INSTITUTE. DC Plans Have Helped Participants Save. Now They Need to Help Them Spend. Research

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1 INSTITUTE Research August 2018 DC Plans Have Helped Participants Save. Now They Need to Help Them Spend. New Focus on the Distribution Phase KEY ELEMENTS Sponsors are devoting more attention to the distribution phase of defined contribution (DC) plans; that is, the period in which participants are drawing down assets. One key issue: whether to retain retiree assets in the plan. Sponsors should address that question, and if the answer is yes, they need to make sure the plan s design and the recordkeeper s capabilities support this choice. The investing industry is also responding to the growing interest in the distribution phase with new retirement income products, but they can be quite complex. Plan sponsors should evaluate the breadth of choices they wish to offer retirees, as well as the level of fees and complexity. Once operational considerations have been addressed, plans must focus on the fund lineup and the overall communication efforts, which differ from those needed for the accumulation phase when participants are building up their wealth for retirement. Callan believes that plan sponsors should document their philosophy on whether they wish to retain the assets of retired and terminated participants. The issue of asset retention will become increasingly important as demographics shift. James Veneruso and Tom Shingler Fund Sponsor Consulting Group Knowledge. Experience. Integrity.

2 It may be hard to believe, but the 401(k) the most popular type of defined contribution (DC) plan turned 40 this year. Up to now, the retirement industry has focused on improving the accumulation phase of DC plans, and it has accomplished a great deal to help participants retire with dignity. But as DC plans enter middle age, the retirement industry should start thinking more about the distribution phase, when participants are drawing down the assets they have accumulated over their working lives. Plan sponsors are recognizing this need, and in a survey conducted in 2017 ranked retirement readiness as their most likely primary area of focus over the next 12 months. 1 Callan has made the distribution phase a focus of our research over the past year, for these reasons: Demographics are changing, and as a result so are participants needs: Participants are living longer and spending more time in retirement, according to research from the Employee Benefits Research Institute (EBRI) and the Federal Reserve. While only 6% of assets in the DC system are held by those over age 65, 33% are held by those near retirement totaling well over $2 trillion, according to EBRI. Current DC plan options and operational functions may not meet the needs of all participants near or in retirement for payouts from their accumulated assets. New managed-payout product solutions are being created that are worth consideration for inclusion in DC plans. What Changing Demographics Mean for DC Plans As the U.S. population ages and more assets shift to retirees, this begs the question: Do plan sponsors even want to retain retirees and their assets in DC plans? According to Callan s 2018 Defined Contribution Trends Survey, nearly half of plans sought to retain assets from retired participants and more than a third sought to do so with assets of terminated participants; 50% sought to retain assets of both groups (Exhibit 1). While some of the big changes from 2016 to 2017 are due to the percentage of public defined contribution plans in the 2017 survey, controlling for this the pattern still holds: More plan sponsors are getting off the fence and affirming a desire to retain terminated and retiree assets. Retaining those assets brings the benefits of asset scale to the plan in the form of lower investment management Exhibit 1 How Plans Handle Assets of Retired/ Terminated Participants* 28% 48% 26% 38% % 11% 18% 12% 3% 2% Seek to retain retiree assets Seek to retain assets of terminated participants Do not seek to retain retiree assets Do not seek to retain assets of terminated participants Other/ Don't know *Multiple responses were allowed. Source: Callan 2018 Defined Contribution Trends Survey Defined Contribution Trends Survey, Callan, Page 14. 2

