a “broad range of investment alternatives” 

has been provided only if the participant has a reasonable opportunity to: 

(A) Materially affect the potential return on amounts in his 

individual account with respect to which he is permitted to exercise 

control and the degree of risk to which such amounts are subject;

(B) Choose from at least three investment alternatives:

 (1) Each of which is diversified;

 (2) Each of which has materially different risk and return 

characteristics;

 (3) Which in the aggregate enable the participant or beneficiary 

by choosing among them to achieve a portfolio with aggregate risk 

and return characteristics at any point within the range normally 

appropriate for the participant or beneficiary; and

 (4) Each of which when combined with investments in the other 

alternatives tends to minimize through diversification the overall 

risk of a participant's or beneficiary's portfolio;

(C) Diversify the investment of that portion of his individual 

account with respect to which he is permitted to exercise control so 

as to minimize the risk of large losses, taking into account the 

nature of the plan and the size of participants' or beneficiaries'

accounts.

 2 See Participant Directed Individual Account Plans, 56 FR 10724-01, 1991 WL 301434 (Mar. 13, 

1991) (“This requirement was based on the statement of Congress in the Conference Report 

accompanying the enactment of ERISA that the regulations promulgated pursuant to section 

404(c) ‘generally will require that for there to be independent control by participants, a broad 

range of investments must be available to the individual participants and beneficiaries.’”).
5

This set of requirements shows that what began with Congress’s general 

directive to diversify plan investments to avoid “large losses” had evolved into a 

far more sophisticated, specific incorporation of investment theory, which itself 

was rapidly evolving in the world of financial economics. Modern portfolio 

theory, premised primarily on the relationship between risk and return, was 

founded by Harry Markovitz in the 1950s and continues to evolve today. The 

repeated references to risk and return in the foregoing parts of Rule 404c-1 reflect 

the parallel evolution of modern portfolio theory beginning in the 1950s to the 

present, and the law’s incorporation of modern portfolio theory as reflected in the 

“diversify the investments” requirement in 1974, to Rule 404c-1’s advanced 

standard quoted above that was adopted in 1992,3 the qualified default investment 

alternatives adopted in 2006 that are discussed below.4

The Department expressly intended that Rule 404c-1’s diversification 

standard incorporate general investment theory. In the adopting release, the 

Department stated: 

The Department believes that the criteria set forth in paragraph 

(b)(3)(i)(B) reflect well established investment principles which 

are appropriate to the defining of a broad range of investment 

alternatives. The Department also believes that adoption of these 

principles provides plan sponsors the design flexibility necessary 

to accommodate changes in participant needs and changes in 

investment products and markets.5

The Rule recognizes both the need for diversification within and across 

investment options, as well as the concept of risk/return characteristics that reflect 

“the range normally appropriate for the participant or beneficiary.”6 The Rule 

thereby reflects the investment theory that combining investments the 

performance of which is generally uncorrelated can reduce the overall risk of a 

portfolio, as well as the importance of matching particular risk/return 

characteristics to the needs of different participants. 

In 2006, Congress created an additional safe harbor for qualified default 

investment alternatives (“QDIAs”). Interestingly, the safe harbor provides that a 

participant shall be deemed to exercise control over his account if he actually does 

not exercise control (i.e., “in the absence of an investment election by the 

 3 See Final Regulation Regarding Participant Directed Individual Account Plans, 57 FR 46906-01, 

1992 WL 277875 (Oct. 13, 1992) (Participant Directed Adopting Release).

4 See Default Investment Alternatives Under Participant Directed Individual Account Plans, 72 FR 

60451 (Oct. 24, 2007) (QDIA Adopting Release).

5 See Participant Directed Adopting Release, supra (emphasis added).

6

 Id.
6

participant,”)7 if the employer invests the participant’s assets in a QDIA as 

prescribed by the Department. Here, the Department moved from the realm of 

imposing general investment theory to picking the specific types of investments 

into which employers could default participants under the Section 404(c) safe 

harbor. It became the arbiter of what specific risk/return characteristics were 

“normally appropriate” for the participant or beneficiary.

Under Congress’s general instruction that QDIA’s “include a mix of asset

classes consistent with capital preservation or long-term capital appreciation, or a 

blend of both,” the Department selected: 

three categories of investment alternatives that it determined 

appropriate for achieving meaningful retirement savings over the 

long-term for those participants and beneficiaries who, for one 

reason or another, do not elect to direct the investment of their 

pension plan assets.8

Each of these three categories of QDIAs must: apply “generally accepted 

investment theories,” be diversified so as to minimize the risk of large losses,” 

and achieve “long-term appreciation and capital preservation through a mix of 

equity and fixed income exposures.” 

The Department’s guidance did not stop with these general statements of 

generally accepted investment theory. It required that life-cycle and target-date 

funds, for example, take into account a “participant's age, target retirement date 

(such as normal retirement age under the plan) or life expectancy,” but not the 

“risk tolerances, investments or other preferences of an individual participant.” 

