THE ANCHOR LEG OF THE DC PLAN:

Transcription

1 Topic Paper November 2017 THE ANCHOR LEG OF THE DC PLAN: Helping Participants Finish Strong with a Retirement Tier DREW CARRINGTON, CFA, CAIA Senior Vice President, Head of Institutional Defined Contribution MARY BETH GLOTZBACH Vice President, Senior Institutional DC Strategist TOM WATERS Vice President, Senior Institutional DC Strategist Auto-features and financial wellness seem to dominate industry headlines these days. To be sure, innovations such as auto-enrollment, auto-escalation and age-based default investment alternatives are impactful developments that have benefited millions of participants. But noticeably absent from much of the headlines are initiatives designed to better serve the group of participants who are preparing or ready to spend their hard-earned retirement savings. We refer to this cohort as the pre-retirees and retirees in our defined contribution plans or simply, participants over 50. Over 60% of DC plan assets reside with these individuals. 1 And yet most plans lack many (if any) investment options, planning tools, and even plan document provisions that can make the plan truly work for them in retirement. At Franklin Templeton, we believe that one of the next areas of focus and innovation in the DC industry should be in the development of a Retirement Tier in DC plans. While there is no silver bullet retirement income solution that will meet the needs of every participant, a great deal of options exist that can help households fit the DC plan into the context of their complex and unique retirement plan. And we think it s critical that these investment options are accompanied by retirementoriented tools and advice, retirement-friendly plan design/document provisions, and targeted communications that can help this group. In this paper, we lay out a unique perspective on this group of participants over 50 and what makes for an effective Retirement Tier: We challenge common misconceptions about participants and tiers in DC plans, examining plan data on unique contexts and behaviors of participants as they approach retirement. We illustrate how four pillars of the Retirement Tier work together and how it can complement the rest of the tiers in a DC plan. We discuss a range of tools, investment options, plan design provisions and targeted communications designed to address the unique and complex needs of participants over 50. We explain how the makings of a Retirement Tier already exist in many plans, and how this framework can help build on progress in making DC plans into participantfriendly sources of income in retirement. For Use with Financial Professionals and Plan Sponsors Only / Not for Use with Plan Participants

2 WHAT THE DATA TELL US ABOUT PARTICIPANTS APPROACHING RETIREMENT As an industry, we often take a simplified view of participants as being generally disengaged and unresponsive to communication and education. We at Franklin Templeton believe these assumptions are worth challenging, particularly with regard to the population over 50 that tends to face increasingly complex and unique financial situations as they approach retirement. PARTICIPANTS OVER 50 HAVE MOST OF THE ASSETS DC Plan Assets by Age Group 1% 18% 11% 26% 20s 30s 40s 50s 60s 44% Source: Employee Benefit Research Institute and The Investment Company Institute, as of December 31, Most recent available data. Default Options Become Less Popular with Age The interaction between tiers in a DC menu and how participants personalize their asset allocation to their unique household situation is in-line with some recent research conducted by Financial Engines. In that study, they found that 89% of participants already use other investment options in conjunction with targetdate funds (TDFs). In addition, 54% of the participants who have changed their asset allocation from the default said that they did so because the TDF was either too risky or not risky enough for their needs. 2 Adding investment options in the Retirement Tier provides participants greater ability to customize their portfolio to help them better strategize and execute their retirement income plan. Expanding Options Beyond the Default TDF TDF+ Core Menu TDF+ Core Menu+ Retirement Tier 2 The Anchor Leg of the DC Plan: Helping Participants Finish Strong with a Retirement Tier

