Desire to Move to Lifetime Income Options -- Is It Real?

I read an article this morning that tells me, among other things, that two in ten defined contribution (DC) plan participants plan to use some portion of their plan assets to purchase lifetime income products. I don't dispute the research that was done, but I absolutely dispute that behaviors will be as the data imply.

Before you read on, I want to be clear. Any criticism that I have here is not of the author. The piece does an excellent job of explaining what the data say. My criticism is also not of the data collection. The Employee Benefit Research Institute (EBRI) asked legitimate questions and reported the answers that they received.

But, this is a case where I posit that a perfectly good interpretation of perfectly good data is likely to not be a good predictor of future behaviors, at least not as the law exists today. What we need to help these data to be a reliable predictor is a statute that is focused on retirement policy not on the assumption that small groups of people will abuse the Tax Code. And, once that statute works, we need plan designs that give well-meaning plan participants the ability to customize their individual retirement income streams to meet their own needs without worry that somehow they will fall prey to regulations that were written to stop abuse by a few. (For the retirement and tax geeks reading this, yes, sections like 401(a)(9), I mean you.)

Is this newfangled design DC? Maybe or maybe not. Is this newfangled design defined benefit (DB)? Maybe or maybe not. Why do we really need such a broad distinction?

I'll return to the design issues later, but first I am going to make a u-turn back to my comment about these data as predictors.

Yes, two in ten DC plan participants would like to get some lifetime income or longevity protection from their DC plans. But, what options are available? Generally speaking, whether they are in plan or out of plan, they are retail priced annuities (meaning they are priced favorably for the annuity provider and therefore unfavorably for the annuity buyer). There are traditional annuities and there are qualified longevity annuity contracts (QLACs). The experience in the marketplace thus far (anecdotally) is that participants will pay anywhere from 15% to 40% more for these annuities from DC plans than would be considered actuarially equivalent to a lump sum in a DB plan. Insurers need to be both risk-averse and profitable and therein lies a difference. DB plans, on the other hand, are intended, generally speaking, to provide optional forms on an agnostic basis.

So, how do we get there? As I said earlier, changing the statute to allow common-sense streams of income for participants is a great first step. Then we need a new type of design. To me, it probably doesn't fall into the current, common notion of DB or DC.

Let's call it the Plan of the Future.

And, once those common-sense options are available, my prediction is that far more than two in ten participants will want some amount of lifetime income whether it's from DC plans, DB plans, or just qualified retirement plans.

Instead of Making Defined Contribution Look More Like Defined Benefit, ...

I don't think I've ever ended the title of a blog post with an ellipsis before. But, surely, there's a first time for everything.

Lately, the benefits press has written an awful lot about what must be the latest trend in employer-provided retirement benefits -- making the defined contribution (DC) plan look more like the defined benefit (DB) plan. Perhaps I am missing something, but it appears that this "major" initiative has two components to it (that's right, just two):

• Communication of an estimate of the amount of annuity a participant's account balance can buy
• The option to take a distribution from the plan as either a series of installments or as an annuity

Let's consider what's going on here.

Annuity Estimate

Yes, there is a huge push from the government and from some employers to communicate the annual benefit that can be "bought" with the participant's account balance. Most commonly, this is framed as a single life annuity beginning at age 65 using a dreamworld set of actuarial assumptions. For example, it might assume a discount rate in the range of 5 to 7 percent because that's the rate of return that the recordkeeper or other decision maker thinks or wants the participant to think the participant can get.

I have a challenge for those people. Go to the open annuity market. Find me some annuities from safe providers that have an underlying discount rate of 5 to 7 percent. You did say that you wanted a challenge, didn't you?

I'm taking a wild (perhaps not so wild) guess that in late 2016, you couldn't find those annuities. In fact, an insurer in business to make money (that is why they're in business, isn't it) would be crazy today to offer annuities with an implicit discount rate in that range.

But, annuity estimates often continue to use discount rates like that.

Distribution Options

Many DC plans offer distribution in a series of installments. Participants rarely take them, however, For most participants, the default behaviors are either 1) taking a lump sum distribution and rolling it over, or 2) taking a lump sum distribution and buying a proverbial (or not so proverbial) bass boat.