No reasonable financial planner would: (1) consider such a limited set of factors 

to be sufficient to determine the best investment choice for a client, or (2) 

willingly ignore the client’s risk tolerances, investments or other preferences. In 

fact, a broker who provided a recommendation based solely on a client’s “age, 

target retirement date (such as normal retirement age under the plan) or life 

expectancy” generally would violate his obligation under the federal securities 

laws to make suitable recommendations. In some cases, the law allows financial 

advisors to provide investment advice without adequate information, but only if 

the client refuses to provide it upon request.

We make this point not to criticize the Department for permitting 

employers to invest participants’ assets based on inadequate information (we 

agree with that position), but rather to emphasize the extraordinary reach of its 

role in fashioning investment theory to fit the particular circumstances. The 

 7

 The safe harbor applies even in the absence of decision by the participant to participate in the 

plan where an employer automatically enrolls employees.

8 QDIA Adopting Release, supra.
7

Department could have required that the employer collect sufficient information 

to make a decision that was appropriate for that participant similar to the 

information that a financial advisor would be required to collect. It also could 

have permitted investment decisions without adequate information as long as the 

employer had attempted to obtain the information and documented that attempt. 

We agree, however, that such positions would have dissuaded employers from 

adopting automatic enrollment and/or encouraged them to direct participants’ 

assets to overly conservative QDIAs.

Instead, the Department chose, to its credit, to permit employers to make 

investment decisions – within the parameters of generally accepted investment 

theory as determined by the Department – based on inadequate information 

about particular participants’ investment needs. It made the tough call to fill the 

regulatory void created by the fiduciary safe harbor with what can only be 

described as a finely balanced application of specific, substantive investment 

theory. The Department decided that participants who decline to choose 

investment options in a plan into which they may have been placed automatically 

are better off being invested in an investment option that reflects an extremely 

crude estimate of the risk and return characteristics that would be most 

appropriate for a participant based solely on their age, target retirement date or 

life expectancy. We agree that the Department made the right call and, more 

importantly for purposes of this letter, this was a call that the Department was 

required to make.

The QDIAs approved by the Department also reflect a failure, however, 

on the Department’s part regarding its recognition of its role in applying 

substantive investment theory in the context of 401(k) plans. As described above, 

the Department has a responsibility to apply generally accepted investment 

theories as a general matter, and that responsibility is especially pronounced 

where the theories it adopts will be applied to participants who, by definition, 

have declined to make an investment choice and where investment decisions will 

be made for them based on inadequate information. As discussed further below, 

the Department’s unwillingness to accept the logical consequences of its QDIA 

policy illustrates the kind of incoherent policymaking that places participants at 

greater risk.

The Department authorized target-date funds as QDIAs on the condition 

that they provide:

varying degrees of long-term appreciation and capital preservation 

through a mix of equity and fixed income exposures based on the 

participant's age, target retirement date (such as normal retirement 

age under the plan) or life expectancy.

It also expressly authorized employers to disregard participants’ “risk tolerances” 

and “investments,” when investing QDIA assets in a QDIA target-date fund. The 
8

problem with this approach is that the Department did nothing to ensure that 

QDIA target-date funds accounted for the fact that they would not reflect anything 

about a participant’s risk tolerance or other investments. Both of these factors 

would be critical to determining, for example, whether a target-date fund that was 

more or less aggressive than average might be the best fit for a particular 

participant. A more aggressive target-date fund would be appropriate for a 

participant, all other factors being equal, who had a high risk tolerance and/or 

substantial outside investments in low risk securities. A more aggressive targetdate fund would not be appropriate for a participant, all other factors being equal, 

who had a low risk tolerance and/or no such risk-offsetting investments.

Note that this is not a question of what is the optimal equity/debt mix for a 

50-year-old who plans to retire at age 65, for example. Rather, our point is that 

the optimal equity/debt mix for that 50-year-old when based solely on his age and 

expected retirement date is decidedly not an outlier debt/equity mix. Nor is our 

point that many target-date funds are overly aggressive.9 Rather, it is the risk that 

permitting extremes when investment decisions are based on very little 

information creates an unacceptable level of risk for participants. Allowing 

target-date funds to use allocations that are more or less aggressive than average 

increases the risk created by making investment decisions without knowing the 

risk tolerances or investments of the investors. The Department cannot eliminate 

this risk because no target-date fund will meet every participant’s particular needs 

and some degree of investment error is unavoidable, but it has a responsibility to 

minimize this risk by requiring that the unavoidable cost of investment error be 

minimized. 

We recognize that this analysis would require that the Department provide 

some mechanism for determining what we have referred to as an “average” 

debt/equity mix. It is difficult for a government agency to take this step, 

especially in a political climate in which some influential commentators seem to 

reject even the possibility that financial services regulation benefits society. But 

it is a step that the Department is required to take as a matter of law, policy and 

practice. The Department should have followed the ineluctable logic of its 

authorization of informationally deprived decisions to invest participant assets in 

target-date funds, and limited the variance in their risk characteristics. The result 

of the Department’s failure to do so was that, in 2008, “target date funds for 2010 

suffered losses of as little as 4 percent to as much as 40 percent.”