3 Financial Contexts Become More Complex and Varied When we consider auto-enrollment and how to set new hires on a path to a financially secure retirement, we often take an overly simplified view. We view them as young, single, and lacking any other sources of retirement income. But in reality, most new hires have been in the workforce for some time, and they ve likely already been participating in a DC plan prior to their new employment. A more appropriate way to view DC participants is through a longitudinal lens recognizing that their current plan assets may only be a snapshot in their broader retirement savings history. MOST PARTICIPANTS ARE MAKING HOUSEHOLD DECISIONS Percentage of People Currently Married by Age Group 80% 60% Men Women 40% 20% 0% Source: United States Census Bureau Age Group Another perspective that we should consider, especially as people get older, is that in most cases they are making financial decisions in the context of their entire household. The US Census Bureau s most recent findings show that for the age cohort closest to retirement (55 to 64), 66.4% of men and 60.0% of women are currently married. 3 These numbers contrast starkly with Americans ages 20 34, the vast majority of whom are unmarried. Finally, it s worth noting that households nearing retirement age generally hold multiple retirement account balances as well as other financial assets that will serve as sources of income in retirement. When a married participant hits age 65, the average percentage of assets that DC account represents as a percentage of total household, non-transactional financial assets is only about 39%. 4 Viewing DC plan participants through this broader lens, it becomes clear that DC participants nearing or in retirement are a very heterogeneous group with complex needs. The move to simplify menus and rely on automation does not apply so well in this context. These participants are looking for help with how to fit their current DC plan in the context of their entire, unique, household financial situation. A More Engaged Participant Participants over 50 years old tend to be much more engaged than conventional wisdom suggests. A recent Franklin Templeton study shows that 91% of DC plan participants over 50 check their balances at least annually. 5 62% reported rebalancing or making changes to their portfolios at least annually. Finally, 52% of the individuals we surveyed said they actually preferred to self-manage their DC investment options. These findings reflect that this group is paying attention, prefers to be involved and wants to be informed. This is likely due to their proximity to retirement and the complexity of their unique financial situations. In our assessment, this group is much more open to utilizing in-plan tools and responding to targeted, relevant communications. ftinstitutional.com 3

4 THE THREE-TIERED PLAN, REVISITED The concept of tiers is familiar to most DC industry professionals. It helps us organize our approach and in-plan offerings to meet the needs of different types of participants. Here we ll outline the common threetiered plan structure and some common misconceptions around it, and explain how a Retirement Tier builds on this framework and effectively complements these tiers. The Classic Three-Tier Framework First, let s clarify what makes up a traditional three-tier plan, by our definition. TIER 1 TIER 2 TIER 3 Participant Type DO IT FOR ME Reluctant Investor DO IT WITH ME Engaged Investor DO IT MYSELF Proactive Investor Investment Offerings One-Size-Fits-All Solution QDIA Building Blocks Core Menu Supplemental Choices Brokerage Window We use a number of different category labels and terms in the industry when it comes to tiers, but they all paint a similar picture. DC plans are made up of a range of investment options, tools and features intended to meet the needs of different participant groups with varying levels of engagement. Here are some of the common misconceptions about this framework. Assumption #1: Tiers Are Mutually Exclusive It s easy to believe that each tier is made up of distinct sets of participants with similar characteristics. But in reality, participants are dynamic individuals with varied financial contexts. They may straddle multiple tiers, or reflect conflicting behaviors tied to different tiers. For instance, a participant may appear disengaged by taking no action at enrollment and defaulting into the QDIA option. Yet they may also be proactive in the plan in using a student loan repayment calculator and adjusting their contribution level. A realistic view of participants calls for some ambiguity around precisely what tiers they sort into. 4 The Anchor Leg of the DC Plan: Helping Participants Finish Strong with a Retirement Tier