Why is this? I think it's a behavioral question. But, when retiring participants look at the amount that they can draw down from their account balances, it's just not as much as they had hoped. In fact, there is a tendency to suddenly wonder how they can possibly live on such a small amount. So, they might take a lump sum and spend it as needed and then hope something good will happen eventually.

Similarly, if they have the option of getting an annuity from the plan, they are typically amazed at how small that annuity payout is. And, even with the uptick in the number of DC plans offering annuity options, the take rate remains inconsequentially small.

A Better Way?

Isn't there a better way? 

Part of the switch from DB plans to DC plans was predicated on the concept of employees get it. They understand an account balance, but they can't get their arms around a deferred annuity. So, let's give them an account balance.

Part of the switch from DB to DC plans was to be able to capture the potential investment returns. Of course, with that upside potential comes downside risk. Let's give them most of that upside potential and let's take away the worst of that downside risk. That sounds great, doesn't it.

Once these participants got into their DC plans, they wanted investment options. I recall back in the late 80s and early 90s that a plan with as many as 8 investment options was viewed as having too many. Now, many plans have 25 or more such options. For what? The average participant isn't a knowledgeable investor. And, even the miraculous invention commonly known as robo-advice isn't going to make them one. Suppose we give them that upside potential with professionally managed assets that they don't have to choose.

Oh, that's available in many DC plans. They call them managed accounts. According to a Forbes article, management fees of 15 to 70 basis points on top of the fund fees are common. That can be a lot of expense. Suppose your account was part of a managed account with hundreds of millions or billions of dollars in it, therefore making it eligible for deeply discounted pricing.

There is a Better Way

You can give your participants all of this. It seems hard to believe, but it's been a little more than 10 years since Congress passed and President George W Bush signed the Pension Protection Act (PPA) of 2006. PPA was lauded for various changes made to 401(k) structures. These changes were going to make retirement plans great again. But, for most, they didn't.

Also buried in that bill was a not new, but previously legally uncertain concept now known as a market-return cash balance plan (MRCB). 

Remember all those concepts that I asked for in the last section, the MRCB has them all. Remember the annuity option that participants wanted, but didn't like because insurance company profits made the benefits too low. Well, the MRCB doesn't need to turn a profit. And, for the participants who prefer a lump sum, it would be an exceptionally rare (I am not aware of any) MRCB that doesn't have a lump sum option.

Plan Sponsor Financial Implications

Plan sponsors wanted out of the DB business largely because their costs were unpredictable. But, in an MRCB, properly designed, costs should be easy to budget for and within very tight margins. In fact, I might expect an MRCB to stay closer to budget than a 401(k) with a match (remember that the amount of the match is dependent upon participant behavior). And, in a DB world, if a company happens to be cash rich and in need of a tax deduction, there will almost always be the opportunity to advance fund, thereby accelerating those deductions.

Win-Win

It is a win-win. Why make your DC plan look like a DB when there is already a plan that gives you the best of both worlds.

Pension Risk (where to) Transfer

I opened my Plan Sponsor News Dash this morning and staring me in the face was the headline "Pension Risk Transfer Decisions More Than Financial." It was catchy enough that I decided to click on the link. What I found was that the attendant article was based on a white paper published by Prudential.

Think about that. One of the insurers that seeks business from companies looking to transfer their pension risks is warning plan sponsors that there may be more than meets the eye. While I give Prudential credit for laying out some of the issues, their doing so would certainly make me if I were a plan sponsor think twice.

Prudential focuses on what they describe as the three pillars of service delivery:

• Retiree communication and education
• Transaction and transition
• Consultation and commitment

This is good stuff and it is important.

There are a few other elements that get less notice in the white paper (and perhaps it is Plan Sponsor's analysis of it). Prominent to me among those elements are the irreversibility of a decision to annuitize obligations of the plan and that such a decision is fiduciary in nature. Without commenting on whether they will have merit, what this commentator smells is litigation.

That's right. Not all annuity purchases will provide the same levels of security and service as plan sponsors expected. Without offering a legal opinion as I am not qualified to do so (I am not an attorney and do not and can not practice law), plan sponsors would appear to be well protected by following guidance from the Department of Labor (DOL) regarding "safest available annuity providers." But, as in many transactions that take time, that status could change during the process.