10 

The Department’s current position continues to be, in effect, that it is 

appropriate for employers to place participants in high risk target-date funds even 

 9

 We disagree with the position expressed by some critics that target-date funds necessarily should 

assume very little risk.

10 Remarks of SEC Chairman Mary Schapiro before the Solutions Forum on Fraud, Washington, 

DC (Oct. 22, 2009). Although this statement reflects all target-date funds, we have no reason to 

believe that the performance range of target-date funds in 401(k) plans was materially different.
9

if they have a low risk tolerance or other characteristics that would make a high 

risk target-date fund a particularly inappropriate investment selection. The 

Department has an obligation, having established the investment theory pursuant 

to which target-date funds qualify as QDIAs under the fiduciary safe harbor, to 

ensure that that investment theory is implemented consistent with the fact that 

investment decisions will be made without regard to important participant 

characteristics. 

The target-date fund issue discussed above illustrates how, when the 

Department hesitates to act consistently with its own investment theories, the 

result can be investment decisions that are harmful to participants. It is the 

Department that has told employers that placing low risk tolerance participants in 

high risk target-date funds is permissible. Some might argue that forbearance by 

the Department in regulating the risk characteristics of target-date funds will 

allow more efficient free market forces to find the most efficient combination of 

investments, but this is a fantasy. The alternative to the Department’s taking a 

position is not the free market. The fiduciary safe harbor eliminates the free 

market right of a low risk-tolerance participant to bring a fiduciary claim against 

the employer who defaults that participant into a high risk target-date fund. The 

natural constraints that are normally are present in the free market have been 

removed by the QDIA safe harbor.

To a large extent, it is the Department that decides what investments are 

appropriate for the 401(k) market. Employers are permitted, indeed, implicitly 

encouraged to place participant assets into target-date funds on the sole basis of 

the participant’s age or expected retirement date, yet the range of asset allocations 

permitted in these funds will inevitably result in some participants, based on their 

risk tolerance or other investments, for example, being placed in extremely 

inappropriate investments. And the Department has expressly authorized 

employers to ignore risk tolerance and other investments, where other regulatory 

regimes require that advisers make a reasonable effort to incorporate these 

factors.

The Department cannot have it both ways. It must either: 

• permit employers to make investment decisions based on what every 

financial professional would agree is inadequate information and, 

accordingly, narrowly circumscribe those investment decisions so as to 

minimize or eliminate the risk created by the inadequacy of information 

about participants on which the decisions are based, or

• require employers to collect information about participants’ characteristics 

and afford employers greater freedom to use that information to make 

more tailored investment decisions for which they will be held fiduciarily 

responsible. 
10

Each of these approaches is reasonable in theory, if not in practice. What is in no 

way reasonable, however, is for the Department to permit investment decisions 

that, for example, reflect a very high or very low risk tolerance where the 

participant’s actual risk tolerance is permitted to have, and almost certainly will 

have, no bearing on the investment decision. This approach is internally 

inconsistent. The result is the kind of incoherent policymaking that creates 

significant risk for America’s retirees. 

This letter is not about target-date funds, however; nor is it intended to 

suggest that such incoherent policymaking has been a systemic problem at the 

Department in this area. To the contrary we believe that the Department’s most 

recent initiatives regarding QDIAs, fee disclosure and conflicted investment 

advice demonstrate a laudable, implicit recognition of its role in applying 

substantive investment theory in the context of 401(k) plans. 

One purpose of this letter is to encourage the Department to demonstrate a 

stronger commitment to this role. For example, we hope that the Department will 

respond directly to commenters who complain that the Department’s actions 

represent excessive government interference by pointing out that the 

Department’s role is necessarily intrusive. For example, the argument made in 

the context of the regulation of 401(k) plans that the “government should not 

dictate the solution or attempt to regulate exposure to investment risk” is either 

naïve or disingenuous.

11 A 401(k) plan is itself a form of government subsidy, 

which triggers a necessarily heightened public stake in its operations and 

structure. For decades, the public interest in 401(k) plans has been partly 

expressed by “regulating exposure to investment risk,” including express statutory 

mandates that the Department to regulate “exposure to investment risk.” To view 

the establishment of QDIAs as anything other than regulating “exposure to 

investment risk” shows an unwillingness to engage in serious debate about the 

appropriate scope of the Department’s role in regulating 401(k) plans. The 

Department’s ability to develop coherent 401(k) policies will depend partly on 

its commitment to expressly rejecting arguments that are fundamentally 

inconsistent with law, established public policy and decades of precedent as 

applied to the Department’s role in regulating 401(k) plans.

The Department should clarify that these commenters’ complaints are with 

Congress and the fundamental structure of the Section 404(c) safe harbor (or, 

based on recent public debate, the very existence of a fiduciary duty under Section 

404(a)) -- not with the Department. Their issue is not with how the Department 

does its job, but whether it does its job at all.