3 and plan administration costs. Terminated participants may also benefit from a potentially lower cost structure than they could achieve as an individual investor, and their investments are in a plan that has fiduciary oversight from a board, committee, and investment adviser. Employers seeking to retain assets are sending a message that participants long-term financial well-being is important, even after leaving the company. Sadly, many participants are not aware of the benefits of staying in a DC plan. According to MFS s 2017 participant survey, 83% of employees believed IRAs offered lower fees compared to their employer plan. Another 87% felt they could access better investment options outside of their employer plan. With this in mind, communicating the benefits of fiduciary oversight and economic scale to drive down fees should be a step in retaining retiree assets. But not all plan sponsors will wish to keep retiree assets in the plan. One reason is the fear of litigation from disgruntled terminated participants, with the added concern that retirees, with potentially more time on their hands, may be more litigious. Second, tracking retired and terminated participants also adds administrative costs to a plan. Callan believes that plan sponsors should document their philosophy on whether they wish to retain the assets of retired and terminated participants. The issue of asset retention will become increasingly important as demographics shift, particularly for mature companies. Supporting the Asset-Retention Philosophy If a plan sponsor wishes to retain the assets of retirees, plan design features and recordkeeper functionality must support this approach. Questions to consider include whether to allow installment withdrawals or just lump sum distributions. If periodic distributions are allowed, what is the cost to the participant? Consider that it may not be economical for participants to keep their assets in a plan if they are charged $25 for every distribution, which could be as frequently as monthly. The functionality must not only be permitted in plan documents but also administratively supported by the plan s recordkeeper. Recordkeeper distribution capabilities vary greatly. To assess the landscape, Callan surveyed 23 leading recordkeepers to gauge how well equipped they are to handle the distribution phase for retirees. Encouragingly, we found that: All of the providers support periodic distributions as well as installment payouts All allow for monthly, quarterly, semi-annual, and annual payouts All but two allow for payments made via ACH or check. However, 7 of the 23 charge variable fees for distributions, and 13 do not allow the participant to specify a source of funding for either partial or installment distributions. Additionally, 4 of the 23 do not allow participants to specify a percentage distribution but rather require a dollar amount. For these vendors, funds must be drawn pro rata across investment options and often across accounts. This is not ideal for participants. For instance, a retired participant may want to withdraw assets only from an incomegenerating investment, such as the stable value fund. Knowledge. Experience. Integrity. 3

4 Plan sponsor communication efforts should also support the asset-retention philosophy. Targeted efforts should be made to make participants aware of the mechanics of distribution options as well as the investment choices that are well-suited for periodic distributions. In the next section, we discuss the investment options that could support distributions, and new product creation in this area. State of Solutions Retirement income products date back thousands of years. Annuities can be traced to 225 AD, when Romans could exchange lump sums for annual stipends. 2 Tontine schemes enjoyed popularity in 18th century Europe. 3 Within the modern DC space, the product set has evolved in fits and starts. In general, with greater income predictability comes greater complexity (and cost), with the notable exception of managed payout funds, which we will explain below (Exhibit 2). Exhibit 2 How Retirement Income Products Balance Complexity and Predictability Income Predictability Target Date Retirement Income Stable Value Managed Account Qualified Longevity Annuity Contract Annuity Guaranteed Minimum Withdrawal Benefit Managed Payout Complexity When reviewing the options, plan sponsors should evaluate the breadth of choices they wish to offer retirees, alongside the level of fees and complexity. Managed Accounts According to Callan s 2018 DC Trends Survey, 52% of plan sponsors offer a managed account solution. With these, a participant (or recordkeeper) provides participant-level information (age, contribution level, outside assets, etc.) and the managed account provider takes discretion over the account to build a customized asset allocation, often using the core fund lineup. Many managed accounts now feature drawdown solutions as an integral part of the service, generally taking the existing fund lineup and designing an asset allocation to withdraw assets at a certain rate. They can also further help those in retirement strategize around taxes and Social Security issues. 2 An adult aged 15 could expect to live to the ripe old age of 46, Coale & Demeny, Regional Model Life Tables and Stable Populations, 2nd ed. (1983) 3 In a tontine, the surviving member takes ownership of the pool of money once the other contributors have passed on. For more on this see The Simpsons, Season 7, Episode 22, The Curse of the Flying Hellfish, for a colorful treatment of the concept. 4

