Retirement under pressure
A key characteristic for the developed world has been the expectation of a stable retirement for the middle class. This expectation for a worry-free retirement has undergone some stress. In this paper, we would like to explore the pressure on our retirement system and how some employers are using income replacement option products to potentially improve the outcomes for their employees.
Foundations of retirement -- the three legs of the stool
The foundation of retirement has traditionally come from three sources: Social Security, pensions (i.e. defined benefit plans), and defined contribution plans, like a 401(k). We will consider them one at a time.
We can fairly compare Social Security payments to an annuity from an insurance company. In this case, instead of an individual consumer paying the insurance company for a lifetime of payments, the government agrees to pay based on residuals of economic growth and garnished wages. Regarding Social Security solvency, it has been well established our anticipated levels of economic growth and increased lifespans have strained the system. Additionally, the demographics are lopsided towards imminent retirees (i.e. there are more retiring baby boomers than working adults necessary to support them). The US has had to adopt an unsustainable level of borrowing to make up for the current and projected shortfalls in a variety of spending programs, including Social Security.
Thus, Social Security is ultimately going to have to change. Compared to the complex ethics of other government benefit programs (Medicare and Medicaid), Social Security is relatively straightforward to fix. Directly cutting benefits, indirectly reducing benefits by weakening the rate of increase (i.e. Cost Of Living Allowances) via inflation, increasing retirement age limits, increasing tax revenues, or privatizing Social Security (so it acts more like a defined contribution investment plan) could fix the system. Each of these actions will place additional burdens on us, as beneficiaries, but isn’t unexpected. Anecdotally, the younger demographic cohorts (e.g. Generation X, Millennials) have been warned the Social Security benefits enjoyed by prior generations would not be there at retirement; the recognition of a more spartan standard of living is the active presumption for many future retirees.
The pressures impacting the government’s Social Security system have had a similar impact on employer sponsored pension plans (defined benefit). In the face of these pressures, many employers have been eager to dismantle or phase-out their defined benefit plans and revert to other systems with smaller or more predictable financial liability. There are vestiges of pension plans for government workers and some large institutions, but their popularity is clearly declining. State Budget Solutions reports $2.8 trillion of state debt is from unfunded pension liabilities. The pressure to reform public pensions, reduce benefits, and remove the ability of public employees to collectively bargain for benefits will continue to marginalize the once-ubiquitous pension plan.
So, with the stable and predictable income streams from social security and pension plans likely to be substantially curtailed, typical employees must rely on their savings and whatever they’ve managed to accrue in their defined contribution plans to fund retirement.
The Shortfalls of relying purely on defined contribution plan for retirement
Since we, broadly speaking, have to rely on our defined contribution retirement savings, let’s consider some of the problems with that system. First, most employees simply aren’t saving enough to retire in their 60’s; studies demonstrate, despite the warnings, many retirees have unrealistic dependence on Social Security. Second, for those fortunate retirees who have saved substantial assets in their retirement accounts, can easily overdraw from their nest-egg because they may not know what a sustainable drawdown rate is --- drawing 15% of your retirement assets every year won’t maintain enough assets to support a 20 or 30 year retirement, but it happens with sad regularity. After a lifetime of saving, retirees faced with the temptation of an uncommonly large pool of money can easily withdraw too much too quickly.
These aren’t new problems and broad level solutions are already being considered. For instance, Senator Tom Harkin recently proposed a government-sponsored, hybrid pension plan to augment existing DC plans, but we believe, given the political environment, new activist programs like this have a marginal chance of being implemented in the near future. In the meantime, it is still up to employers and employees to generate their own solutions.
Income replacement options: converting assets to a defined benefit-like income stream.
So, there are disadvantages of a pure defined-contribution driven retirement but a desire for a stable income stream akin to the defined benefit programs of old.
Imagine a typical investor retiring at age 65. As a single person, he could simply cash out of his 401(k) or IRA account, pay the necessary taxes, and use the lump sum to purchase an annuity to provide a lifetime of income. The investor will need to do his homework, manage their accounts, be satisfied by the soundness of his insurer and the terms of his contract, but this is at least a viable solution for a retiree.
Most readers of this newsletter are not individuals trying to compare annuity plans; most of our readers are employers --- retirement plan sponsors --- and the service providers to these plans. We can consider a solution on a larger scale. Specifically, there has been an explosion of interest in new products that seek to replicate the stability of a defined benefit stream within the structure of a defined contribution plan; these products are called income replacement products and they often promise guaranteed income for life. Understanding the rationale for adding these products to a retirement plan line-up is the core reason for this white paper.
