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.

Preparing the Higher Paid for Retirement

Retirement readiness is getting lots of press these days. With the decrease in the number of ongoing defined benefit (DB) retirement plan, many people are finding that they are not on a path to perhaps ever be ready to retire. While most of the focus has been on lower paid, nonhighly compensated (NHCE) workers, the discussion may be more relevant for the higher paid (HCEs) workers, especially those who are not among the very highest paid. When I was growing up, these people were often referred to as the upper middle class. Today, I don't hear that term as often.

Yesterday, I read an article that on its surface would seem to address this issue. It focused on the small employer, small plan world. It laid out a multi-step additive solution:

• Safe harbor 401(k)
• Cross-tested profit sharing
• Cash balance plan
• Nonqualified plan

There is nothing wrong with this solution. In fact, at companies that take this approach, it is likely that full career employees whether they are NHCEs or HCEs will have sufficient retirement benefits to be able to retire with a style of living similar to what they had when they were working. 

That's not bad.

But, as I said, the focus here is on small employers in which the management team (often one or two owners) are earning really substantial amounts of money. While the approach outlined above and in the article may be somewhat optimal, it's not unlikely that with a less optimal approach that these HCEs could retire comfortably.

Before we go on, however, why should we care about the rest of the HCEs -- those people who for the most part have annual incomes in the range of, say, $125,000 to $200,000. They are pretty well paid. What could possibly make it difficult for them?

They do pay more in taxes. It's not unlikely that they will have to fund college educations for their child(ren) as they may make a little too much for significant financial aid to be available. And, as most people aspire to a style of living in retirement at least similar to what they had when they were working, it's going to take a lot more savings for these people to make it to that retirement target. Further, in today's world, with so many employees having a 401(k) plan as their only retirement vehicle, those HCEs who would like to save as much as the financial gurus recommend are just not able to do that in a qualified plan.

Many of these same HCEs have jobs that are not physically stressful. As a result, if they choose to, and if an employer will have them, these people can work well past traditional retirement ages. One might question whether that is good for society. Is it a desirable result? (I'll leave the thinking on that to the reader.)

What can we do? 

Since most people reading this (likely all) will not be legislators, we can't change the law even if that might be a desirable result. As I have said many times, using the 401(k) as a core retirement plan prepares almost no one for retirement. To the extent that companies feel any obligation to their employees, they must do something different.

That different plan should have some particular characteristics:

• It should be affordable to the employer
• The cost of that plan should be relatively stable; that is, volatility should be limited
• The plan should offer annuity and lump sum options to participants when they reach retirement age
• The plan should be easy to understand
• The plan should be easy to administer
• The benefit should be portable since in today's modern workforce, an employee who stays with you for more than five years is the exception, not the norm
• It should benefit the rank and file well
• It should benefit the upper middle class well
• It should benefit the executive group well

Most of the retirement world doesn't seem to want you to know about it, but this plan exists today and it is specifically sanctioned by the Internal Revenue Code.

And, for all of you who are scrambling to learn more, there is plenty of information for the industry insider and the lay person alike. But, if you have more questions, you can always click here.