5 These solutions, though, carry the same limitations that face managed accounts more broadly, chief of which are cost and engagement. In order to truly harness the value, participants must engage and supply data. The fact that managed account providers can increasingly pull data from a recordkeeper mitigates this concern to some extent; however, it remains a consideration for a product as customized as a drawdown solution. Cost also remains a hurdle, with some solutions charging up to 60 basis points per year in addition to the underlying asset management fees. Stable Value For those looking for a predictable stream of income, many plans already offer stable value (71% in Callan s DC Index, admittedly skewed toward the larger end of the DC market). Such funds use insurance wraps around a generally intermediate bond portfolio to provide a stable NAV. Stable value funds typically offer a yield premium above money market funds. But wrap contracts often forbid plan sponsors from offering competing options, which could include low-duration bond funds, TIPS options, and even managed accounts. And in a rapidly rising interest rate environment, the crediting rate for stable value will typically lag the increase in money market yields due to the longer duration of the underlying portfolio (Exhibit 3). Exhibit 3 Stable Value Premiums and 90-day T-bill Rates Stable Value Premium (money market) 90-day T-bill Basis Points Year Source: Callan Despite these issues, stable value funds or even more staid money market options could play a role for in-plan retirees looking for a steady (albeit conservative) level of income. Knowledge. Experience. Integrity. 5

6 Target Date Options As the default option in over 85% of plans, 4 target date funds (TDFs) can play an integral role in any discussion of retirement income products. While most providers agree on the proper allocation to growth assets including equities, high-yield bonds, and REITs for younger participants (high), true differentiation occurs in the near and in-retirement phase. As Exhibit 4 shows, the distribution of growth-asset allocations among providers is most pronounced for those in and near retirement. Exhibit 4 Growth Assets Rolldown Analysis Growth Assets (%) High Median Low Age While much of the conversation with TDFs focuses on the accumulation side of the glidepath, providers can differentiate themselves from a crowded field by communicating the drawdown protection of their target date funds and the portfolio construction of their funds for the post-retirement set. Few providers currently discuss the yield for their income vintages. These vintages are often a given series most conservative allocation, and they are not widely understood or marketed. The industry would benefit from information such as the yield and distribution frequency/flexibility inherent in these income funds. By doing so, providers and plan sponsors could leverage the power of these default options to facilitate asset drawdowns. Annuities Despite their long track record and ubiquity, annuities remain stuck in the mud. The lack of uptake on annuities is unique to the DC space. Despite our nostalgia for the lifetime paychecks from the defined benefit (DB) system, 70% of DB participants eschew annuity payments and instead opt for a lump-sum payout when it is available. 5 On the plan sponsor side, the major concerns involve the absence of a safe harbor for annuity selection as well as lack of recordkeeper portability (Exhibit 5). If guaranteed products cannot be ported from one recordkeeper to another, a plan can either eliminate the guaranteed product (and participants must forgo the premiums they have paid) or remain with a suboptimal recordkeeper. There is currently legislation that would amend ERISA and lay out specific criteria for selecting an annuity benefit provider. 6 4 Callan s 2018 DC Trends Survey, Page 24 5 Pensions: Take a Lump Sum or Not? Kiplingers, H.R. 4604, sponsored by Reps. Lisa Blunt Rochester and Tim Walberg, house-bill/4604 6

7 Longevity insurance represents another possible avenue for an annuity product to gain traction. A qualified longevity annuity contract (QLAC) creates a longevity safety net and also allows those in retirement to define a specific drawdown period the time between when they retire (e.g., 65), and the age when the QLAC provides annuity income (e.g., 80 85). QLACs can also address the issue of cognitive decline by providing a guaranteed stream of income later in life, when participants may have trouble making financial decisions. The IRS in 2014 exempted them from the calculations for minimum required distributions (provided certain criteria are met). 7 The rules limit the amount one can annuitize to 25% of the applicable retirement account assets or $100,000, whichever is lower. Exhibit 5 Plan Sponsor Concerns About Annuities If your DC plan does not offer an annuity-type product, please indicate why by rating the following choices: Least important Most important Unnecessary or not a priority 3.7 Uncomfortable/unclear about fiduciary implications 3.7 No participant need or demand 3.0 Availability of defined benefit plan 2.5 Too costly to plan sponsors/participants 2.4 Difficult to communicate to participants 2.2 Concerned about insurer risk 2.0 Products are not portable 1.9 Uncomfortable with available products 1.9 Too administratively complex 1.8 Lack of product knowledge 1.5 Recordkeeper will not support this product 0.8 Source: Callan 2018 DC Survey. Managed Payouts Managed payout funds represent an area of much recent innovation, though uptake remains slow. Payout funds typically contain a multi-asset mix and offer a recommended distribution rate to help retirees manage their withdrawals. The underlying mix across the market varies from all-equity to all-fixed income (Exhibit 6). Exhibit 6 How Different Payout Funds Vary Asset Classes Included Withdrawal Target Rate Intends to Deplete Principal Equity Exposure Inception Multi-sector bond 5% No 0% 2007 Bond ladder Varies Yes 0% 2015 Multi-asset Reset annually Yes Varies Not launched Multi-asset 4% Yes Multi-asset 2-5%; varies by risk-return Starts at 20% and goes to zero by No Varies by risk-return 2015 Multi-asset % No Varies (currently 60%) 2008 Equity income 7.8% (current yield) No 100% 2013 Source: Callan 7 Knowledge. Experience. Integrity. 7