In simple terms, think of an income replacement option as annuity program that has been standardized for a wide number of participants. Some income replacement options are like fixed annuities, with little to no upside potential. Some income replacement options are like variable annuities: they invest in underlying investments (like a balanced mutual fund of equity and fixed income) with the potential for appreciation in the markets. Depending on the specific product, income replacement funds may look like a variable annuity with a number of “rider” provisions. For instance, they may guarantee a minimum market value, and provide a stable income stream based on “high-water marks” of that minimum market value. Again, the provisions depend on the specific product.
Adding an income replacement option is usually simple for the employer; for the most part, it’s like adding any other fund into an investment lineup. For the employee, while they contribute to the fund, it is like the accumulation phase of an annuity; once they start taking payments, they are in the annuitization phase.
The advantages to income replacement plans
Now that we have a basic understanding of these products, let’s consider their advantages to adding them into a traditional defined contribution lineup.
First, the greatest benefit of these products is they remove one of the key perils of retirement: outliving your money. The insurer now bears the risk that an employee will be drawing benefits if he is lucky enough to have a healthy, vibrant, 30-plus year retirement.
Second, these products significantly reduce market risk for employees. Reducing investment risk is an obvious advantage for employees have suffered through two significant market crashes in the past decade.
Third, income replacement options impose a budgetary discipline to spending. The products generate a predictable income stream, typically around 4% to 5%, of the total market value of the underlying investment. Drawing beyond that eats into the principal of the investment, immediately lowering the future income stream. As a related advantage, seeing what your nest-egg will predictably generate over the long-term can also solidify an individual’s retirement personal goals.
Fourth, when comparing income replacement products to traditional annuities, these products are often able to create an effective economy-of-scale. It is true that income replacement products will require higher fees than direct investment in the underlying investments (i.e. buying shares of an ordinary balanced mutual fund), but they are often less expensive than a one-on-one annuity contract an individual could purchase from an insurance company.
Lastly, these products exist within the ordinary structure of an existing, tax-deferred 401(k). Research shows that simple, easy-to-access solutions have the best impact of participant behavior. Easy access to an annuity-like income stream without the inconvenience of managing accounts or the immediate tax-hit of moving assets into a taxable account (to purchase a traditional annuity) is a benefit to employees.
The disadvantages to income replacement plans
Most economics textbooks will tell you “there is no such thing as a free lunch”. In other words, there are few actions without a cost. Income replacement programs are a popular and growing trend partly because of their notable benefits to employees; however, their costs need to be addressed.
First, there are higher fees for income replacement products. Providers of these products are adopting new risks; they are going to get paid to do it. We’ve already suggested most employees are not saving enough for retirement, so adding an additional layer of fees may rapidly deplete the reserves which were already potentially insufficient.
Second, for employer sponsored products, participant education becomes key because the utility of these products is depends on the unique needs of the participant. One size does not fit all equally. For instance, a 20 year old employee usually can bear more investment risk than a 55 year old, but they have access to the same income replacement option in their 401(k) lineup. The 25 year old employee might be better off absorbing the market risk inherent rather than paying additional fees for a level of stability that is not required. Participant engagement is also key because there are fewer accepted standards and accumulated knowledge about how to optimally combine annuities and insurance, as an asset class, into an investment portfolio; effective advice and communication for the employee is required.
Third, these products are essentially insurance, not investments. There’s nothing wrong with insurance per se, but the due diligence bar for investment committees and other agents for the plan becomes necessarily higher because of the additional level of complexity. Not only will employer have to contend with the already high scrutiny afforded to traditional investment selection decisions, they will have to demonstrate prudent process in comparing insurance products as well. Each income replacement product is different, with features (akin to “riders” in a classic annuity model) that are not easily comparable. Further, in the worst case scenario of an insurer default, the guarantee of stable future income is assuredly nullified and investors should understand how their underlying investments will be returned to them. Finally, the legal language surrounding allowable investments (i.e. safe harbor rules, QDIA) does not clearly spell out how insurance products may be prudently selected.
Fourth, there is less flexibility. Income replacement funds are generally more liquid than a classic individual’s annuity contract with an insurance company, but access to funds is limited by the stipulations of the product or subject to higher penalties for early withdrawals. Logistically, these products are uniquely tied to a specific recordkeeper / insurer platform, so adding these products limits the portability of the plan. (This is an incentive for recordkeepers and insurers to create and market these products.)
Some employers have done the calculation and decided the benefits of these products outweigh the costs and have added them to their lineup. Some have decided the costs outweigh the potential gain and not added income replacement options to their lineup. We look forward to the opportunity to provide thoughtful, objective recommendations for your plan. For more information, please feel free to discuss these issues with us, your investment consultant, and/or fiduciary consultant.
SOURCES AND OTHER READING:
Judy Ward, “From Curiosity to Action.” Planadviser July-August 2012: 54-57