 11 Testimony of Paul Schott Stephens before the Committee on Education and Labor, U.S. House 

of Representatives, at 17 (Feb. 24, 2009) available at

http://edlabor.house.gov/documents/111/pdf/testimony/20090224PaulSchottStevensTestimony.pdf.
11

That being said, we agree that the Department must exercise restraint and 

stay within its role, which is far from unbounded. What we object to is the 

absurdity of arguments, for example, that the Department should not be taking 

positions on what are generally accepted investment theories, and the 

Department’s overly politic reluctance to meet these arguments head-on. It is 

imperative that the Department fully embrace its necessarily intrusive role in the 

context of evaluating annuities in 401(k) plans because a half-hearted policy on 

annuities, as illustrated by the target-date funds example discussed above, may 

leave America’s retirees worse off than if the Department had never waded into 

this issue in the first place. When the Department takes action on the issue of 

annuities in 401(k) plans, its actions will necessarily be in the form of 

investment advice; the only question is whether that advice will be good or bad 

for Americans. 

II. Low Income Participants

We believe that the Department should tailor its approach to annuities in 

401(k) plans to reflect particular concerns relating to low income workers. The 

participants with the lowest incomes have the most to lose if they make poor 

investment choices. We know that even if they make good investment choices, 

they are likely to rely heavily on Social Security and other transfer payments for 

their living expenses in retirement. Every dollar by which a low income worker’s 

retirement income is reduced has a substantially greater impact than for a high 

income. The dollar lost to a low income worker is far more likely to reduce the 

worker’s ability to afford food, shelter and medical care than it is likely to reduce 

a high income worker’s ability to pay for these necessities.12 

It is the inadequacy of low income workers’ income to cover basic living 

expenses that presents the greater risk of undermining the viability of the Social 

Security system. The viability of the Social Security system depends on an 

inherently unstable political compromise. It is not, as popularly described, a 

“retirement system” in the sense of providing a mechanism for workers to save 

and invest current income that they then are paid in retirement.13 Rather, it is 

structured as a current transfer of wealth from workers to retirees.14 In contrast, a 

 12 This principle is often referred to as the declining marginal utility of money. See generally

Joshua Greene & Jonathan Baron, Intuitions about Declining Marginal Utility (June 2000)

available at http://ssrn.com/abstract=231183.

13 For example, the President’s Commission to Strengthen Social Security describes Social 

Security as follows: “This 12.4 percent of wages paid into Social Security currently buys for these 

Americans an inflation indexed annuity upon retirement, as well as insurance against disability 

and protections for dependents and survivors.” The Final Report of the President’s Commission to 

Strengthen Social Security at 28 (Dec. 2001). While such rhetoric may itself “strengthen” the 

perception that Social Security has a strong foundation, Social Security taxes do not actually 

“buy” anything in the sense of taxpayers having purchased a contractual property right. 

14 Even this characterization gives excessive credence to Social Security as a bona fide “system” 

because current Social Security revenues (taxes) are not specifically earmarked for Social Security 
12

401(k) plan represents a contractual property right that, while in a limited sense 

itself “political,” is a far more politically viable structure for the long-term 

stability of our retirement system then Social Security. It is low income workers 

who are most dependent on Social Security, and the capacity of 401(k) plans 

generally and annuities specifically to place their retirement security on the 

politically and socially firmer ground of private, contractually protected 

arrangements should be a significant consideration as the regulation of 401(k) 

plans develops. 

Private retirement plans also reflect a more coherent financial theory of 

retirement planning than government transfer payments. The statement above 

that Social Security represents a current transfer of wealth from workers to 

retirees is somewhat wishful because much of government spending is funded 

through borrowing, not current tax revenues. Thus, while the structure of a 

private retirement plan comprises a deferral of current consumption to fund future 

consumption, the structure of Social Security partly comprises current 

consumption funded by future deferral of consumption. We are not expressing a 

view on the Keynesian aspect of this observation, but rather on the different 

question of whether a pay-later approach, all things being equal, is more likely to 

enhance Americans’ retirement security and promote a strong capitalist 

democracy than a pay-now approach. We believe that it is not.

Another way of making the same observation is to note that the muchdebated privatization of Social Security has actually been well underway for 

decades in the form of a continuous expansion of tax-advantaged retirement 

funding mechanisms (e.g., 401(k), 403(b), and 457 plans; IRAs; and Roth IRAs). 

The foregone tax revenues from tax-deferred investment vehicles are functionally 

no less transfer payments than are Social Security benefits. This privatization is 

structurally unsound, however, because it is used primarily by moderate and high 

income workers and does little to mitigate the transfer- and debt-based structure 

of our Social Security retirement system for low income workers. We believe that 

annuities have the potential to address this increasing structural segregation of 

retirement policy between a public system for low income workers funded 

through transfer payments and borrowing on the one hand, and a private, prefunded system for other workers on the other hand.

