Friday, May 10, 2013

DOL Suggests Rules on Lifetime Income Illustrations

Earlier this week, the Employee Benefit Security Administration (EBSA) of the Department of Labor (DOL) released three items related lifetime income illustrations for benefit statements for defined contribution plan participants. I know, that's a mouthful. Here's what we got from them:

  • An advance notice of proposed rulemaking (ANPR) under Section 105 of ERISA that gives us an idea of what future regulations might look like and to seek comments
  • A "fact sheet" discussing briefly what they have done
  • A lifetime income calculator using the methodology expressed as a safe harbor in the notice
For background, the Pension Protection Act of 2006 (PPA) established a requirement for annual benefit statements from qualified retirement plans. All these years later, we don't know how to do the required lifetime income illustrations.

The ANPR tells us that any set up of assumptions that we use that employ generally accepted investment theory will probably be considered reasonable. EBSA also gave us safe harbor assumptions. When push comes to shove, we expect that most sponsors (or their vendors), once the regulations become effective, will opt for simplicity and use the DOL's safe harbor assumptions.

What are they, you ask?
  • Contributions continue to normal retirement age at the current (dollar amount), increased by 3% per year
  • Investments return 7% per year
  • Discount rate of 3%
  • To convert account balances to annuities, use the interest rate on Constant Maturity 10-year T-bills
  • Use a 417(e)(3) mortality assumption (for those who don't keep their noses mired in the Internal Revenue Code, this means that the mortality assumption is to be the one currently used for most pension purposes under the law)
  • If you're married, you and your spouse were born on the same day ... even if you weren't
  • For purposes of converting the current account balance to a lifetime income stream, payments begin immediately and you are assumed to be your current age or normal retirement age, whichever is older
To me, some of these assumptions are not bad and some are ... well, they're not not bad. Let's start at the top. For people who stay in the workforce continuously until retirement, the 3% annual increase in contributions is probably as reasonable as anything else. But, very few people stay in the workforce continuously anymore. There are all of maternity leave, paternity leave, layoffs, reductions-in-force, and then there are the companies that freeze pay or cut benefits making the 3% annual increase assumption a bit lofty.

How about investment returns of 7% per year combined with a 3% discount rate? That's a 4% real rate of return, net of expenses. Did anyone watch the Frontline special on PBS telling you how your account balances are eroded by expenses? If you did, I bet you don't think a 4% real rate of return is reasonable.

What a participant is to receive in his or her statement are four numbers:
  • Current account balance on the effective date of the statement
  • Projected account balance on the later of the effective date of the statement or normal retirement date
  • The amount of lifetime income that could be received on the current account balance over the lifetime of the participant or joint lifetime of the participant and spouse if married
  • The amount of lifetime income that could be received on the projected account balance over the lifetime of the participant or joint lifetime of the participant and spouse if married
I see several outcomes from this exercise.
  • Participants will have an overly rosy view of their defined contribution plans
  • Despite that, they will suddenly think that their 401(k)-only retirement program isn't very good
  • Most participants will not achieve the lifetime income projections that the illustrations suggest
So, what happens?
  • Just as they do with Summary Annual Reports, participants find the nearest trash can or recycling bin and insert these statements, or
  • Participants read the statements and ask their generally unknowledgeable friends what they mean
  • Participants go to HR and ask HR what it means
  • When participants start to understand, they learn that a 401(k)-only retirement program is generally not very lucrative unless they defer far more than they are currently which they probably don't they can afford
Some will complain. Some will jump ship.

What can an employer do? An employer can say that this result is fine and move on as if nothing happened. Or, an employer can decide paternalistically that it has some responsibility here and revisit retirement design. Perhaps the answer is that old dinosaur, defined benefit. Perhaps the answer is another old dinosaur, profit sharing. Either way, both have far more flexibility in design than do 401(k) plans.

The DOL needs intelligent comments on this one. I hope it gets them.