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?

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.

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.

Blip Theory -- The Downfall of 401(k) Outcome Theory

Most of the non-regulatory material that I read about 401(k) plans these days deals with participant outcomes. In fact, outcome seems to be one of the big buzzwords for 2014. We are suddenly talking about financial outcomes, health outcomes, and every other kind of outcome you can think of.

Don't get me wrong, I think it would be great if we all have wonderful outcomes. I just don't believe the studies that tell us how to get there.

In the typical piece that I read, I learn that in order to get the best outcomes, participants should begin saving at the beginning of their working career, increase the percentage of their pay that they save over time and convert their account balance (one way or another) to an inflation-adjusted annuity for longevity protection.

That's great. And, when a smart person models what will happen if a young adult follows this guidance, that person will always be destined to have a highly prosperous retirement.

But, it seems that very few people, even those who started saving when they were fairly young, are actually on target to have that very prosperous retirement.

Why not? What happened?

Life happened.

None of these models seem to reflect real life. In real life, people have periods of unemployment. During that unemployment, they stop saving. In fact, to the extent that those people have not also saved well outside of their 401(k), many will need to take distributions from those very 401(k) plans (paying income tax and the early distribution excise tax) just to stay afloat.

Where is this event in the models?

In real life, many young people actually do start to save at a modest rate and gradually increase the amount that they save. But, in real life, many of those people choose to have children and some will have them without having made a truly conscious decision to do so. Kids cost more money than anyone seems to think they will. That increase in savings rate often fails to be sustainable.

Where is this event in the models?

In real life, in 2014, an awful lot of people participate in high-deductible health plans. They are told that one of the great tax benefits of the modern world comes to people who put money away in a health savings account (HSA) to fund the high deductible part of their plans. This is a great idea as well, but real wages have not been increasing for probably the last 15 or more years. This model expects participants to save upwards of 10% of compensation in their 401(k) plans and an additional, say, $4000 per year in their HSAs. That's a lot of money. I think more people than not would tell you that this is just not feasible.

Where is this conundrum in the models?

Purchasing an in-plan annuity or taking an annuity distribution in your 401(k) is often an excellent idea. But, not all plans have them. Among those that do, many are not offered on a particularly favorable or attractive basis. The models that I have seen use a current, no-profit basis for converting your account balance to an annuity.

Where can I get one of these annuities on which an insurer makes no profit?

I'm all for wonderful outcomes. But, somebody needs to merge blip theory with outcome theory. Under blip theory, and I have never heard the term used before the morning of January 17, 2014, just as the road to hell is paved with good intentions, the road to wonderful outcomes is paved with potholes hereinafter known as blips. When models start including realistic numbers of blips, I'll start to believe the expected outcomes.

Does 401(k) Auto-Enrollment Work?

It was hailed as one of the great ideas to come from the Pension Protection Act of 2006 (PPA). Auto-enrollment, technically known as an Automatic Contribution Arrangement (ACA), was supposed to be a revolutionary change to 401(k) plans that would allow participants in this generally non-defined benefit world to someday retire comfortably.

The IRS submitted a Compliance Questionnaire to 1200 401(k) plans that had filed Form 5500. If you are interested, you can read their report for yourself. To me, one of their key findings was around plans that use ACAs. Of participants eligible for ACAs, here is the actual data:

• 43% defer at the default rate
• 29% elect a rate higher than the default rate
• 7% elect a rate lower than the default rate
• 21% opt out of participation entirely

In my experience, the most common auto-enrollment rate is 3% of pay. If that is truly representative of US companies at large, then 71% of participants are deferring 3% of their annual compensation or less. 

That's not good. Even for participants who defer for quite a long time, annual deferrals of 3% of pay, even with employer matching contributions added to them will not get anyone to a comfortable retirement.

One of the types of ACAs available to plan sponsors is a qualified automatic contribution arrangement (QACA). QACAs generally provide for auto-escalation in default deferrals. Oversimplifying somewhat, a QACA must have a default deferral percentage of at least 6% of pay in the third year following the initial period and cannot increase to a rate above 10% of pay. QACAs are exempt from ADP and ACP testing.

Participants in QACAs who do not opt out of the defaults will often have enough savings to retire comfortably. That's the good news. The other side of the coin is that IRS data shows that only about 5% of all 401(k) plans have ACAs and of those, fewer than 1/4 are QACAs. That means that roughly 1% of all 401(k) plans are QACAs. Many of the rest will have very few participants who will have prepared themselves through saving with sufficient money to retire.

That's not good. 401(k) auto-enrollment is not working as it should.

The US Retirement System is a Success?

I read a white paper from the Investment Company Institute (ICI) entitled "The US Retirement System is a Success." You can read it here if you like.

I beg to differ. Among the positions that ICI has taken is that the number of people actively saving for retirement and the amounts they are earmarking for retirement are increasing. Both of these may be true, but then again, it may be the way the questions are being asked today and were being asked in the past.