5 Assumption #2: Participants Remain Permanently in One Tier We also have a tendency to view participants as generally consistent in their behaviors over time. If they re disengaged and unresponsive to communications, they re Tier 1 and probably always will be. As the previous section outlined, there are observable behaviors in participants as they age that dispel this notion. A wealth of evidence indicates that the average participant becomes more engaged in the plan with time. They will diversify away from the default option, review their benefit elections more frequently, take action in response to targeted communications, etc. We ought to recognize that the tiers become less distinct and permanent as participants age. Assumption #3: Tiers Are Composed of Only Investment Options Finally, we believe that one more fundamental assumption with respect to tiers that ought to be challenged is that tiers are made up of investment options only. Increasingly, plan sponsors are embracing the notion of financial wellness, with the understanding that the employer and the DC plan have a role to play in helping employees seek to achieve financial security and a successful transition to retirement. Investment options are not the only factors that play a role in participants success. In our view, each tier can encompass a broader set of features that help plan sponsors think about how to best serve participants that demonstrate characteristics of that tier. As we ll explore in detail in the following section, we believe there are four general categories for the features that make up a strong tier: (1) tools, advice and coaching, (2) targeted communications, (3) investment options, and (4) plan design features and changes. A More Expansive Definition Tiers 1. TOOLS AND ADVICE 2. TARGETED COMMUNICATIONS 3. INVESTMENT OPTIONS 4. PLAN DESIGN CHANGES ftinstitutional.com 5

6 INTRODUCING THE RETIREMENT TIER We believe that DC plan sponsors, consultants and advisors ought to expand the common notion of the three-tiered investment menu and start incorporating a Retirement Tier into their DC plans. Unlike other tiers in the DC plan, our view of a Retirement Tier is a more comprehensive set of complementary solutions that are targeted for participants nearing or in retirement. This is not a one-size-fits-all solution (QDIA Tier), nor is it a smorgasbord of investment options (Classic Core Menu Tier) it bridges all categories. The Retirement Tier Complements the Other Tiers TIER 1 TIER 2 TIER 3 RETIREMENT TIER Tools and investments to appeal to all types of participants approaching retirement A Retirement Tier is a set of carefully chosen investments, tools and advice that can help pre-retirees and retirees execute a strategy to fit their DC plan into the context of their overall household financial situation. It also serves participants that identify with any of the three traditional tiers, and is complementary of the other tiers in the menu. While every in-plan option must be available to all participants, components of a Retirement Tier can exist in a separate section of the record keeper s web portal, and targeted communications can drive participants over 50 to it. Characteristics of the Retirement Tier A key characteristic of the Retirement Tier is that it s not mutually exclusive with the rest of the plan. Rather, we see the Retirement Tier as a piece of the overall DC puzzle (and by extension, the household retirement mosaic). It should work hand in glove with what s currently available in the rest of the plan. When an individual gets to the point where they need more specialized tools and investment options, the Retirement Tier serves as that outlet. For example, a typical young, early-career participant would generally be well-served to be invested in the QDIA (a TDF in this case). As that person progresses in their career and starts to deviate from the average, it might make sense for that person to personalize their asset allocation with some of the investment options in the core menu. That person, for example, may want to add more risk assets to their portfolio and can do so by adding equity to their asset allocation. When that person then gets closer to retirement, they may need to add more income- or inflation-oriented assets to their portfolio and can further change the asset allocation to reflect their situation by accessing the Retirement Tier. 6 The Anchor Leg of the DC Plan: Helping Participants Finish Strong with a Retirement Tier

7 This point underlines a key characteristic of the Retirement Tier: there is no single, one-size-fits-all solution. There can t be. Participants circumstances and preferences diverge with age, and different options are necessary to meet different needs. Moreover, the tier is complementary and should serve all types of participants that identify with each of the three main tiers. Multiple options for instance, both flexible and guaranteed income solutions can better meet the needs of more participants. Components of the Retirement Tier But as we discussed earlier, the concept of a Retirement Tier does not end with the investment menu. It goes beyond the investment menu to help increase the utility of the investments. The three other components of a high-functioning Retirement Tier are plan design changes, targeted communication programs, and tools and advice geared to help educate participants and assist them in planning and executing their retirement strategy. The Four Pillars of the Retirement Tier 1. TOOLS AND ADVICE 2. TARGETED COMMUNICATIONS 3. INVESTMENT OPTIONS 4. PLAN DESIGN CHANGES Social Security Optimizer Catch-up contribution second escalator Laddered / Defined Maturity Bond Funds Allow for partial ad-hoc withdrawals Expense Assessment Tool Resource Center (reverse mortgage, Medicare) Invite mid-career hires to save at higher rates Invitation to use targeted tools Managed Payout Funds Inflation Protection Insurance Solutions Allow terminated participants to continue loan payments ftinstitutional.com 7