8 Plan sponsors can select from options that run the gamut in terms of volatility and the level of recommended payout. These options also vary in whether the design intends for the withdrawal to be funded from yield and returns, or by eating into the principal as well. The appeal of payout funds lies in their simplicity and liquidity; many of them are available as mutual funds. Without guarantees, the messy recordkeeping portability issues do not crop up. The fund can cleanly be sold without any loss of premiums but this must be balanced with decreased income predictability. Ultimately the success of such funds will depend heavily on the communication that accompanies them. In a participant-directed plan, participants need to know what funds the plan offers and which of those are the most appropriate for the distribution phase of their plan experience (Exhibit 7). These payout funds in particular require participants to set up the distribution with their recordkeeper. As previously detailed, recordkeepers capabilities differ widely with regard to distributional flexibility. Exhibit 7 Summary of Retirement Income Solutions and Their Features Name of Solution In Plan Guaranteed Flexible Managed payout funds Managed account Stable value Annuity as a form of distribution payment In-plan guaranteed income for life product Annuity placement solutions Longevity insurance/qlac?* *Due to the dearth of options currently in the market, it remains to be seen if actual implementations will be in or out of plan. From Intention to Implementation With these options in mind, plans must decide how to put the desire to retain retiree assets into action. Once operational considerations (recordkeeper capabilities and plan document updates) have been addressed, plans must focus on the lineup and overall communication efforts. With regard to the plan lineup, much of the effort in framing and shaping it has focused on accumulation. Whether it is the plan name ( XYZ Savings Plan ) or the structure of the lineup (typically eight equity and three fixed income options 8 ), the framing and plan architecture signal accumulation. To shift the focus to retirement and drawing down assets, the lineup should be viewed through the prism of a retiree (Exhibit 8). 8 This is the structure of the Callan DC Index 8

9 Exhibit 8 The Two Types of Lineups Accumulation Phase Investment Lineup Callan Clean Sheet Investment Structure Distribution Phase Investment Lineup Callan Clean Sheet Investment Structure Tier I Asset Allocation Options Tier II Core Options Tier III Specialty Options Tier I Asset Allocation Options Tier II Core Options Tier III Specialty Options Target Date Funds (5-year Increments) Capital Preservation Target Date Retirement Income Fund Managed Account with Drawdown Functionality Stable Value Core Fixed Income Inflation Protection Large Cap Equity Non-U.S. Equity SMID Cap Equity This distribution lineup could easily include other options (e.g., a payout fund). Options for those in the distribution phase would ideally range from very conservative to less conservative as well as possibly including inflation-sensitive options to allow the latitude for participants to prioritize specific risks such as longevity risk (with a presumably higher equity option) or inflation risk. The difference in the two lineups helps to focus attention on solutions. It is important to note that all participants would have access to the accumulation and distribution phase options; communications about the distribution phase lineup would be targeted to participants near or in retirement. One possibility is providing access to a micro site on the recordkeeper s plan website. At this point the onus firmly resides on the communication effort to differentiate accumulation tools from distribution ones. Communication efforts within the DC framework receive mixed reviews at best. 9 The pre-retiree demographic, though, represents an interesting exception, since it shows higher levels of engagement. 10 This demonstrates a willingness to seek help. The question is whether plan sponsors in conjunction with their partners (recordkeepers, consultants, etc.) can fill the existing void. 9 For more detail on the tricky nature of participant communication and how even subtle word choice can impact effectiveness, see this question and answer article with Greg Jenkins, managing director and head of Institutional Defined Contribution for Invesco, and Gary DeMoss, managing director, participant communications, for Invesco Consulting, Participant Communications: It s not what you say, it s what they hear 10 Employees Approaching Retirement Defy Conventional Wisdom on Plan Engagement, Franklin Templeton, October 2015 Knowledge. Experience. Integrity. 9