Consider insurer EL (those who were in this business 25 years ago may recognize a thinly veiled reference). At the time that defined benefit sponsor DBS makes its decision to annuitize certain of its obligations under the plan, EL has solid ratings from all of the major ratings agencies. DBS makes the decision based on a financial analysis to annuitize those obligations with EL. As we know, the process takes significant time and after a number of months, there are rumblings that EL may not be as solid as had been thought. Its ratings begin to slip.

Is DBS required to rethink its decision to annuitize with EL? Does it matter how far along in the process they are? Do the rumblings have to be substantiated? Do ratings have to have changed? Does anybody really know?

It's not unlikely that some attorney somewhere will find some potentially wronged participant or conversely and that the participant will decide that it's the right time to engage that attorney to litigate the matter. The fact is that even when you are fairly certain as a defendant that you will prevail in litigation, the defense is expensive. Did you factor that cost into your analysis of the financial effects of pension risk transfer (PRT)?

Suppose there was a better way. Suppose there was a way to intelligently transfer pension risk without making potentially questionable fiduciary decisions. Suppose you could leave the decisions that you really don't want to make up to your plan participants.

I'm not suggesting that you make the PRT process a democracy. No, I'm not suggesting that you assemble a quorum of participants and put the decision to a vote. But, there might be ways to give participants a say in the matter. And once a participant makes the decision for you, aren't you alleviating the burdens of litigation risk and front page of the newspaper risk?

If you are looking to go down the PRT road, annuitizing might be the right decision. On the other hand, it might not. 

Shouldn't you let someone else apprise you of other options? Isn't this the discussion you should be having as you start the new year?

Derisking Your Defined Benefit Plan or Not

Every couple of years, there is a new trend in the remaining corporate defined benefit plans. Lately, it has been derisking in one sense or another. In fact, the Mercer/CFO Research 2015 Pension Risk Survey says that plan sponsors have been spurred by a perfect storm of events.

I'm not going to argue with there having been a perfect storm of events, but I think that everyone else's idea of what constituted the perfect storm is a bit specific and technical. They focus on falling interest rates, a volatile equity market, and a newly (last year) released mortality table. Instead, I would tend to focus on constantly changing pension rules both in the law and in financial accounting requirements that give plan sponsors a constantly moving target.

But, all that said, the study tells us that 80%-90% of plan sponsors are pleased with the risk management actions they have taken to date. What makes them pleased? Is it that they have cleaned up their balance sheets? Is it that their funding requirements have decreased? Has the derisking decision helped them to better focus on or run their businesses?

Isn't that last one what should be at the crux of the matter? The fact is that 2014 was not a good year to offer lump sum payments to individuals with vested benefits if what you were looking to do was to pay out those lump sums when the amounts would be low. Underlying discount rates were very low meaning that lump sums would be larger. Similarly, the cost of annuities was high, but many chose to purchase annuities for substantial parts of their terminated and retired participants.

What all of these plan sponsors did was to decrease future volatility in pension costs (however they choose to think of cost). For many, that truly was a good thing. But, at what cost?

For some, that cost was significant. For others, it was not.

Defined benefit pension plans used to be viewed as having a degree of permanence. That is, when funding them, calculations assumed that the plan would go on forever. While we know that forever is a very long time, we also know that plans with benefits that are based on participants' pay in the last years of their careers are wise to consider the amounts that they are likely to have to pay out in the future as compared to the amounts that would be paid out if everybody quit today. That is not reality. There used to be what are known as actuarial cost methods that allowed sponsors to do that and frankly, they resulted in larger current required contributions. But, those larger current contributions tended to be very steady as a percentage of payroll and that was something that CFOs were comfortable with.

But, the wise minds in Congress with the advice of some key government workers determined that this was not the right way to fund pension plans. Actually, their real reasons for doing so were to reduce tax deductions for pension plan funding thereby helping to balance the budget.

Sounds stupid, doesn't it? It is stupid if what you are doing is making sponsorship of a pension plan untenable for most corporations.