8 HOW THE RETIREMENT TIER WORKS In this section, we detail the four pillars of a Retirement Tier. We use Social Security Optimization as a focal point to demonstrate what each of the four pillars can contribute and how they can work together to improve outcomes for participants as they transition to retirement. Every Pillar Is Connected TOOLS AND ADVICE PLAN DESIGN CHANGES TARGETED COMMUNICATIONS INVESTMENT OPTIONS Why Social Security Optimization? Consider this: Social Security is the most ubiquitous retirement asset we have in the United States. For many people, Social Security will be a significant component of their retirement income pie. But it can be a complicated decision when to claim these benefits. There are literally millions of potential combinations of ways and times for a married couple to file for Social Security benefits, according to Laurence Kotlikoff, professor at Boston University. 6 Our research shows that despite the importance and complexity of filing for Social Security benefits, a large percentage of people file in a very non-strategic way. In our most recent RISE survey, we found that 56% of people surveyed began receiving Social Security benefits before full retirement age (FRA). 7 Of those people, 49% said they did so simply because they were eligible. The potential impact on aggregate retirement income is enormous. For an individual born in 1955 and earning $80,000, waiting until age 70 to file could mean a 56.1% increase in total benefits received by age 90 (the hypothetical lump sum equivalent would be $339,832). 8 8 The Anchor Leg of the DC Plan: Helping Participants Finish Strong with a Retirement Tier

9 1 Tools and Advice DC plans are embracing the idea of financial wellness, with the introduction of engaging tools that help participants with financial challenges broader than just 401(k) investment decisions, such as how to pay down student loans. But most of these planning and education tools are geared toward younger participants. A Retirement Tier would further extend this concept to tools that are specifically useful for the group of participants nearing the end or already at the end of their careers. Including a Social Security Optimizer tool that helps participants understand these permutations and the impact that the decision of when to start collecting Social Security benefits will have on retirement income and guides them to an optimal collection age is a true easy win for sponsors. Apart from a Social Security Optimizer, a Retirement Expense Assessment tool could also help participants understand the level of income they may need in retirement, and plan their final working years accordingly. A resource center that includes information about reverse mortgages, Medicare and other considerations for retirees could also be impactful. Finally, one-on-one coaching can be a great benefit to many participants, particularly those who are less digitally savvy. In many cases, participants have a well-developed plan to finance their retirement that they may simply need to talk over with a professional in order to transition to retirement with confidence. 2 Targeted Communications One key targeted communication plan sponsors could send to participants when they turn 62 is to educate them on the benefits of delaying Social Security. They could use the opportunity to introduce them to a Social Security Optimizer tool as well. Because we know this group is much more engaged, they are more likely to positively respond to the communication, thus helping them be prepared to make more informed and strategic decisions around how and when to file for Social Security benefits. This would have a tremendously positive impact on how households then manage their 401(k) assets. The Evolution of Participant Communications SAVINGS EDUCATION PLANNING EDUCATION Age 50 years Relatively large balance Another example of a birthday-driven targeted communication would be a notice to all people who turn 50 in a given year that they are now eligible to make catch-up contributions. There are a number of communications tied to birthdays that can help participants over 50 prepare for retirement, addressing Social Security, Health Savings Accounts and other timely topics. ftinstitutional.com 9

