Fact or Fiction in the Retirement Wellness Media

Sometimes you just have to wonder. Well, maybe you don't have to wonder, but I can speak for myself -- I certainly do have to wonder. The data that I read about simply cannot coexist. We cannot have record numbers of people deferring to 401(k) plans at record rates and yet still have almost universally low-five figure account balances, on average. At least we cannot unless we also have record amounts of leakage via plan loans, withdrawals, and both deferral and work stoppages.

I'm not going to cite a bunch of data here because I don't have it at my fingertips. I'm on the road and it's 5:30 AM, so think of this as your favorite (or not favorite) blogger ranting. I'm allowed, or at least I'm pretty sure I'm allowed.

Once upon a time (no, this is not the start of a fairy tale or one of Aesop's fables), American workers almost uniformly looked forward to the day when they could retire. They did that, in large part, on the backs of their corporate-sponsored defined benefit plans.

As we knew back then, defined benefit plans had many things about them that worked well toward this goal including (but definitely not limited to):

• Ability to generate lifetime income
• Lifetime income that could be compared to retirement expenses to understand what other resources might be needed
• Workforce management ability for plan sponsors using tools like retirement subsidies and early retirement windows

Since then, we've seen changes ... many changes. Initially, they were design and structure changes. With the growth of 401(k) plans and Congress' constant tinkering with defined benefit plans in a supposed effort to save them, there was first a move toward what we now know as hybrid plans (largely cash balance) and then toward freezing and sometimes terminating those defined benefit plans. Thinking back, the most common complaint I heard from corporate finance executives was the financial accounting volatility. Later on, funding volatility became perhaps a bigger issue.

I'll come back to this part of my rant later, but first it's time to return to my original topic.

According to an article that I read yesterday, 74% of respondents to a question said that lifetime income is important, but only 25% thought they had a way to generate it. So, in a tribute to the recently departed Adam West (the "real" Batman), riddle me this fine readers: "How does this comport with all the other articles telling me how well the 401(k) system is working?" Clearly something must be rotten in the state of Gotham.

We can do all of the modeling that we want and honestly, that modeling is in fact valid if, and that's a big if, participants can follow those models for their entire careers.If a person starts deferring at a reasonable level to their 401(k) when they are, say, 25 years old and continue to defer until some reasonable retirement age, all the while getting reasonable returns, that person will be able to retire and likely not outlive their resources.

They can do that, however, if they can use those balances to generate a steady stream of lifetime income. 

But, having reached the holy grail of retirement, these same people now want to do all the things they dreamed of while working. They wanted to retire to the beach or the mountains. They want to travel the world. They want to spoil their grandchildren. 

There is a problem with all of that. Those expenses are pretty front-loaded. That is, they are going to be very expensive in the first years of retirement. That will in turn deplete account balances that can be used to generate lifetime income. In other words, lifetime income may not be what you thought it was going to be. Or, said differently, the retirement wellness data must have a lot of fiction in it.

Once upon a time, that focus was on defined benefit plans. They focused on the employee who typically retired from a company in their 50s or 60s having worked for that company for 30 years or so. We all know that the current workforce doesn't tend to work 30 years for the same company, so that plan may be wrong.

But a defined benefit plan can still be right. Let it take a different form. Defined benefit plans have evolved to the point where they can look and feel like defined contribution plans, but critically still operate as defined benefit plans.

Why is this so critical? If the large majority of people think lifetime income is important, then we need plans that promote it. Yes, those people can get lifetime income from their 401(k), but if they are doing it through a commercial annuity, they have to purchase that annuity at "retail" rates. On the other hand, if they have a defined benefit plan, they can get better lifetime income from the same amount of money because they are getting the annuity at wholesale rates.

Now, there's a way to generate retirement wellness.

Holy Happiness, Batman.

Why 401(k) Plans May Not Be the Answer

Get a job. Find a new employer. Typical questions that get asked include compensation, health benefits, vacation, and do you have a 401(k) (or all too frequently, do you have a 401?)? Prospective employees usually don't ask about the 401(k) plan or about any other retirement plan, but simply want to know if there is a 401(k). Does it have a matching contribution? People don't ask.

According to a study from Aon Hewitt, 73% of those eligible are participating in 401(k) plans, but 40% of them are saving at a level below the full match level. Many of those plans have auto-enrollment, but that level of deferral is below the level required for a full matching contribution. Once people are enrolled at the automatic level, many tend not to defer enough to get a full match.