Risk truly became a 4-letter word for pension plan sponsors. As time went by, it became important for sponsors to find new ways to mitigate that risk.

Unfortunately, many of them have been so eager to do that over the last few years that they likely overspent in their derisking efforts. For others, it was clearly the prudent thing to do.

My advice is this if you are considering your first or some further tranche of derisking. Consider the costs. Consider how much risk you mitigate. Make the prudent business decision. What would your shareholders want you to do?

Then decide whether you should derisk.

Defined Benefit Supply and Demand

This should be good. This fool is writing about supply of DB plans and demand for DB plans? No, not really. But, we are going to look at a really simple way that supply and demand affect DB plans.

There are lots of DB plans out there that are frozen, be it soft or hard. Presumably, very few of them will ever be unfrozen. More likely is that plan sponsors are seeking to terminate those plans that are frozen. And, since the process for doing other than a standard termination often requires a plan sponsor to go into bankruptcy (yes, there are other ways, but that is beyond the scope of this article).

Let's look at the standard termination process in the simplest of terms. A plan has to be fully funded (including employer commitments) for the purchase of annuities, sufficient to provide all the benefits accrued and vested in the plan. Determining the level of assets to do that should be fairly simple, right?

Of course, it's simple. Presumably, you know what your funded status is on a PPA basis and you just pick up the phone and call your actuary. Actuaries have good rules of thumb for estimating everything, so your actuary will just give you a loading factor and you'll know where you stand, right?

Not so fast. Life insurance companies that are in the annuity business presumably want plan termination business. It's where they can get a large volume of business quickly. Let's consider a couple of scenarios.

Plan investments perform well, interest rates stay stable. If this is the case, then funded statuses will improve. A reasonable number of plans will be able to terminate. Insurance companies will presumably hit their goals for annuity volume.

Plan investments perform well, interest rates go up. Now, virtually everyone will think they can terminate their plans. The market will be flooded with demand for annuities. Insurers either will not be able to accommodate that much volume or will be able to create that impression.

In the second case, there is more demand, but no change in supply. I learned about this in Economics 101 (actually, it was called 14.001, and if you understand that, you'll know where I took it). Prices go up. So, your actuary's rule of thumb is going to be off by a bit ... and in the wrong direction.

We could create lots more scenarios to look at supply and demand, but this is pretty basic stuff. It's intuitive.

If you have a frozen plan and you're looking to terminate it, wouldn't you like to be able to track this loading factor or ratio of plan termination liability to PPA liability? Now you can. Contact us. Contact me.

Doing as They are Doing, Not as They are Saying

Trivia buffs could tell you that the only X-rated movie ever to win the Oscar for Best Picture was Midnight Cowboy (I know, it wouldn't have been X-rated 10 years later, but they had different standards back then). Many who know that would know the theme song from the movie, but paraphrased slightly and with apologies to Harry Nilsson, it could also be the theme for today's defined contribution (DC) plan sponsors:

Everybody's talking at us, But we don't here a word there saying, only the echoes in our minds

Great song if you're one of the six people who has never heard it. But, why, you might ask is this lunatic who hasn't been blogging this week (I talk some time off for the birth of a granddaughter) writing about a 40+ year-old song? Aon Hewitt did a survey of DC plan sponsors and found that only 3% plan to add in-plan annuity or insurance products to their plan in 2011. But, in other surveys, those same plan sponsors are saying that such products are a hot topic and that they are on of their highest DC plan priorities.

Get the song reference now?

Instead of going down what they are hearing and even know is the right path,

They're going where the sun keeps shining, through the pouring rain, they're going with what's closest to their nose

The simple fact is that nobody wants to be first. Yeah, I know, somebody has to be first, but that is often a road fraught with mine fields. But, there was a first 401(k) plan. There was a first cash balance plan. There was once a first target date fund, and now, flawed as they are, very few sponsors are afraid to walk that road once less traveled.

So what are the holdups? In my opinion, it all falls under the category of risk. Once upon a time, if there was no regulatory guidance, the prevailing strategy was to just go out and do it, but no more. With apologies to The Shadow, who knows what evil lurks in the hearts and minds of plaintiff's bar? Litigation is rampant. As a plan sponsor, even if you know you can win, the cost of defense may be prohibitive.

