Retirement Income Solutions for defined contribution Plans

Transcription

1 Retirement Income Solutions for defined contribution Plans Contributor: Matt Smith - Aon Consulting - Spring 2009

2 Retirement Income Solutions for DC Plans Introduction: For more than two decades, employers have been assisting their employees in accumulating wealth for retirement through sponsorship of DC plans, mainly in the form of 401(k)s. As more individuals become aware that their personal savings and 401(k) accounts will play a meaningful role in their retirement security, thoughts turn to the next phase of retirement, the income phase. Precisely, the income phase of retirement is when the individual begins drawing down their savings in order to meet their financial needs once they are no longer earning a paycheck (or, when their paycheck no longer meets all of their current financial needs). Employers who sponsor DC plans are beginning to ask themselves, What should (or could) we be doing to help our employees prepare for the income phase of their retirement? There are many issues that need to be considered when addressing this question and the issues are complex. This article attempts to organize those issues in a logical format so as to provide the DC plan sponsor a structured guide to thinking through their answer. Our goal here is to indentify the issues we believe need meaningful consideration rather than to provide all the answers. Each employer and their situation is unique, therefore the right answer for any given DC plan will be unique to that plan. In Plan or Out? One fundamental consideration is whether to provide the solution within your DC plan or separately outside the plan. Some of the factors that will influence this decision are: Fiduciary - Level of fiduciary responsibility you wish to take in connection with the products, advice or solutions. Integration - How integrated you want the solution to be with the accumulation phase of your plan (pre-retirement). Automation - How automated you want the solution to be (compulsory, semi-compulsory or discretionary). Customization - How individualized you want the solutions to be. 1 aon consulting 2009

3 Education Regardless of the structure of the solution, what role should education play in the retirement income planning solution? Education in the pre-retirement phase (the need to save, how much to save, how to invest properly) has become a common feature of DC plans. The efficacy of these education efforts is unclear. So much so that features that require no education such as automatic enrollment, automatic escalation of contributions, and default investing have taken on increased prominence in DC plans since the passage of PPA in In most plans however, little or no education is delivered on the topic of retirement income planning. Retirement Income Risks Solutions should be constructed with an understanding of the risks inherent in planning for retirement income. These risks can either be managed, offloaded to another party, or a combination of the two. Simply managing while retaining ultimate responsibility for a risk is usually a less expensive way to go. On the other hand, offloading a risk allows you to largely eliminate the risk by paying a fee to another party for assuming responsibility. In other words, the solution may be protected (insured), not-protected (self-insured) or, a combination of both. Either way, the main retirement income planning risks are: Spending risk - Spending at a rate too high to be sustainable. Longevity risk - Living longer than expected. Investment risk - Experiencing lower or more volatile investment returns than expected. Planning risk - The failure to plan accurately or at all. aon consulting

4 Retirement Income Solutions for DC Plans Retirement Income Planning Tenets An individual has a substantially better chance of meeting their financial needs in retirement if they have a plan. We believe the tenets of sound retirement income planning are: A Plan - There should be a plan and it should be of sufficient detail to be meaningful. Individualized - The plan should be individualized to the person or couple considering their unique level of wealth as well as their specific spending and bequest needs. Risk tolerances - The plan should consider the individual or couple s tolerance for specific risks including income shortfall, investment volatility, spending discipline, and planning discipline. Frequency of review - The plan should be reviewed and adjusted (if necessary) on a regular basis. In addition, if conditions or planning assumptions change significantly or rapidly, a review of the plan should take place regardless of the pre-planned review frequency. Flexibility - The plan should be designed and implemented with a sensible amount of flexibility allowing for plan changes in the future without incurring unnecessary fees or penalties. Product Design Features With the knowledge of the inherent risks and planning tenets, we can look at some of the solution features that should be considered. The following design features should be factored into your decision: Optional - Many retirement income solutions require a long-term commitment on the part of the participant in order for the participant to experience the benefits of the solution. In some cases, early withdrawal or cancelation can be excessively wasteful for the participant. This is why, unlike an accumulation investment decision, the decision to participate in a retirement income solution should be an active decision on the part of the participant rather than a passive decision (such as defaulting). Multiple carriers - Where there is a risk being protected by a counter-party (such as with an insurance product), that risk should be spread across multiple insurance carriers, to the extent that this is feasible and practical. Replaceable carriers - A mechanism should exist to replace an insurance carrier if the plan fiduciaries feel it necessary, without disrupting the retirement income solution. Portability - Individuals should be able to take their retirement income solution out of the plan if they wish. Group rates - Where solutions are created and distributed to a large group, the group should benefit through lower fees. Fee transparency - There should be clear transparency of implicit and explicit fees. In addition, fee transparency should extend to the discrete features of the solution. For instance, it should be clear what fee is being charged for investment management versus longevity protection. Fee reasonability - Reasonability can only be determined once there is complete transparency. Once the fees are identified and clear, the plan sponsor can make a fair comparison across the alternatives available. In addition, it should be clear which parties 3 aon consulting 2009

5 are being paid for providing which features within the product or solution. Where multiple parties are providing benefits and collecting fees, cross-subsidies (if any) should be transparent. Other Design Considerations Additional design considerations include: Dynamic asset allocation - The solution should have enough flexibility for the asset allocation within the solution to shift when conditions warrant. This could take the form of providing the individual a choice of asset allocation or allowing the solution manager the discretion to change the underlying asset allocation when they feel it is necessary. It is beyond the scope of this article to list the conditions that might cause the need to change the asset allocation. Our point here is that the need for flexibility is key. Defensible asset management - Defensible means there should be clear and compelling reasons for the asset management features within the solution (such as active versus passive investing or multiple versus single manager investing). Survivor options - Knowing that many people reach retirement as part of a couple rather than merely as individuals, consideration should be given in the solution design for options that allow income to continue (in whole or in part) beyond the life of the first-to-die of the couple. Simplicity All of these design considerations need to be weighed against the need for simplicity. The solution must be simple to understand, simple to buy, simple to own, and simple to explain. If there is one thing we ve learned through our decades of DC accumulation experience, it is that complexity creates anxiety and anxiety creates suboptimal behavior. If the solution is too complex it has less of a chance of being taken up in the amounts needed to make a meaningful difference in people s retirement income planning. Note: The product design portion of this article is largely derived from the forthcoming book: The Retirement Plan Solution: The Reinvention of Defined Contribution, Ezra, Collie, Smith, John Wiley & Sons, New York2009, (Available Summer 2009 wherever books are sold) aon consulting

6 Aon Consulting is among the top global human capital consulting firms, with 2008 revenues of $1.4 billion and 6,000 professionals in 117 offices worldwide. Aon Consulting is shaping the workplace of the future through benefits, talent management and rewards strategies and solutions. Aon Consulting was named the best employee benefit consulting firm by the readers of Business Insurance magazine in 2006, 2007 and 2008.