10 3 Investment Options In the event that a participant in a DC plan, in the context of what s best for their household, makes the decision to delay Social Security benefits, that household may need to figure out how to fund their retirement from the time they retire to the time they start receiving benefits. That is why it s essential that an effective Retirement Tier have investment options that satisfy the needs associated with a wide range of circumstances. An investment option designed to provide more cash flow predictability while still earning income would be a logical solution. A laddered series of defined maturity bond funds could allow the participant to sequester savings needed to meet household expenses, and provide the necessary income until Social Security begins. If, for example, the individual needed $50,000 pre-tax income per year for four years, they would allocate that amount to four defined maturity bond funds, each maturing in consecutive years. This practice is essentially creating a tool used by financial advisors for decades: a bond ladder. FLEXIBLE SOLUTION TO HELP GENERATE CASH FLOW IN RETIREMENT Hypothetical 401(k) Allocation 401(k) Bond Portfolio Ladder pays out principal and interest each year at maturity Maturity Year Other investment options that could be part of the Retirement Tier are managed payout funds to help target an income or yield. Additionally, inflation protection funds can help guard against decreasing purchasing power. Finally, this tier could also include insurance based products such as guaranteed minimum withdrawal benefit (GMWB) contracts or qualified longevity annuity contracts (QLACs). 4 Plan Design Finally, there are many plans that have plan documents with provisions that are either outdated or in conflict with what plan sponsors state as their goals for the plan. For example, 69% of plan sponsors agree that participants should leave their assets in the plan and allow them to drawn down over time. 9 However, only 13% of DC plans allow terminated participants to take ad-hoc, partial distributions from the plan. 10 A very simple but effectual plan design change would be to amend the plan document to allow for partial, ad-hoc withdrawals. Not only would this be aligned with a commonly stated goal of the DC plan, but it could also help facilitate the use of other tools and investment options in the DC plan, such as the aforementioned Social Security Optimizer tool and managed payout funds or defined maturity bond funds. 10 The Anchor Leg of the DC Plan: Helping Participants Finish Strong with a Retirement Tier

11 CONCLUSION Ultimately, the goal of most participants in a DC plan is to accumulate enough assets over their working careers to serve as a key source of income in retirement. Plan sponsors have stated that the goals of their DC plans have largely transitioned from a pure savings vehicle to one that should be used as a source of retirement income as well. 11 Despite those facts, the industry has been slow to evolve DC plans to make that vision a reality. The reality is that participants are taking action on their own to fit their DC plan assets into their retirement plan. Many are diversifying away from default options as they age, and many are rolling over into IRA s soon after retirement. A Retirement Tier can help make the plan serve the needs of participants at all stages of the plan, and nudge them toward an on-time, financially secure retirement. Many plan sponsors have already started down this path, perhaps without recognizing it. Each new in-plan investment or tool, plan design change or targeted communication that helps participants over 50 is a step toward a robust Retirement Tier. It can and should look different in each plan, as plan sponsors make enhancements to their plan to better serve their own participants needs. Approaches will differ, but the shared goal should be to make DC plans work for participants, all the way through retirement. ftinstitutional.com 11

