Retirement Income: The New Perspective for 401(k) Plans
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1 Retirement Income: The New Perspective for 401(k) Plans Provided compliments of Virtus Investment Partners PlanAdvisorTools.com
2 Retirement Income: The New Perspective for 401(k) Plans Background and Introduction As the Baby Boomers, the first 401(k) generation, approach retirement, the focus has become benefit adequacy (Will they have enough money?) and sustainable retirement income (Will the money last for their lifetimes?). This represents a shift from the original intent of 401(k) plans to be supplemental savings plans as opposed to retirement plans.. Advisors should be attuned to these changes and should consider the following services for plans and participants: Educating plan sponsors on government initiatives about these issues Assisting plan sponsors with provider services for benefit adequacy and retirement income, including automatic enrollment, automatic deferral increases and retirement income projections Providing gap analysis services Retirement education for participants who are 50 years and older The DOL Concern and Guidance Workers today face greater responsibility for managing their assets for retirement, both while employed and during their retirement years... Participants may have difficulty envisioning the lifetime monthly income that can be generated from an account balance... The Department believes that expressing a participant s current and projected account balances as lifetime income streams would allow participants to make informed retirement planning decisions. - U.S. Department of Labor, 05/07/13 With that explanation, the Department of Labor issued an Advance Notice of Proposed Rulemaking to start the process of deciding whether participants in defined contribution plans should be given projections of retirement income. The process will likely require that participants be given those projections on their plan statements. Realistically, it could be as long as a year and a half to two years before a final regulation is in place. However, advisors who believe that income projections would help participants should work with their plan clients and recordkeepers to deliver projections before they are required. Visit or call us at for more information. 2
3 Before going into the details about the DOL notice, let s start with a high-level overview of the expected mandate and the practical consequences. The mandate is likely to be that, for defined contribution plans including 401(k) plans, participants will be given projections of retirement income on their statements. But, that s just the beginning of the story. Once a participant knows the amount of his projected income, the obvious question is, How much do I need? In other words, most participants will want an idea a rule-of-thumb or benchmark of their needs. One commonly accepted rule-of-thumb is an 80% replacement of final pay. That 80% includes income from Social Security, personal assets, and retirement plans. For most participants, the amount of replacement income will be a personal decision based on factors such as pre-retirement level of income and desired standard of living in retirement. However, in order to provide the information to all participants, it will be necessary to have a ruleof-thumb. Some participants will then analyze their personal circumstances and decide on a different amount, but it is likely that most participants will consider this estimate when planning for their future needs. If there is a gap between the projected income and the amount that is needed, participants will want to know what they need to do to close the gap. For example, a participant may need to defer another $50 per paycheck in order to reach an 80% income replacement ratio. For obvious reasons, that is called gap analysis. While the first step the projection of retirement income could be mandated by the DOL, the second and third steps will require voluntary responses by plan sponsors, advisors, and recordkeepers. In other words, it will be up to the private sector to fill those holes. Comment to Advisors: Surveys report that more plan sponsors are evaluating the success of their plans based on the results that the plans are producing. As a result, focused 401(k) advisors and recordkeepers should introduce those services and educate plan sponsors on their importance for good participant decisions in an attempt to gain a competitive advantage. In other words, the projection of retirement income could develop faster than the DOL schedule... now that the private sector can see where the DOL is going. In addition, the changes may cause advisors and plan sponsors to provide more retirement planning services to participants, for example, retirement planning and education for participants 50 years and older. 3
4 Discussion of DOL Analysis This portion of the article discusses the structure and specifics of the DOL notice. This discussion will be helpful for those advisors who would like to have a more detailed understanding of this issue. As a starting point, the DOL contemplates requiring several projections all of which require that certain assumptions be made. The three possible projections are: The conversion of a participant s current account balance into monthly income assuming that the participant had already reached the plan s retirement age but using the current account balance. In other words, for this first illustration, there is no assumption of future earnings, additional deferrals, or employer contributions. It is a straight conversion of the current account balance into retirement income. But, as mentioned earlier, it assumes that the participant is already at the plan s retirement age, which most often is 65. As a result, this projection only requires the use of assumptions to convert the account balance into monthly retirement income. A projection of the participant s current account balance to an estimated account balance at the participant s retirement age under the plan. This requires assumptions about earnings rates, inflation, and continued employer contributions and employee deferrals (and increases in those contributions and deferrals). The conversion of the projected account balance into monthly retirement income. This is similar to the first illustration and the same assumptions would be used to convert the account balance into retirement income. In the notice, the DOL proposes two general fiduciary rules and two safe harbor fiduciary rules. The first general rule is, stated simply, that plan sponsors use reasonable assumptions in developing the projections. (Realistically, recordkeepers will actually calculate the projections and put them in the participant statements but the legal burden and responsibility to do it properly falls on plan sponsors.) The proposed general rule is that projections shall be based on reasonable assumptions taking into account generally accepted investment theories. The DOL goes on to say, though, that a projection would not be considered reasonable unless it is expressed in current dollars and takes into account future contributions and investment returns. Among other things, this means that the projected account balance must be reduced by an inflation factor, so that it is expressed in today s dollars. The obvious reason is that, without an inflation adjustment, a projection 20 or 30 years into the future could produce account balances of very large amounts, which could possibly lead to flawed decisions by unsophisticated participants. 4