And, look at the guidance that we do have.While we don't have to worry about the safest available annuity rules for DC plans since PPA, the DOL's annuity guidelines for DC plans don't leave much more room for exploration. Having one of these products in your plan is a fiduciary decision. Title I of ERISA is fruitful ground for litigation. Is your plan ready to be the test case?

What happens when your employees leave your company? Can they actually roll these new-fangled products into their new employer's plan? That's a tough one, but as of today, the answer is probably that in most cases, they will have to find a way to keep that option when they leave.

So, everybody seems to want something, but nobody's doing it yet. What might change that?

1. A safe harbor for these products in DC plans so that fiduciaries going down this path will have less worry of regulatory or even litigation issues.
2. A more fertile field of products which will only come when more plan sponsors adopt these sorts of products for their plans.
3. A requirement that DC plans have some sort of lifetime income option as compared to just lump sums (taken by virtually all participants) and installment options. Of course, participants, even those who know that a lump sum has no longevity protection, are currently unlikely to consider anything else.
4. Reasonable fees. The risk for insurers in offering products of this sort are high, especially when there is anti-selection among the group of people electing them. Insurance companies are not in business to lose money, so fees and expenses are currently high. As the market becomes larger, so perhaps will fees and expenses become more competitive.

We're not there yet, but to complete your lyrical madness for the day, perhaps sometime soon, plan sponsors will be moving from where they are and 

Backing off of the lump sum wind, sailing on annuity breeze, skipping over ERISA like a stone ...

Senators Introduce Lifetime Income Disclosure Act

In a bipartisan effort, Senator Jeff Bingaman (D-NM), along with co-sponsors Herb Kohl (D-WA) and Johnny Isakson (R-GA), has introduced Senate Bill 267, the Lifetime Income Disclosure Act. I would provide you with a link to the actual bill language here, but there is this little problem: it's not yet made it to the Government Printing Office (GPO), nor has it made it to Senator Bingaman's web site. For those who want to read the actual language in the future, I suggest you go to the Library of Congress web site: http://thomas.loc.gov and search on S 267.

Readers do not want the delay inherent in the GPO. If you are here, you want your news now. So, without further adieu, away we go (my tribute to Jackie Gleason). Sponsors of defined contribution (DC) plans will be required to provide participants with annual statements that are patterned after Social Security statements. They will be required to show a participant's projected lifetime income based on a number of assumptions (none of which, IMHO, will actually come true). To relieve plan sponsors of "material burden", the Department of Labor (DOL) will be directed to provide a model disclosure as well as tables to assist plan sponsors in preparing these statements.

This could be interesting. If the assumptions that are mandated or recommended by the DOL are reasonable, roughly half of plan participants will fail to have balances sufficient to support the disclosed annuities. Bring on the cavalry -- plaintiff's bar. But, who will they sue? Plan sponsors? The DOL? Congress?

This is a step in the right direction, though. A bill like this will at least get people thinking about how much annual income their account balances might provide. But, this is at best Step 5 or 6. Step 1 needs to be in the schools. By the time a participant gets into the workforce, he or she needs to have enough financial literacy to understand things like this. But, that's a different rant for a different day. In the meantime, I applaud these three senators for their efforts and I'll keep you informed as this bill moves along.

Pre-Boomers Want Retirement Income Stream

In a poll sponsored by Nationwide Financial and conducted by Harris Interactive, 85% of those age 18-44 support a modification to the current 401(k) structure that would provide a guaranteed annuity stream from 401(k) plans, as compared to 77% of the total adult population. This suggests that as participants get closer to retirement, they are more likely to want a lump sum payment. To me, this is counter-intuitive.

I do not have the exact wording to the question that was asked.

As most surveys of this sort are, the poll has at least a bit of a self-serving element to it. Employer matches would not be available for loans or hardship withdrawals and plans would provide annuities via the purchase of fixed income deferred annuities (something that Nationwide presumably sells ... at a profit).

How big would the insurer's profit be? Do the survey respondents understand that they would be paying for that insurance? It's food for thought, but IMHO, it's a long way away.