ICI uses 1985 as a reference point for a generation earlier. Interestingly, that's the year that I started in the actuarial consulting world. My perception is that we didn't see many people specifically saving for retirement back then. Most companies didn't have 401(k) plans. However, my memory tells me that the vast majority of American workers were covered by defined benefit plans. And, it was fairly likely that the company that you worked for at age 35 was the company you were going to retire from. Workers just knew that their pensions combined with Social Security would provide for their retirement.

Did it work? In a lot of cases, it did. When I got into this business, most times that a company did a plan design study, they looked at replacement ratios at various retirement ages. They looked at winners and losers. It was not unusual for a typical worker's replacement ratio from just a pension and Social Security to exceed 75% of their final pay as a worker.

ICI says that more recent retirees have higher levels of resources to draw on then prior generations. This may be true. But, focus on the words "recent retirees." More people in 2012 are working to older ages than in previous generations because they can't afford to retire. Many of those who have retired recently got their retirement savings during the dot com boom in the 1990s. Those who missed out on that may, in many cases, never be able to retire.

I've implied it many times in this blog that data is a funny thing. Give people data and an agenda and they can do with that data what their agenda asks them to do. I fear that the ICI has done this.

Leakage -- The Scourge of the 401(k)

Leakage -- it is the scourge of the 401(k). What is it? Well, it's not a really well defined term. But, in a nutshell, it's what happens to a participant's account or accounts -- their total savings -- when they have a discontinuity.

Simplified, most people are doing well until they run into some sort of hardship. Then the problems start. If they have a hardship, but they are still employed, they are likely to continue deferring, but perhaps not to the same extent. However, the news gets worse for the unemployed and the underemployed.

The Investment Company Institute (ICI) published a survey recently. They found that 63% of the unemployed who had a 401(k) account with their last employer have taken a withdrawal and 34% of the underemployed (they don't defined underemployed that I saw) have done so.

You've seen those projections. If you get your first real job when you are, say, 25 years old, and you begin deferring and you keep it at it, you'll have a wonderful nest egg by the time you reach retirement age. That's when the angels are looking down on you. But the ICI survey says that with unemployment or underemployment comes the devil known as leakage. And, these days, there just aren't that many people who will never suffer from either or from some other short-term financial hardship. It's part of the way of an extended weak economy.

Suppose we took those rosy projections starting at age 25 and running to even age 70 and looked at them. What's a reasonable rate of investment return? Many of the projections say 8% per year compounded. That means a geometric 8% rate of return. I'll bet you that you can't get a geometric 8% rate of return. If you have  gotten that this century to date, you are probably in the 99th percentile of all investors.

How do you model leakage? Consider this. Little Miss Muffet was a star student at a top school. She graduated, then got her MBA and finally took a good job at a company with a good 401(k) plan at the age of 25. She had read all the articles and began to save in earnest in her 401(k) plan. Uh, oh, Little's employer ran into some business hardships. They had to do a layoff and Little's number came up. She had a house with a mortgage. She had a car payment, and even though she had put aside a bit of a nestegg, the job market was tough. Little Miss Muffet had no alternative but to withdraw her money from her 401(k) plan.

Leakage!

Muffet was now 30 years old. Finally, she got another job, but remember those projections where you start saving at age 25. She can't go back to 25. And, while she got another job, she was desperate and it's not as good a job as she had at age 25.

So, you tell me how Little Miss Muffet is going to overcome leakage to get to a good retirement. As I asked you yesterday, has the 401(k) system failed us? Methinks it has.

The Next Big Thing?

I read today that Retirement Readiness is the next big thing (buzz word) in the retirement community. With the general demise of private defined benefit (DB) plans and companies providing far smaller benefits in defined contribution (DC) plans than they did in their DB plans, it's no wonder. It's also no wonder because most people are carrying huge amounts of consumer debt.

Think about it -- how can someone be preparing for retirement while carrying large amounts of consumer debt. And, while you're at it, add in a mortgage whose outstanding balance may exceed the value of their house. That's not a pretty picture, is it?

The person in that combination position, though, is left with some difficult decisions. Let's consider an individual earning $75,000 (before taxes) per year. That's $6,250 per month. Let's add in that they have $15,000 in outstanding credit card debt, and that the interest rate on that money is 15% per year. Let's assume that our hero(ine) decides to stop using his or her credit card and pay off the debt in 5 years. That's not too bad. Their monthly payments will be just above $350. But then they realize that they have been deferring 6% of pay to their 401(k) plan and that by redirecting that $375 per month, they could pay off their credit card debt in just two years instead of five. That sounds like a great idea. But their employer matches 50 cents on the dollar on the first 6%, so that's an automatic 50% return on their investment, far in excess of the 15% interest rate on their credit card.

Oh, the decisions!

Bottom line, though, most people don't really consider the two of them in combination. They just act, or they just react. And, they don't stop using their credit card.

So, while retirement readiness is a great new buzz word, it's not a new problem. It's been with us for a while, but people still aren't ready. The circumstances just don't seem to be working.

So, where did it come from? Well, none of the other 'best practice' ideas seem to have accomplished anything, so we now have the new thing to talk about.

And, this too shall pass.