Fixing Retirement Inequality

Just last week, I suggested that retirement inequality is nearing an apocalypse. It's an awfully strong statement to make as both the US and the world have plenty of problems to deal with. Since this one is US-centric (I have nowhere near sufficient expertise nor do I have the requisite data to offer an informed opinion outside the US), I thought I would step up and make some suggestions.

First, the problem: according to the most optimistic data points I have seen, somewhere between 60 and 70 percent of working Americans are "on track" to retire. And, these studies, when they are nice enough to disclose their assumptions use pretty aggressive assumptions, e.g., 7 to 8 percent annual returns on assets (the same people who tout that these are achievable condemn pension plans that make the same assumptions) as well as no leakage (the adverse effects of job loss, plan loans, hardship withdrawals, and deferral or match reductions). The optimists don't make it easy for you by telling you that even their optimistic studies result in 30 to 40 percent of working Americans not being on track to retire (a horrible result). They also tend to pick and choose data to suit their arguments using means when they are advantageous, but medians when they are more so.

Yes, we do have a retirement crisis and as the Economic Policy Institute (EPI) study was good enough to make clear, it is severely biased against the average worker.

The EPI study presented data on account balances and similar issues. It did not get into interviewing actual workers (if it did, I missed that part and apologize to EPI). But, I did. I surveyed 25 people at random in the airline club at the largest hub airport of a major US-based airline. People who wait in those clubs at rush hour are not your typical American worker; they tend to be far better off. I asked them two questions (the second only if they answered yes to the first):

• Are you worried about being able to retire some day? 19 answered yes.
• Would you be more productive at work if you felt that you could retire comfortably? All 19 who answered yes to the first question answered yes to the second as well.

While I didn't ask further questions, many groused about fear of outliving their wealth. Some talked about issues that fall under leakage. A few, completely unprompted remarked that if they only had a pension ...

For at least the last 13 years and probably more than that, retirement policy inside the Beltway has been focused on improving 401(k) plans with the thought that pensions are or should be dead. Even the Pension Protection Act of 2006 (PPA) was more about making 401(k)s more attractive than about protecting pensions. Yet, 13 years later with an entire decade of booming equity markets, even the optimists say that one-third of American workers are not on track to retire.

We've given every break that Congress can come up with to make 401(k)s the be all and end all of US retirement policy. They've not succeeded. 

Think back though to when the cornerstone of the US retirement system was the pension plan. The people who had them are often the ones who are on track to retire. 

Yes, I know all the arguments against them and here are a few:

• Workers don't spend their careers at one company, so they need something account-based and or portable.
• Companies can't stand volatility in accounting charges and in cash contribution requirements.
• Nobody understands them.
• They are difficult to administer.

PPA took a step toward solving all of those problems, but by the time we had regulations to interpret those changes, the "Great Recession" had happened and the world had already changed. Despite now having new pension designs available that address not just one, but all four of the bullet points above, companies have been slow to adopt these solutions. To do so, they need perhaps as many as three pushes:

• A cry from employees that they want a modern pension in order to provide them with usable lifetime income solutions.
• A recognition from Congress and from the regulating agencies that such plans will be inherently appropriately funded and therefore (so long as companies do make required contributions on a timely basis) do not pose undue risk to companies, to the government, to employees, or to the Pension Benefit Guaranty Corporation (PBGC) (the governmental corporation that insures corporate pensions) and therefore should be encouraged not discouraged.
• Recognition from the accounting profession in the form of the Financial Accounting Standards Board (FASB) that plans that have an appropriate match between benefit obligations and plan assets do not need to be subjected to volatile swings in profit and loss.

Give us those three things and the pensions sanctioned by the Pension Protection Act can fix retirement for the future. As the EPI study points out, we'll make a huge dent in the retirement crisis and we'll do in a way that makes the problem far less unequal.

It's the right thing to do. It's right for all working Americans.

Using Cash Balance to Improve Outcomes for Sponsors and Participants

In a recent Cash Balance survey from October Three, the focus to a large extent was on interest crediting rates used by plan sponsors in corporate cash balance plans. In large part, the study shows that those methods are mostly unchanged over the past 20 years or so, this, despite the passage of the Pension Protection Act of 2006 (PPA) that gave statutory blessing to a new and more innovative design. I look briefly at what that design is and why it is preferable for plan sponsors.

Prior to the passage of PPA, some practitioners and plan sponsors had looked at the idea of using market-based interest crediting rates to cash balance plans. But, while it seemed legal, most shied away, one would think, due to both statutory and regulatory uncertainty as to whether such designs could be used in qualified plans.

With the passage of PPA, however, we now know that such designs, within fairly broad limits, are, in fact allowed by both statute and regulation. That said, very few corporate plan sponsors have adopted them despite extremely compelling arguments as to why they should be preferable.

Why are they preferable?

For roughly 20 years, the holy grail for defined benefit plan, including cash balance plan, sponsors has been reducing volatility and therefore risk. As a result, many have adopted what are known as liability driven investment (LDI) strategies. In a nutshell, as many readers will know, these strategies seek to match the duration of the investment portfolio to the duration of the underlying assets. Frankly, this is a tail wagging the dog type strategy. It forces the plan sponsor into conservative investments to match those liabilities.