The foregoing reinforces both the importance of considering regulation’s 

affect on low income workers and the role of the Department in applying 

generally accepted investment theory through 401(k) regulation as discussed 

supra at pages 3 - 11. Indeed, the Department should be viewed not as fomenting 

intrusive government regulation, but as promoting free(er) markets. The practical 

alternative to heavily regulated 401(k) plans is not an unregulated retirement 

market, but an even more regulatory, and arguably unsustainable, Social Security 

 payments (benefits). Social Security taxes fund the general treasury, where they provide one 

source for all federal government expenditures.
13

system. Indeed, one irony of criticisms of the Department for over-regulating 

401(k) plans is that it is the Department’s success or failure in fulfilling this role 

that will have a direct impact on the far more intrusive model of providing 

Americans’ retirement income through current transfer payments and

borrowing.15 As long as Congress continues to abdicate its responsibility for 

addressing the long-term problems with Social Security, the Department will be 

the de facto lead policymaker on this issue. 

To return to the primary focus on this discussion – low income workers –

a variety of factors argue for focusing on concerns relating to low income workers 

in developing 401(k) regulations for annuities, including particularly the 

ameliorative effect on Social Security issues that the use of annuities in 401(k) 

plans could have. The social and individual cost of low income workers’ not 

realizing the expected value of their retirement assets in retirement is far greater 

than for other workers. Low income workers who survive paycheck to paycheck 

already are at greater risk of unexpected expenses derailing their lives. In 

retirement and without the potential flexibility that earnings can provide, low 

income retirees are even more vulnerable to investment risk. Workers are and 

should be more risk averse at lower incomes.

Annuities have the potential to reduce or eliminate retirement income risk 

for low income workers. A low income worker who purchases a fixed, inflationadjusted lifetime annuity at retirement can eliminate the retirement income risk 

that an investment portfolio that fluctuates in value presents.16 Purchasing the 

 15 In other words, we reject the view that “true libertarians” should be expected to “object to 

restrictions on default portfolios.” James Choi, David Laibson & Brigitte Madrian, Are 

Empowerment and Education Enough? Under-Diversification in 401(k) Plans at 24 (2005) 

available at

http://www.brookings.edu/es/commentary/journals/bpea_macro/forum/200509bpea_laibson.pdf. 

This view assumes that the alternative to such restrictions is a libertarian marketplace when, in 

fact, the true alternative is a more intrusive government role, not less. By analogy, those who 

oppose federally insuring money market funds on libertarian grounds ignore the fact that their 

position may have the effect of directing cash to riskier, more heavily regulated banks. See

Mercer Bullard, Federally-Insured Money Market Funds and Narrow Banks: The Path of Least 

Insurance (2009) available at http://ssrn.com/abstract=1351987. Unless it is a libertarian 

principle that public policy reforms must be modeled on theoretically perfect ideals, rather than 

practicable, incremental improvements, then Department policies that substitute default-option 

paternalism (401(k) default options) for coerced transfer payments (Social Security) should be 

supported by “true libertarians.” We note that this is an argument that policies that reduce 

government intrusion into the marketplace are libertarian, in contrast with the argument that 

default options are inherently libertarian (or not paternalistic) if they reflect so-called “libertarian 

paternalism.” See, e.g., Cass Sunstein & Richard Thaler, Libertarian Paternalism Is Not an 

Oxymoron, 70 U. Chic. L. Rev. 1159 (2003).

16 See generally Wolfram J. Horneff, Raimond Maurer, Olivia S. Mitchell, & Ivica Dus, 

Optimizing the Retirement Portfolio: Asset Allocation, Annuitization, and Risk Aversion (July 

2006) (quantifying risk aversion and finding fixed annuity a more appealing option for most risk 

averse); Ralph Koijen, Theo Nijman & Bas Werker, Optimal Annuity Risk Management, CentER 

Working Paper Series No. 2006-78 (Aug. 2009) (risk averse investors are less willing to bear 

inflation risk) available at http://ssrn.com/abstract=890730.
14

same annuity while working, where the income stream begins at retirement, has 

the added benefit of eliminating investment risk during the accumulation phase. 

This reduction in risk comes with an attendant reduction in potential returns, but 

the potential downside costs of negative performance are much greater for low 

income workers for the reasons discussed above. 

We recognize that low income workers, as a group, might enjoy higher 

average incomes by investing in the securities markets during both the 

accumulation phase and retirement, but an individual retiree does not receive the 

average retirement income. An individual retiree can sink into poverty regardless 

of the average retirement income of his cohort, just as easily as a person can 

drown in a lake with an average depth of only six inches. The greater the 

variance in the investment success of low income workers, the higher their 

average income is likely to be, but the absolute number of low income retirees 

who fall below a fixed poverty line also will be greater. Greater variance may 

mean that more low income retirees will enjoy higher incomes that they would 

had they purchased an annuity, but it also may mean that more low income 

retirees will go hungry and rely on redistributional policies to survive.

