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401(k) Plan Shortcomings Failing As Retirement Income Program

October 2016

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The current “retirement plan” of choice – 401(k) plans – really aren’t true retirement income plans. While they can be great for accumulating savings, most 401(k) plans don’t do much to help older workers decide if they have enough money to retire, or how to convert their hard-earned savings into a retirement paycheck.

Americans need more help from their retirement plans, they need these plans to take the next step and offer retirement income programs. Recently, collaboration between the Stanford Center on Longevity (SCL) and the Society of Actuaries (SOA) resulted in a new report – Optimizing Retirement Income Solutions in Defined Contribution Retirement Plans: A Framework for Building Retirement Income Portfolios which shows how retirement plan sponsors can complete the 401(k) plan’s transition from a savings account to a retirement income plan.

Why now?

Recently, a number of reports have pointed out that America’s older workers need help with retirement income planning.

  • Retirees need help figuring out how much to save for retirement. Several surveys of older workers show that they need and would like help with developing retirement income. Additionally, when asked to guess the amount of savings they need to retire securely, many workers underestimated the amount they would need.
  • Current 401(k) plans lack retirement income solutions. In August 2016, the Government Accounting Office (GAO) issued a report that highlighted that the majority of older workers do not have access to retirement income solutions in their 401(k) plans. About three-fourths of the plans surveyed did not offer annuities where an insurance company guarantees a lifetime payout.
  • In June 2016, the BiPartisan Policy Center issued a comprehensive report with recommendations to address six significant challenges facing our retirement system. One of these recommendations was for plan sponsors to implement lifetime income solutions in defined contribution plans.
  • Regulatory developments are enabling the use of retirement income solutions in tax-qualified DC plans. In July 2014, the U.S. Treasury Department issued regulations that clarify how qualified longevity annuity contracts (QLACs) can be implemented in DC plans. In October 2014, Treasury issued regulations that would enable a portion of accounts invested in target date funds to be transferred to deferred annuities.

Despite a strong desire from the public for better retirement income options in 401(k) plans, robust retirement income options are not widespread among defined contribution plans. One primary reason is how plan sponsors view their defined contribution plans. According to one study, 91% view them as savings plans, while only 9% view them as vehicles for providing retirement income.

A cultural shift is needed: Employers and plan sponsors need to think of their DC plans as true retirement plans.

The challenges

The long-term shift from traditional pensions to defined contribution and hybrid defined benefit plans (such as cash balance plans) places significant responsibility and challenges on older workers and retirees to successfully generate retirement income that lasts for the rest of their lives. For example:

  • Longevity risk is placing a lot of stress on retirement savings, as a retiree might need income for 30 or more years. But, many retirees are not prepared to manage this critical task on their own, especially because there is much uncertainty around how long an individual retiree will actually live.
  • Market volatility complicates the task of generating retirement income by managing withdrawals from an investment portfolio throughout retirement. Since 1987 there have been four major market meltdowns. With retirement potentially lasting 20 to 30 years or more, it’s prudent for retirees to expect and plan to survive more meltdowns in their future.

Engineering optimal retirement income solutions

The recent SCL/SOA report applies modern portfolio theory (MPT) concepts to the retirement income phase. Just like there are different asset classes for accumulating savings, there are different retirement income classes for generating regular cash flow in retirement. These retirement income classes include:

  • Social Security
  • Annuities from insurance companies
  • Systematic withdrawal plans (SWPs) using invested assets
  • Work (Part-time or Full-Time in retirement)

Assets in defined contribution plans, like a 401(k) plan, can be deployed acknowledging how the above retirement income classes might interact. Of course, there can be other sources of retirement income, such as IRAs, home equity, and investments or insurance products owned by the retiree. Ideally, retirees would develop their retirement income strategy by integrating all of their financial resources.

The SCL/SOA report supports a portfolio approach to constructing diversified retirement income portfolios. This approach reflects that various retirement income generators (RIGs) have different characteristics regarding important goals such as the amount of retirement income that’s expected over the retiree’s life, and how to address common retirement goals.

Typical retirement income goals can include:

  • a desire for liquidity to meet emergencies,
  • maximizing expected retirement income,
  • income that doesn’t decrease due to capital market volatility,
  • income that keeps up with inflation, and
  • income that retirees can’t outlive.

Just as there is no “one-size-fits-all” approach to the asset allocation decision, the retirement income allocation decision should reflect each retiree’s unique circumstances and goals.

A better approach – how DC plan sponsors can help

Defined contribution plan sponsors can design and communicate a retirement income program that enables retiring employees to convert their savings into reliable retirement income. A key part of this program is a retirement income menu with simple “check the box” options that retiring employees can elect; this menu would be integrated with their investment menu that is already familiar to their workers while they’re accumulating savings.

The SCL/SOA research supports a retirement income menu design with at least three distinct retirement income generator options:

  • Systematic withdrawal plan from invested assets in the 401(k) plan
  • Guaranteed, lifetime annuities offered by an insurance company
  • A temporary payout from plan assets that enables delaying Social Security benefits in order to increase total retirement income

Retiring workers would be able to allocate their savings among more than one retirement income generator. Whenever possible, they could make future changes in the way that remaining assets are deployed, although this may not be possible for savings invested in certain types of annuities.

Using computer modeling offered by the plan sponsor or plan administrator, retirees would be able to estimate how much retirement income they might receive with various retirement income generators. This is a critical retirement planning task – not many older workers are capable of completing the necessary calculations on their own. An easy-to-use modeling capability can help many older workers decide if they have enough savings to retire, and to consider the necessary tradeoffs between the retirement income goals expressed above.

The default retirement income solution should be designed carefully to meet the needs of greatest number of retiring employees, while also protecting plan sponsors from fiduciary liability. In today’s environment, the “default” many retirees elect is a lump sum rollover from their employer’s plan into an IRA. This default has the potential to expose retirees to reduced retirement incomes, compared to solutions that could be offered within the employer’s plan. Good retirement income solutions exist today that are much better than current practice in most DC retirement plans, which is often to do nothing to help older workers.

Plan sponsors shouldn’t wait for the “perfect” retirement income solution to be developed – it doesn’t exist. Don’t let perfect be the enemy of the good.

 

This article was written by Jamie Hopkins from Forbes and was legally licensed through the NewsCred publisher network.

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