Imagining Retirement Plans Through the Eyes of a Child

Imagine retirement plans. Imagine retirement plans through the eyes of a child (gratuitous Moody Blues reference for readers in my age range).

I know, this sounds really strange. Of all the people who are not thinking about retirement, kids are at the top of that list. Bear with me though. I will bring you back.

Before I do, however, think back to when you were a child. You probably either lived in a house on a street where there were other kids or in an apartment where there were other kids around or went to school where there were other kids. One way or another, most of us found ourselves around other children.

Now, think about what really made you beam with pride and joy. There were lots of things -- good grades, winning a game or a race, and being the first kid on the block to have something that every kid wanted. It didn't have to be something big. But, if you had it first, every kid wanted to be you.

I promised that I would bring you back and I'm going to start now. Take yourself out of the mind of a child. At least do that a little bit, but we're going to be meandering back and forth a bit on this short journey.

Think about the employer-employee relationship. Some employees want a job; others want a career. Some employees want a paycheck; others want to be somewhere where they want to come to work. Some employers want to have employees who collect a paycheck and perhaps as small a paycheck as the employer can get away with; others want to be employers of choice.

From an excellent article in Fast Company, "[O]ne of the top factors most likely to keep professionals at their company for 5+ years ... is having strong workplace benefits ... ." The article continued, "[I]n comparison, the least enticing factor for keeping professionals at their current companies is having in-office perks such as food, game rooms, and gyms."

Employers that want to be employers of choice will care about this stuff. And, so will employees. And, many of these employees actually do remember being children. Just as I do, they remember things like spending a nickel on a stick of Topps bubble gum that came with five baseball cards and upon opening the pack seeing that they were the first kid they knew of to get a Mickey Mantle. You really do have something special then.

Often times, employers that want to be employers of choice want that because they know that the cost of unwanted employee turnover is so high. In fact, when companies are counting their beans, if they use 150% of one year's pay as a proxy for the cost of an unplanned and unwanted turnover of a professional employee, then 1) they are likely pretty close, and 2) they will realize that the cost of benefits probably pales in comparison to the cost of turnover.

One of those benefits that we mentioned is a retirement program (note that I talk about a program not an individual plan). Most companies, or certainly many if not most, have 401(k) plans. Their employees don't really know what they are, but everybody thinks they are important, and, in fact, they are. So, giving an employee a 401(k) plan doesn't make her feel special when she looks at it through her eyes of a child.

But, suppose I told her that I had a special plan for her. We don't have to give that plan a name. Suppose I told her that I, her employer, value my employees and that I was going to give her something like a match, but that it was better. Suppose I told her that I was going to auto-enroll her in our 401(k) plan because everybody says auto-enrollment is a best practice, but even if a year came where she had to stop deferring to the 401(k) plan, I was still going to contribute the same 5% of pay to her retirement account. And, by the way, those assets that accumulated from those over and over again five percents were going to grow based on professional investments. And, someday when she retires, she'll be able to take her benefit as a lump sum, or as an annuity, or as some combination of the two.

Imagine how a child thinks about that.

The child's eyes light up.

She is the first kid on her block to have this special benefit.

She is special.

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.

Are You Better Off than You Were 20 Years Ago?

Nearly 40 years ago, Ronald Reagan asked voters if they were better off than they were four years earlier. And, that was the beginning of the end for Jimmy Carter's reelection hopes. So, without trying to end anything for you, I ask if you are better off from a retirement standpoint than you were 20 years ago.

For Americans as a group, I think the answer is a clear no. Our retirement system has been broken by the momentum that has gathered around the 401(k) plan. After all, when Section 401(k) was added to the Internal Revenue Code in the Revenue Act of 1978, it was never intended to be a primary retirement vehicle. In fact, it was a throw in that even among those who were there, there doesn't seem to be much agreement on why it was thrown into the Act.

When it was, however, defined benefit (DB) pension plans were in their heyday. People who were fortunate enough to be in those plans then are now retired and an awful lot of them are living very well in retirement. On the other hand, people who are now retiring having been in 401(k) plans only have their retirement fates scattered all over the place. Some are very well off, bit others are essentially living off of Social Security.

Let's consider where those people went wrong. For many, when they first had the opportunity to defer, they chose not to. They had bills to pay and they just couldn't make ends meet if they didn't take that current income. By the time they realized that they should have been saving all along, they couldn't catch up.

For others, they were doing well until they lost a job. Where could they get current income? They took a 401(k) distribution.

Yes, I am very well aware that the models show that people who are auto-enrolled and auto-escalated in a 401(k) plan with a safe harbor match will fare quite well. Those models all assume no disruptions and constant returns on account balances of usually around 7%.

Let's return to reality. The reality is that young workers are (likely because of all the campaigns telling them to do so) deferring liberally when they start in the workforce. The problem is, and I get this anecdotally from young workers, that more of them than not reach a point where they just can't defer at those levels any more. They get married, buy a house, and have kids, and the financial equation doesn't work. So, they cut back on deferrals. I know a number who have gutted one or more of their 401(k) plans in order to buy a house. The fact is that it's not easy to defer, for example, 10% of your pay into your 401(k), another 5% into your health savings account (HSA), and save money for a down payment on a house.

Where were we 20 years ago? For many Americans, they were about to be getting those notices that their DB plans were getting frozen. Congress killed those DB plans. The FASB killed those DB plans.

When I got into this business in 1985, most (not all) corporate pension plans were being funded responsibly. And, this status was helped, albeit for only a year or two by the Tax Reform Act of 1986 (shortening amortization periods). One of the big keys, and this will be understood largely by actuaries, is that we had choices of actuarial cost methods. My favorite then and it would be now as well for traditional DB plans is known as the entry age normal (EAN) method. The reason for this is that under EAN, the current (or normal) cost of a plan was either a level cost per participant (for non pay-related plans) or a level percentage of payroll for pay-related plans. Put yourself in the position of a CFO -- that makes it really easy to budget for.