Expressing this point in terms of a normal distribution curve, greater risk 

may move the average retirement income to the right, but it will also increase the 

length of the tail on the left. Greater variance in investment returns will create a 

larger absolute number of outliers and, importantly, a larger number of outliers 

that fall below a minimum income level. When one’s position on the left tail is a 

matter of affording or not affording a nice vacation or cable television, the 

prospect of maximizing overall societal wealth through investment in the capital 

markets may justify greater risk-taking. We believe that, when a retiree’s position 

on the left tail determines whether he can afford basic necessities, however, the 

individual and social costs of what may be a societally wealth-maximizing 

strategy exceed its potential benefits. The Department must recognize the rational 

basis for greater risk aversion among low income workers when considering the 

role of annuities in 401(k) plans. 

III. Least Sophisticated Participants

The regulation of 401(k) plans also should be particularly tailored to the 

needs of the least sophisticated participants. Unsophisticated participants are 

most likely to make bad investment decisions and are most vulnerable to abusive 

sales practices. An annuity is at once both a greater and smaller risk with respect 

to unsophisticated participants. For example, a simple, inflation-adjusted, fixed 

annuity based on standardized terms and a fully disclosed, standardized price 

presents substantially less risk than does managing a pool of investments. Such 

an annuity would reduce an ongoing monitoring requirement to a single decision, 

and that decision would be far simpler than the process of selecting an appropriate 

mix of investments and planning and managing a schedule of withdrawals in 
15

retirement (“withdrawal risk”). A fixed annuity eliminates behavioral risk, i.e., 

the risk that worker will implement a good plan but fail to stay with it in practice. 

An annuity need not comprise all of a worker’s retirement portfolio to 

provide these advantages. It can provide these advantages even if it represents 

only a part of a worker’s retirement portfolio. For example, an annuity might 

provide for a welfare-based minimum level of income, which would mitigate the 

complexity risk presented by the rest of a portfolio being invested in securities. 

Unfortunately, annuities also have the potential to exacerbate the risk 

created by complexity. Insurance companies offer fixed annuities with a variety 

of features. Each additional feature makes an annuity more difficult to evaluate 

and to compare with other annuities. The greater the complexity, the greater the 

likelihood that the least sophisticated participants will make poor investment 

choices and/or pay excessive fees. Participants will be not able to correct their 

mistakes when the annuity purchase is irrevocable.

The problems encountered by the least sophisticated participants will also 

be exacerbated by the fact that this group overlaps disproportionately with low 

income participants. Low income participants are less likely to have the 

educational background, for example, that would provide them with greater 

sophistication and are definitionally less likely to have sufficient disposable 

income to retain a professional adviser. This latter point makes it likely that they 

will bear the brunt of conflicted advice that the Pension Protection Act permits 

employers to provide through a plan. 

In summary, unsophisticated participants are more likely to make bad 

investment decisions, and, when they are also low income participants, the 

adverse effects of bad decisions will be magnified. We believe that the regulatory 

foundation on which the Department’s approach to annuities should be principally 

based is the special concerns relating to low income, less sophisticated 

participants. The Department should consider investment risk, complexity risk 

and withdrawal risk as particular concerns. This may require, for example, that 

the Department promote or require the offering of simpler options that admittedly 

may not be perfectly aligned with each individual participant’s needs but that 

would generate a net benefit when all risks are considered. The Department must 

not allow the perfect to be the enemy of the good. It must be realistic about the 

characteristics of the 401(k) plan participants who are most at risk. 

IV. Variable Annuities

It is an unfortunate aspect of the regulatory context for annuities that they 

happen to be involved in more sales abuses than any other retail financial services 

product. Variable annuities are the most prominent repeat offenders in regulatory 

enforcement actions and are almost universally viewed negatively in the financial 
16

press and in the academic literature.17 For example, personal finance writer Liz 

Pulliam Weston has labeled variable annuities the “worst retirement investment you 

can make,” and Investment Sense, LLC, has called them “one of the most overhyped, 

most oversold, and least understood investment products.”18 One analyst estimates 

that variable annuities transfer approximately $25.6 billion a year “of spendable 

investment returns” from vulnerable investors to the insurance industry and its sales 

force.19 To be frank, we were stunned by the Department’s request for comments on

whether 404(c) regulations should “be amended to encourage use for these 

products” (emphasis added).

If anything, the Department should take steps to discourage the rampant 

overuse of variable annuities. Variable annuities are routinely the subject of 

antifraud enforcement actions. As has been noted elsewhere, 

While industry trade associations have argued that “there have been 

few concerns in the life insurance marketplace that would justify 

additional regulatory oversight,” concerns over abusive practices 

involved in the marketing and sales of annuities and more particularly 

variable annuities have led NASAA to issue numerous warnings 

about the products to investors and were similarly identified as a 

problem area in the joint SEC-FINRA-NASAA Investor Alert on 

schemes to defraud senior investors.20

 17 See generally Letter from AARP, North American Securities Administrators Association, Fund 

Democracy and Consumer Federation of America to Chairman Christopher Dodd and Ranking 

Member Richard Shelby, Committee on Banking, Housing and Urban Development, U.S. Senate 

(Feb. 2, 2010) (discussing abusive sales practices in sale of variable annuities to seniors) (Variable 

Annuities Senior Citizen Letter).