12 IMPORTANT LEGAL INFORMATION All financial decisions, strategies and investments involve risk, including possible loss of principal. Unless otherwise noted, the views and opinions expressed are those of the authors or individuals quoted, as applicable, as of the date of the article, may change without notice and will not be updated to reflect subsequent developments. Such views and opinions do not necessarily represent those of Franklin Templeton Investments ( FTI ). Views and opinions expressed by individuals who are FTI employees may differ from those of other FTI employees. This communication is general in nature and provided for educational and informational purposes only. It should not be considered or relied upon as legal, tax or investment advice or an investment recommendation, or as a substitute for legal or tax counsel. Any investment products or services named herein are for illustrative purposes only and should not be considered an offer to buy or sell, or an investment recommendation for, any specific security, strategy or investment product or service. As a financial professional, only you can provide your customers with personalized advice and investment recommendations tailored to their specific goals, individual situation, and risk tolerance. Franklin Templeton does not provide legal or tax advice. Federal and state laws and regulations are complex and subject to change. FTI cannot guarantee that such information is accurate, complete or timely; and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. If you are a benefit plan or IRA fiduciary, please note: Franklin Templeton Investments (FTI) has provided this communication to you on the understanding that you are a registered broker/dealer, investment adviser, manage or control over $50mm, or otherwise qualify for the independent fiduciary with financial expertise exception under the DOL Fiduciary Rule. If this is not correct, please let FTI know promptly. FTI is not undertaking to provide you or your clients with impartial investment advice or advice in a fiduciary capacity solely by providing the information contained herein. FTI may have a financial interest in the funds it advises and investment services it provides because of the investment management and other fees it receives. Statements of fact are from sources considered reliable, but no representation or warranty is made as to their accuracy, completeness or timeliness. FTI makes no warranties with regard to information in this article or results obtained by its use and disclaims any liability arising out of the use of, or any tax position taken in reliance on, such information. Past performance does not guarantee future results. 1. Source: Employee Benefit Research Institute and the Investment Company Institute, as of December 31, Most recent available data. 2. Source: Financial Engines, Not So Simple: Why Target-Date Funds Are Widely Misused by Retirement Investors, March Source: United States Census Bureau. Available at: 4. Source: Morningstar from Federal Reserve Board of Governor s 2014 Survey of Consumer Finances, Summary Extract Public Data. 5. Source: The Franklin Templeton In-Plan Retirement Income Web Survey was a 15-minute online survey administered during March All 455 respondents were working (full-time or part-time) or previously worked for a large employer (1,000 employees or more), with at least $100,000 in DC plan balances (including current or former plans). 6. PBS NewsHour. 34 Social Security Secrets You Need to Know Now. July 30, Source: The 2017 Franklin Templeton Retirement Income Strategies and Expectations (RISE) survey was conducted online among a sample of 2,013 adults comprising 1,009 men and 1,004 women 18 years of age or older. The survey was administered between January 5 18, 2017, by ORC International s Online CARAVAN, which is not affiliated with Franklin Templeton Investments. 8. Source: Franklin Templeton with data derived from the Social Security Administration, Quick Calculator on ssa.gov website as of June This hypothetical is for illustrative purposes only; individual Social Security benefits will vary. Taxes have not been taken into account. Full Retirement Age (FRA) is at least 66 for individuals born in 1943 through 1959; 67 if born 1960 or later. Estimated monthly benefits are based on a birthdate of 6/5/54, $80,000 in current earnings covered by Social Security and a future retirement date of June in the selected year. Additionally the Quick Calculator assumes future increases in prices and earnings each year through retirement year, and that the individual works every year until benefits are received. Future increases are estimated using the national average wage index (AWI) under the intermediate assumptions in the 2016 Trustee s Report: Assumes cost of living adjustment (COLA) increases of 3% per year effective January of each year. This is calculated using the net present value of the monthly payments from Social Security as of June Hypothetical investment assumes a 5% (pre-tax) rate of return, compounded monthly, and monthly withdrawal equal to the Social Security benefit payment. Source: 9. Source: The Cerulli Report, U.S. Retirement Markets 2014: Sizing Opportunities in Private and Public Retirement Plans, Cerulli Associates. Only plan sponsors to plans with over $100 million in DC assets were surveyed. 10. Source: Retirement distribution decisions among DC participants An update, Vanguard, September Source: The Cerulli Report, U.S. Retirement Markets 2014: Sizing Opportunities in Private and Public Retirement Plans, Cerulli Associates. Franklin Templeton Distributors, Inc. One Franklin Parkway San Mateo, CA (800) franklintempleton.com For Use with Financial Professionals and Plan Sponsors Only / Not for Use with Plan Participants 2017 Franklin Templeton Investments. All rights reserved. RDCIO WPDCT 11/17