Better is the strategy where liabilities match assets. We sometimes refer to that as investment driven liabilities (IDL). In such a strategy, if assets are invested aggressively, liabilities will track those aggressive investments. It’s derisking while availing the plan of opportunities for excellent investment returns.

How exactly does this work?

I alluded to the new design that was blessed by PPA. It is usually referred to as market-return cash balance (MRCB). In an MRCB design, with only minor adjustments necessitated by the law, the interest crediting rates are equal to the returns on plan assets (or the returns with a minor downward tweak). That means that liabilities track assets. However the assets move, the liabilities move with them meaning that volatility is negligible, and, in turn, risk to the plan sponsor is negligible. Yet, because this is a defined benefit plan, participants retain the option for lifetime income that so many complain is not there in today’s ubiquitous defined contribution world. (We realize that some DC plans do offer lifetime income options, but only after paying profits and administrative expenses to insurers (a retail solution) as compared to a wholesale solution in DB plans.)

When asked, many CFOs will tell you that their companies exited the defined benefit market because of the inherent volatility of the plans. While they loved them in the early 90s when required contributions were mostly zero, falling interest rates and several very significant bear markets led to those same sponsors having to make contributions they had not budgeted for. The obvious response was to freeze those plans and to terminate them if they could although more than not remain frozen, but not yet terminated.

Would those sponsors consider reopening them if the volatility were gone? What would be all of the boxes that would need to be checked before they would do so?

Plan sponsors and, because of the IDL strategies, participants now can get the benefits of professionally and potentially aggressively invested asset portfolios. So, what we have is a win-win scenario: very limited volatility for sponsors with participants having upside return potential, portability, and wholesale priced lifetime income options.

The survey, as well as others that I have seen that focus on participant outcomes and desires, tells us that this strategy checks all the boxes. Now is the time to learn how 2018’s designs are winnersfor plans sponsors and participants alike.

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.

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.

Opinion: American Workers Need Pensions and They Should Look Like This

Since I last blogged, I've seen a lot of survey data. Among the very compelling themes has been that Americans are afraid that they will not have enough money with which to retire. Those fears are well founded for many.

As I've written here many times, the 401(k) plan was never intended to be the primary retirement source of retirement income for American workers. Neither was Social Security. Rather, Social Security was intended to be a supplement to bridge people for what was usually just a few years of retirement before death. Section 401(k) was a throw-in in a late 70s tax law that was suddenly discovered. It was intended to give companies a way to help their employees to save more tax effectively. And, remember, in the late 70s, the norm was that whatever company employed you at age 35 was likely to be your last full-time employer. ERISA had recently become law and most American workers had defined benefit pensions. These plans were designed to assist employers in recruiting and retaining employees.

Then, again, as I've written many times, along came change through the government and through quasi-governmental organizations. Employers didn't like the mismatch between cash flow requirements and financial accounting charges. New pension funding laws, beginning in 1987, were designed not to ensure responsible funding of pension plans, but to provide an offset to tax expenditures (a fancy name for tax breaks and government overspending). Looking at it from the standpoint of someone in Congress trying to decrease tax expenditures, if you can decrease required company contributions, you decrease their tax deductions, and thus cut those evil tax expenditures.

Nearly 30 years later, pensions have tried hard to go the way of the dinosaur. The fact is, however, that there are still lots of defined benefit pension plans out there. But, they don't look the same as they did 30 years ago. The laws have changed, creative minds have been at work, and new and better designs have emerged.

American workers generally should have employer-provided defined benefit pension plans. But, since these creative minds have been at work, what exactly should these new plans look like?

• While they offer a sense of stability in retirement, annuity payments do not appeal to many Americans and they do not necessarily understand them. So, while all defined benefit plans must have annuity options, they should also have lump sum options.
• The plans should not be "back-loaded" (a term that means that most of your accruals and therefore cost to your employer emerges late in your career). The typical final average pay plan of yesteryear was designed so that most of your accruals occurred close to or after you were eligible to retire. This made some sense when you spent your whole career with one employer. But, in 2016, that very rarely happens. So, plans should accrue benefits fairly ratably.
• Benefits should be portable. That is, you should be able to take them with you either to an IRA or to another employer. This works best if there is a lump sum option through which you can take a direct rollover and maintain the tax-deferred status.
• Employer costs should be predictable and stable. This can be achieved when there is no longer a mismatch between assets and liabilities in a plan.
• Employers should see that plan assets are professionally managed, but fluctuations in asset returns from those that are expected can be borne by plan participants.

This sounds like pension nirvana, doesn't it? Such plans and designs can't possibly exist.

Well, they do. 

The plan design that accomplishes this is often known as a Market Return Cash Balance Plan (MRCB).

While an MRCB carries with it all of the required characteristics of defined benefit plan and it looks a lot like a 401(k) or other defined contribution plan, it brings with it additional benefits. It satisfies all of the bullets I've outlined above. Budgeting gets easy and predictable. There is no "leakage" due to sudden expenses when a participant's car decides to break down or an unexpected flood ravages their house.

An MRCB is very suitable to be a primary retirement plan. You want to save a bit extra? That's what your 401(k) plan is for. 

If you are an employer and you're reading this, you really need to know more, don't you?