But Congress and the FASB knew better. In the Pension Protection Act of 1987 (often referred to OBRA 87 because it was one title of the Omnibus Budget Reconciliation Act), we had it imposed on us that we must perform a Unit Credit (another actuarial cost method) valuation for all DB plans. And, in doing that Unit Credit (UC) valuation, we were given prescribed discount rates. At about the same time (most companies adopted what was then called FAS 87 and is now part of ASC 715), DB plan sponsors also had to start doing a separate accounting valuation using the Projected Unit Credit (PUC)  (Unit Credit for non-pay related plans) actuarial cost method. Most of those sponsors found that their fees would be less if they just used these various unit credit methods for their regular valuations as well and we were off and running ... in the wrong direction.

You see, PUC generally produced lower funding requirements than EAN and the arbitrary limits on funding put in place by that second funding regime known as current liability (the UC valuation) and most DB plans had what is known as a $0 full funding limit. In other words, they could not make deductible contributions to their DB plans during much of the 1990s. And, it stayed that way until prescribed discount rates plummeted and there were a few years of investment losses.

What happened then?

CFOs balked. They had gotten used to running these plans for free. Suddenly they had to contribute to them and because the funding rules were entirely broken, the amounts that they had to contribute were volatile and unpredictable. That's a bad combination.

So, one after another, sponsors began to freeze those DB plans. And, they did it at just the time that their workers could least afford it.

For all the data and models that tell us that it should be otherwise, more people than ever before are working into their 70s, generally, in my opinion, because they have to, not because they want to. As a population, we're not better off in this regard than we were 20 years ago In fact we are far worse off.

Even for those people who did accumulate large account balances, many of them don't know how to handle that money in retirement and they don't have longevity protection.

We need a fresh start. We need funding rules that makes sense and we need a plan of the future. It shouldn't be that difficult. I'd like to think that my actuarial brethren are smart people and that they can design that cadre of plans. They'll be understandable, they'll be portable as people change jobs, they'll have lump sum options and annuity options , and they'll even have longevity insurance. They'll allow participants the ability to combine all those in, for example, taking 30% of their benefit as a lump sum, using 55% for an annuity from the plan beginning at retirement, and 15% to "buy" cost-of-living protection from the plan.

That's great, isn't it? Even most of the 535 people in Congress would probably tell you that it is.

But those same 535 people don't really understand a lick about DB plans or generally about retirement plans (there are a few exceptions, but very few). In order to get that fresh start, we need laws that will allow those designs to work.

We surely don't have them now.

Over the years, Congress has punished the many plan sponsors because of a few bad actors. If 95% of DB plans were being funded responsibly, then Congress changed the funding rules for 100% of plans to be more punitive because of the other 5%.

Isn't it time to go back to the future to get this all fixed?

Let's kill the 401(k) as a primary retirement plan and develop the plan of the future. It could be here much sooner than you think.

Wake Up and See the Light, Congress!

Congress has a once-in-a-generation opportunity. Since its first major overhaul in 1922, Congress has seen fir to make earth-shaking changes to the Internal Revenue Code (Code) once every 32 years. 1922. 1954. 1986. And, while it seems that they may be one year early this time, they are pitching tax reform once again.

The concept of qualified retirement plans as we know them today comes from the Employee Retirement Income Security Act of 1974 (ERISA) signed into law that Labor Day in 1974. Since that time, there have been relatively few changes to the Code affecting retirement plan design. And, frankly, most of them have come on the 401(k) side. In fact, Section 401(k) was added to the Code after ERISA and since then, we have been blessed with safe harbor plans, auto-enrollment, auto-escalation,Roth, and qualified default investment alternatives (QDIAs). Over the same period, little has been codified or regulated to help in propagating the defined benefit plan -- you know, that plan design that has helped many born in the 40s and early 50s to retire comfortably.

Isn't this the time? Surely, it can be done with little, if any, effective revenue effects.

Since ERISA, there have been really significant changes in defined benefit (DB) plan design including the now popular traditional cash balance plan, the even better market return cash balance plan, pension equity plan, and less used other hybrid plans. And, DB plans have lots of features that should make them more popular than DC plans, especially 401(k) plans.

• Participants can get annuity payouts directly from the plan, thereby paying wholesale rather than the retail prices they would pay from insurers for a DC account balance.
• Participants who prefer a lump sum can take one and if they choose, roll that amount over to an IRA.
• Assets are professionally invested and since employers have more leverage than do individuals, the invested management fees are better negotiated.
• In the event of corporate insolvency, the benefits are secure up to limits.
• Plan assets are invested by the plan sponsor so that participants don't have to focus on investment decisions for which they are woefully under-prepared.
• Participants don't have to contribute in order to benefit.

But, they could be better. Isn't it time that we allowed benefits to be taken in a mixed format, e.g., 50% lump sum, 25% immediate annuity, 25% annuity deferred to age 85? Isn't it time that these benefits should be as portable as participants might like? Isn't it time to get rid of some of the absolutely foolish administrative burdens put on plan sponsors by Congress -- those burdens that Congress thought would make DB plans more understandable, but actually just create more paperwork, more plan freezes, and more plan terminations?

Thus far, however, Congress seems to be missing this golden opportunity. And, in doing so, Congress cites the praise of the 401(k) system by people whose modeling never considers that many who are eligible for 401(k) plans just don't have the means to defer enough to make those models relevant to their situations.

Sadly, Congress prefers to keep its collective blinders on rather than waking up and seeing the light. Shame on them ...