5 On the other hand, the safe harbor option for plan sponsors who do not want to take any fiduciary risk is much more specific and limited. In order for plan sponsors to have certainty about the availability of the fiduciary safe harbor, they need to have a specific set of assumptions for contributions, returns, and inflation. In that regard, the DOL contemplates using the following assumptions: Contributions (which include both deferrals and employer contributions) will be continuously made until the normal retirement age under the plan at current annual dollar amounts, increased by 3% per year Investment returns of 7% per year A discount rate of 3% per year so that the projected account balance is expressed in today s dollars In the notice (which is on the DOL s website at the Department goes into considerable detail explaining its rationale for each of those assumptions. Comment to Advisors: These safe harbor assumptions are likely to be closely scrutinized by the private sector, including recordkeepers and advisors. The common belief is that most plan sponsors will want the protection of the safe harbors. It follows that most recordkeepers will accommodate the desires of plan sponsors and, therefore, use the safe harbor assumptions for their projections. As a result, the safe harbor for projecting account balances and the safe harbor for converting account balances into retirement income may be the most debated and controversial parts of the guidance. The second proposed general rule includes assumptions for converting account balances into retirement income. The general fiduciary requirement is that plans must use reasonable mortality and interest rate assumptions (taking into account generally accepted actuarial principles). On the other hand, the safe harbor criteria are specific. Those are: Rate of interest: The 10-year constant maturity Treasury securities rate. Mortality assumption: The section 417(e)(3)(B) applicable mortality table. The notice also says that unisex tables must be used, consistent with a 1983 U.S. Supreme Court decision about annuity purchase rates for ERISA-governed plans. Comment to Advisors: At this early stage, the significance of those specific assumptions is not whether they are right or wrong, but instead that the DOL is creating a safe harbor for plan sponsors... so that they will not be fearful of fiduciary liability because they provide the projections of monthly retirement income. The DOL will undoubtedly get many comments about the safe harbor assumptions, including recommendations for improving the safe harbors and the quality of information given to participants. Those comments will be reviewed and debated in the months ahead and, ultimately, the DOL will include a set of assumptions either the current ones or ones that are modified based on the comments in a proposed regulation. The private sector will then have one more opportunity to submit comments before the guidance becomes a final regulation. 5
6 Keeping in mind that there will be changes before plans are required to provide these projections, the important takeaways for advisors are: Projections of participant retirement income will probably be required in a year or two. The big picture result will likely be that plan sponsors and participants begin to see their 401(k) plans as sources of retirement income rather than as accumulations of wealth. The private sector will develop products and services that support the concept of retirement income. This may include gap analysis, retirement education, insurance products that provide retirement income and mutual funds and managed accounts that provide retirement income. Advisors who embrace these concepts do not need to wait until the regulation is final. Instead, those advisors can work with plan sponsors and recordkeepers to begin giving income projection to participants... as well as education, services and products to support those projections. Plan sponsors should not be concerned about liability for projecting retirement income. A number of providers have been offering these projections for many years without any issues. The key is that the assumptions be reasonable and that participants be given periodic and regular updates, for example, quarterly or annually. Those periodic updates will, in effect, self-correct any deficiencies in the assumptions as participants get closer to retirement. Conclusion The truth is that 401(k) plans were never intended to be retirement plans. Instead, they were designed to be supplemental savings plans supplementing the retirement benefits from defined benefit plans and social security. However, with the termination of many defined benefit plans in recent decades, 401(k) plans have been forced into the role of retirement plans. In the future, 401(k) plans will also be seen as providing either directly from a plan or through an IRA retirement income to participants. Advisors have an opportunity to help plan sponsors and participants understand and prepare for this shift. Download this and other Virtus White Papers at: 6
7 Provided compliments of This article was written by C. Frederick Reish, a partner at Drinker Biddle & Reath LLP. Reish is in the firm s Employee Benefits & Executive Compensation Practice Group and Chair of the Financial Services ERISA Team. He has specialized in employee benefits law since 1973 and works with both private and public sector entities and their plans and fiduciaries; representation of plans, employers and fiduciaries before the governing agencies (e.g., the IRS and the DOL); consulting with banks, trust companies, insurance companies and mutual fund management companies on 401(k) investment products and issues related to plan investments; and representation of broker-dealers and registered investment advisers on issues related to fiduciary status and compliance, prohibited transactions and internal procedures. Drinker Biddle & Reath LLP is unaffiliated with Virtus Investment Partners. This material is provided by Virtus Investment Partners for informational and discussion purposes only. Plan sponsors and others should consult their own counsel and designated advisor, if applicable, for specific guidance on their particular circumstances. The analysis and opinions provided may not be relied upon as investment advice and may change without notice. Statements of fact are from sources considered reliable but no representation or warranty is made as to their completeness or accuracy. Unless otherwise noted, the opinions provided by the authors and other sources are not necessarily those of Virtus Investment Partners. Information provided is general and educational in nature. It is not intended to be, and should not be construed as, investment, legal, estate planning, or tax advice. Virtus Investment Partners does not provide legal, estate planning, or tax advice. Laws of a specific state or laws relevant to a particular situation or pensions in general may affect the applicability, accuracy, or completeness of this information. Federal and state laws and regulations are complex and are subject to change. Consult with an attorney or a tax or financial advisor regarding your specific legal, tax, estate planning, or financial situation. All investments involve risk. An investor should consider the fund s investment objectives, risks, and charges and expenses carefully before investing or sending money. This and other important information about the Virtus Funds can be found in the fund s prospectus. To obtain a prospectus, please call or visit Please read the prospectus carefully before investing. Mutual Funds distributed by VP Distributors, LLC, member FINRA and subsidiary of Virtus Investment Partners, Inc. All third party marks are the property of their respective owners. NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE Virtus Investment Partners, Inc.
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