18 Liz Pulliam Weston, The Basics: The Worst Retirement Investment You Can Make (updated 

January 2008); InvestSense, LLC, Common Sense InvestSenseTM ... Variable Annuities (2002); 

see also, Caroline Greer, The Great Annuity Rip-Off, Forbes (Feb. 9, 1998).

19 Scott Burns, Variable Annuity Watch, 2008, AssetBuilder – Registered Investment Adviser.

20 Variable Annuities Senior Citizen Letter, supra, citing: NASAA News Release, “NASAA 

Identifies Traps Likely to Burn Investors This Summer” (June 17, 2008); NASAA News Release, 

“State Securities Regulators Issue Senior Investor Alert” (Sep. 10, 2007); NASAA News Release, 

“State Securities Regulators Identify Top 10 Traps Facing Investors” (May 15, 2007); Protecting 

Senior Investors: Report of Examinations of Securities Firms Providing “Free Lunch” Seminars,

Securities and Exchange Commission, North American Securities Administrators Association and 

Financial Industry Regulatory Authority (2007); NASAA News Release, “State Securities 

Regulators Release ‘Unlucky 13’ Investor Traps” (Feb. 16, 2006). See also FINRA Investor 

Alert, “Should You Exchange Your Variable Annuity?” (last updated Mar. 2, 2006) (citing 

abusive sales practices); Joint SEC/NASD Report on Examination Findings Regarding BrokerDealer Sales of Variable Insurance Products (June 2003); FINRA Investor Alert, “Variable 

Annuities: Beyond the Hard Sell” (last updated May 27, 2003); NASD Regulatory and 

Compliance Alert, “Advertising of Bonus Credit Variable Annuities” (Summer 2000) (warning 

against misleading sales practices); NASD Notice to Members 99-35, “The NASD Reminds 

Members of their Responsibilities Regarding the Sales of Variable Annuities” (May 1999); NASD 

Notice to Members 96-86, “NASD Regulation Reminds Members and Associated Persons that 

Sales of Variable Contracts are Subject to NASD Suitability Requirements” (Dec. 1996).
17

We encourage the Department to review carefully the materials produced by other 

regulators on variable annuities that are cited in the immediately preceding 

footnote before taking any steps that might promote the sale of variable annuities 

and thereby facilitating the perpetration of sales abuses upon America’s investors.

At the heart of widespread sales abuses involving variable annuities is the 

fact that they are not really annuities at all. Functionally, variable annuities 

operate as investments rather than as lifetime income sources. The word 

“annuities” in the term “variable annuities” is principally a sales pitch. There is 

generally no meaningful advantage provided by the annuity option offered by 

variable annuities. This is partly reflected in the low incidence of variable annuity 

purchasers who actually annuitize their investments. One study found that less 

then 0.8% of variable annuity purchasers actually converted to a fixed income 

annuity.21

Variable annuities’ primary practical advantage is tax deferral, yet that 

advantage is of no benefit to participants in already tax-deferred 401(k) plans. 

Variable annuities are extremely complex, which presents particular concerns for 

less sophisticated investors, and their fees are consistently higher than fees 

charged by other types of investment options. There are numerous studies that 

question whether the special features of variable annuities benefit more than a 

small number of purchasers.22 The death benefits provided by variable annuities 

are generally considered to be overpriced, 23 as are their guaranteed withdrawal 

benefits.24

The Department should consider that any expansion of the role of 

annuities in 401(k) plans is likely to provide greater opportunities for insurance 

agents to advise client to buy insurance products under the conflicted advice safe 

harbor. History shows that it is variable annuities that are most likely to be the 

 

21 See Jeffrey Brown, Rational and Behavioral Perspectives on the Role of Annuities in Retirement 

Planning, NBER Working Paper 13537 (2007) (less than 0.8% o variable annuities were 

converted to fixed life annuities, citing Dan Beatrice and Matthew Drinkwater, The 2003 

Individual Annuity Market: Sales and Assets, LIMRA International (2004)).

22 See, e.g., William Reichenstein, An Analysis of Non-Qualified Tax-Deferred Annuities, 73 J. 

Invest. 9 (2000).

23 See, e.g., Moshe Arye Milevsky & Steven Posner, The Titanic Option: Valuation of the

Guaranteed Minimum Death Benefit in Variable Annuities and Mutual Funds, 68 J. Risk & Ins. 93 

(2001) (estimating value of death benefit to be 1 to 10 basis points and median charge for death 

benefit as greater than 10 times that amount).

24 See, e.g., Benny Goodman & Seth Tanenbaum, The 5% Guarantee Minimum Withdrawal 

Benefit: Paying Something for Nothing? TIAA-CREF Research Institute (2008) (concluding that 

guaranteed minimum withdrawal benefit “does not offer much value”) available at

http://www.tiaa-crefinstitute.org/pdf/research/research_dialogue/89.pdf.
18

subject of self-serving recommendations under the Department’s new conflicted 

advice rules, especially if the Department permits computer model 

recommendations to ignore these investment options. Over the last six months, 

the insurance industry has been the most vocal opponent of applying a fiduciary 

duty – which provides the bedrock of regulation under ERISA – to the sale of 

variable annuities. The Department should carefully review insurance lobbyists’ 

recent arguments that the fiduciary duty is incompatible with the business of 

selling variable annuities in its evaluation of the compatibility of variable 

annuities with ERISA’s fiduciary regulatory structure.