The Aon Hewitt study does not, as far as I could tell, explore why this may be. Is it a lack of employee education? Is it an inability to budget for a higher amount, especially in a time where costs of raising a family are increasing, but pay often is not? Is it a fear of the plan?

We can do the math. If a young worker (someone recently out of college, for example) participates in a 401(k) at a meaningful level throughout their career, and especially if there is a good matching contribution to go with it, those workers can eventually retire with a very good retirement income.

But, what about the ones who participate at a lower level, so that they get less than the full match? What about the ones who face temporary unemployment as so many of us do these days and may have to withdraw their 401(k) for funds to live on?

As Roth 401(k) plans have become the rage, this has become even more of a problem. While in a traditional 401(k), access to funds is essentially limited (large tax penalties) prior to age 59 1/2, in a Roth, that inaccessibility largely disappears after the employee money has been in the plan for 5 years. This means that practically speaking, Roths, for all their benefits, may be less retirement plans than their better known predecessors.

If these trends continue, 401(k)s in any form will not be the answer. In fact, for those people who are not using their plans to the fullest extent that they were intended, retirement may be nothing more than a pipe dream.

35 years ago, the answer was defined benefit plans. They provided retirement income pure and simple. But, do to Congress' ongoing efforts to protect pension plans, or so they would have you believe, that dinosaur is nearly extinct. But, 401(k)s will do the trick for only a small percentage of the workforce. For the rest, retirement planning is imperative. And, when they do the modeling, they may not like the future that they see.

Distribution Dilemma in Times of Tax Uncertainty

Recently, I was speaking with a top executive at a decent-sized company. The discussion had much to do with his total compensation, but paramount in his mind was his distribution from his nonqualified defined benefit plan (SERP). You see, due to Code Section 409A and its ties that bind, executives with meaningful amounts of deferred compensation are stuck in a guessing game (more about that later).

409A was added to the Code by the American Jobs Creation Act of 2004 (a misnomer if there has ever been one). It came to be in the wake of the Enron and WorldCom scandals and was put in place to ensure that plans typically limited to management and executives would provide participants with treatment that was no better than that available to participants in qualified plans. For purposes of this discussion, paramount among the restrictions on nonqualified deferred compensation intended to achieve these goals were these (simplifying somewhat):

• Prior to the year in which compensation is deferred, participants must elect both the timing and form of their distribution.
• To the extent that participant wishes to changes his distribution option(s) with respect to money already deferred, he must make that change at least one year prior to the date that distribution would have occurred, AND postpone that distribution by at least 5 years.
• Failure to comply results in significant penalties.

Consider this scenario. You were fortunate enough to be a participant in a SERP. Then, 409A came along and you had to make your "initial deferral election" in that SERP. You didn't know what to do, but you sure liked the idea of the security and favorable conditions underlying a lump sum distribution. Your fellow executives did as well.

That was prior to late 2007. The economy was booming. Smart money was saying that Bush Era tax cuts (put in place by EGTRRA in 2001, but set to expire by the end of 2012) would certainly be extended.

Oops, wrong guess.

There's no way to be sure what's going to happen to the tax rates for the highest earners. But, there is certainly a good possibility that they are going to increase. And, there might be surtaxes for those with
ultra-high (undefined term, but you know what I am talking about) income in any given year. And, you as this executive expecting a lump sum distribution from your SERP would no doubt realize how hard you were going to get hit by this.

What's going through your mind if you remember having made your initial deferral election is that perhaps you should have made a different one. Who knew? Did you think about it that carefully?

I took a highly unscientific poll of people currently in plans subject to 409A. I asked them about their initial deferral elections. Had we been in person rather than over the phone, I expect that I would have gotten funny looks had I used that specific term. But, over the phone, I was able to explain and not see the looks in their eyes. In any event, here are the results of that poll:

• 11 of the 15 had no say in their initial deferral election; it was foist upon them by HR who said that they had made their decision for them based on legal and or accounting advice.
• 9 of the 15 didn't know what the rules were around changes.
• 13 of the 15 have a DB and or DC SERP in which they are scheduled to take a lump sum distribution.
• Given the current economic and tax climate, of those 13, 12 would like to take a different form of distribution.
• Of those 12, 11 said that back when they made their 409A initial deferral election, had they truly understood what they were doing, they would have made a different initial deferral election.

Choosing that distribution option well in advance sure does create a dilemma. There are certainly options, but more people than not don't seem to understand this.