10 Conclusion Changing demographics in the United States demand that the DC plan industry address the needs of retirees. If a plan sponsor does wish to keep retirees in the plan, the following actions take this philosophy from intention to action: Address plan design Are partial withdrawals allowed? Are fees assessed by the recordkeeper on partial withdrawals? What is the flexibility on specifying fund options for partial withdrawals? Are IRA roll-ins allowed? Review the fund lineup Is the current lineup sufficient? What about managed accounts? Should other distribution phase options (e.g., managed payout funds) be considered in the future? Be proactive about communications What is the best way to make those in and near retirement aware of the benefits of staying in the plan? How should the appropriate plan options be communicated to retirees? 10

11 About the Authors Thomas H. Shingler is a senior vice president in Callan s New Jersey Fund Sponsor Consulting office, and works with a variety of fund sponsor clients, including public and corporate defined benefit and defined contribution plans, endowments and foundations, and insurance companies. His responsibilities include strategic planning, investment implementation, manager evaluation, education, and special projects. James Veneruso, CFA, CAIA, is a senior vice president and defined contribution consultant in Callan s Fund Sponsor Consulting group based in the Summit, New Jersey office. Jimmy joined Callan in 2007 and is responsible for providing analytical support to Callan s DC clients and consultants. He is responsible for research and analysis of target date strategies and assists plan sponsor clients with target date manager searches and suitability studies. In this role, Jimmy meets regularly with investment managers to develop an understanding of their asset allocation, philosophy, investment policies, and organizational structures. Knowledge. Experience. Integrity. 11

12 If you have any questions or comments, please About Callan Callan was founded as an employee-owned investment consulting firm in Ever since, we have empowered institutional clients with creative, customized investment solutions that are backed by proprietary research, exclusive data, and ongoing education. Today, Callan advises on more than $2 trillion in total fund sponsor assets, which makes it among the largest independently owned investment consulting firms in the U.S. Callan uses a client-focused consulting model to serve pension and defined contribution plan sponsors, endowments, foundations, independent investment advisers, investment managers, and other asset owners. Callan has six offices throughout the U.S. For more information, please visit About the Callan Institute The Callan Institute, established in 1980, is a source of continuing education for those in the institutional investment community. The Institute conducts conferences and workshops and provides published research, surveys, and newsletters. The Institute strives to present the most timely and relevant research and education available so our clients and our associates stay abreast of important trends in the investments industry Callan LLC Certain information herein has been compiled by Callan and is based on information provided by a variety of sources believed to be reliable for which Callan has not necessarily verified the accuracy or completeness of or updated. This report is for informational purposes only and should not be construed as legal or tax advice on any matter. Any investment decision you make on the basis of this report is your sole responsibility. You should consult with legal and tax advisers before applying any of this information to your particular situation. Reference in this report to any product, service or entity should not be construed as a recommendation, approval, affiliation or endorsement of such product, service or entity by Callan. Past performance is no guarantee of future results. This report may consist of statements of opinion, which are made as of the date they are expressed and are not statements of fact. The Callan Institute (the Institute ) is, and will be, the sole owner and copyright holder of all material prepared or developed by the Institute. No party has the right to reproduce, revise, resell, disseminate externally, disseminate to subsidiaries or parents, or post on internal web sites any part of any material prepared or developed by the Institute, without the Institute s permission. Institute clients only have the right to utilize such material internally in their business. 12

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