Rather than seeking ways to encourage the use of variable annuities in 

401(k) plans, the Department should be seeking ways to protect participants 

against the sales abuses that are so frequently associated with these products. 

Variable annuity options, if allowed at all, should be subject to heightened

scrutiny, with a heavy burden placed on plan sponsors who choose such 

inherently questionable products as 401(k) investment options and the insurance 

companies that sell them.

V. Initial Recommendations

Based on the foregoing discussion, we have the following initial 

recommendations regarding the role of annuities in 401(k) plans:

• Mandatory Annuities. We recommend that employers be required to offer 

two types of standardized annuities as 401(k) plan options. The Simple 

Annuity would provide retirees with an immediate contractual right to a 

fixed, inflation-adjusted income stream for the life of the retiree or the 

retiree and their spouse. It would have no investment or other features. Its 

only fee would be included in the lump sum purchase price. The Future 

Simple Annuity would be identical except that it could be purchased on an 

installment basis during a worker’s career and would provide an 

immediate contractual right to a fixed, inflation-adjusted, lifetime income 

stream beginning at the age of retirement. The essential information about 

each Simple Annuity and Future Simple Annuity would be presented in a 

price/payout chart for different ages that would allow for easy comparison, 

and promote competition, among annuity providers.25 Employers should

be permitted to offer other types of annuities, provided that the 

standardized Annuities received greater prominence and subject to new 

requirements applicable to variable annuities discussed below.

• “Guaranteed” Annuities. The Department should consider requiring 

employers and/or annuity sellers to obtain reinsurance of annuities in 

excess of amounts recoverable from applicable state guaranty funds. 

Fixed annuities are routinely (and, we believe, falsely) advertised as 

 25 See Mercer Bullard, Annuities in Retirement Plans: Live Long and Prosper? Morningstar.com

(Mar. 18, 2010) available at http://news.morningstar.com/articlenet/article.aspx?id=329545.
19

providing a “guaranteed” source of income, although the seller’s promise 

is only as certain as its own creditworthiness and the amount of the 

coverage limit of the applicable state guaranty fund. The greatest benefit 

offered by an annuity is the income security that it is held out as 

providing. Employers and/or sellers should be required to reinsure 

annuities up to a minimum income level. The maximum coverage for 

defined benefit obligations provided by the Pension Benefit Guaranty 

Corporation might be an appropriate benchmark ($4,500/mo in 2010), and 

the Department should consider recommending to Congress that the 

PBGC itself provide reinsurance at least for the mandatory Simple 

Annuities discussed above.

• Variable Annuities. The Department should not “encourage” the use of 

variable annuities. To the contrary, the Department should take steps that 

recognize the long-term, pernicious effect of variable annuity sales abuses 

on America’s investors. We recommend that the Department consider 

special requirements to protect plan participants against these abuses. For 

example, the Department could require employers to obtain from sponsors 

of variable annuities that are offered as 401(k) plan investment options a 

plain English analysis of the sponsor’s determination that the benefits of 

each non-investment feature of the variable annuity exceeds its cost and 

cannot be obtained at lower cost by other means. For example, the 

sponsor of a variable annuity that offers the option to convert to an income 

stream at a future date would be required to show that the additional 

benefit provided by that option exceeded its cost (with data on the actual 

frequency with which annuity options are selected being incorporated into 

this analysis). If a variable annuity offered a death benefit that guarantee a 

minimum account value upon the death of the owner, the sponsor should 

have to demonstrate that the relevant risk of loss could not have been 

achieved more efficiently by other means, such as through the purchase of 

a term life policy and/or a reduction in the risk of the assets underlying the 

variable annuity.

* * * * * * * *

We strongly support the Department’s evaluation of the role of annuities 

in 401(k) plans and sincerely hope that it will not refrain from the full exercise of 

its responsibilities in this area. The retirement security of Americans has entered 

a precarious period in which systematic planning errors may have disastrous 

individual and societal consequences. The Department has an obligation to act 

decisively to guide the investment decisions of the least sophisticated, most 

vulnerable 401(k) plan participants.
20

We look forward to working with the Department to strengthen 

Americans’ retirement security by developing a coherent plan for the full 

integration of annuities into the 401(k) plan marketplace. 

Sincerely,

Mercer Bullard Ken McEldowney

President and Founder Executive Director

Fund Democracy, Inc. Consumer Action

Barbara Roper

Director of Investor Protection

Consumer Federation of America

cc by U.S. Mail: 

Honorable Hilda Solis, Secretary of Labor

Phyllis C. Borzi, Assistant Secretary of Labor (EBSA)