(Should employees assume all of the risks of retirement?) Presentation to HR Florida Conference Location: Suwannee 11/12 August 25, :15 2:15

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1 Retirement t Programs Am I my Brothers Keeper? (Should employees assume all of the risks of retirement?) Conference Location: Suwannee 11/12 1:15 2:15 By: Lane B. West, FSA, MAAA, EA Consulting Actuary 1

2 Contents Am I my Brothers Keeper? (subtitle Should employees assume all of the risks of retirement?) Is there a difference between DB and DC plans? How much retirement income is needed? Retirement Risks Longevity Inflation Investment Other Employer Sponsored Plans Features Risk Assumption What Can Employers Do? By: Lane B. West, FSA, MAAA, EA Consulting Actuary Stanley, Hunt, DuPree & Rhine, Inc. (a subsidiary of BB&T) 2 2

3 There is no Difference between DB and DC plans Purpose of each is the same Target income is the same Benefits must be paid for the same length of time If investment income is deficient, contributions must increase The differences? DB, the employer assumes all of the risks DC, the employee assumes all of the risks DC, the employee typically pays most of the expenses DC, the investment return tends to be less due to a lack of professional management and to a lack of a longer term investment focus 3 3

4 Household at Risk 4 4

5 How Much Retirement Income is Needed? 70-75% Employer provides 100% of post retirement medical needs and full COLA s 80-85% Employer provides some of the post retirement medical needs and no COLA s % Employee assumes all risks. Source: Towers Perrin Recent Georgia State/Aon Study indicates 81% replacement ratio needed for someone earning $50,000 and 84% for someone earning $150,

6 Social Security Benefits at Social Security Retirement Age (SSRA) Age 66 in 2008 (SSRA = 66) Replacement Additional Savings Income Needed Needed Income Ratio 1 to Reach 80% From Age 30 2 $20,000 53% 27% 8.8% $35,000 43% 37% 12.1% $50,000 39% 41% 13.5% $65,000 34% 46% 15.1% $80,000 30% 50% 16.4% $102,000 26% 54% 17.7% 1 Source: 2008 Guide to Social Security and Medicare, Mercer Human Resources Consulting, p Past Salary increases of 5%, rate of return 6%, live to age 90, past retirement earn 5.12% 6 6

7 Retirement Risks What are they? Who will assume them? Pre-Retirement Post-Retirement Inflation Inflation Investment General Disability Medical Death of Spouse Investment Absences from Work Longevity Employer plan changes Death of a Spouse Long Term Care Needs 7 7

8 Pre-retirement Risks Inflation Risk The decrease in purchasing power Final Average Pay plan addresses, Others do not Investment t Risk Wrong market, wrong choices, too aggressive, not aggressive enough, high concentration in one investment Absences from work Especially a problem for women Disability Disabled are unable to save enough to reach their retirement goals Most pensions are not indexed after disability LTD Insurance only provides pre-65 coverage Death of Spouse Risk should be covered by life insurance Employer Plan Changes Pension can be frozen/ not offered Matching contributions can be changed/eliminated 8 8

9 Post Employment/Retirement Risks Post Retirement Inflation Risk The decrease in purchasing power Increase in Medical Costs Fidelity Survey $215,000 needed by a couple to pay costs not covered by Medicare. Investment Risk Wrong market, wrong choices, too aggressive, not aggressive enough, high concentration in one investment Disability Higher medical costs Long term care more likely Length of Stay Personal Care Assistance Death Not a risk if enough retirement t assets are accumulated by retirement Choice of payout options will effect surviving spouse Social Security for 2 worker families decrease. Long Term Care For many, long term care insurance is the answer Long life expectancy due to medical advances can create additional expenses Longevity Outliving the retirement fund 9 9

10 Inflation and Real Returns Over the last 35 years, inflation has averaged 4.9% Over the same period, yields on 10 Year Treasuries have averaged 7.6%, Result is a real interest t rate of 2.7% 10 10

11 Inflation DB Plan (Typical) Will provide pre-retirement inflation protection through the use of final average earnings (or updates for $ per year plans) Will not provide post retirement inflation protection DC Plan (Typical) Will not provide pre- or post- retirement inflation protection Other than by returns in excess of the real return A typical retiree will need to provide his/her own post-retirement inflation protection through accumulation of additional retirement assets COLA is provided by earning a real return over inflation, and starting retirement with enough money. example: withdraw 4% of one s accumulated retirement wealth each year

12 Impact of Return and Inflation on Retirement Income Annual Return of 7.00% Annual Return / Inflation Annual Inflation of 3.50% Alternate: 5% return / 2.5% Age to which funds will last inflation 7.0%/3.5% 5.0%/2.5% Real Return of 3.5% and 2.5% respectively Withdrawal 8% Withdraw initial amount from age 65 and then increase it each year 6% by inflation 5% % Ω 105 3% Ω Ω Warning. Actual Return will not be the same each year and thus the variability in investment returns is a risk factor

13 Investment Risk Employees have a definitive time horizon. Retirees generally do not have sufficient time to make up for asset losses. Investment earnings do fluctuate. While a given asset strategy has an expected rate of return, there is no guarantee. Following illustrates the probability of running out of money

14 Post-Retirement Investment Risk Initial Withdrawal / Annual Increase At 7% Return, money lasts until age Percent that will Percent that will Percent that will run out of money run out of money run out of money by age 75 by age 85 by age 90 A 5%/2.5% 92 0% 3% 9% B 5%/3.5% 89 0% 6% 18% C 6%/2.5% 86 0% 11% 26% D 6%/3.5% 84 0% 21% 42% 50/50 Asset Allocation. Expected Return Eq: 8.25%, FI: 5.25%, expected return 7.00% 14 14

15 Range of Expected Returns (50/50 eq./fi. asset allocation; 7.00% average return, 11% standard d deviation) 12.0% 11.0% Average Retur rn on Investment 10.0% 0% 9.0% 8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% % 2.5% 3.8% 4.4% 4.7% 25% 51% 5.1% 57% 5.7% 59% 5.9% 61% 6.1% 50% 7.0% 7.0% 7.0% 7.0% 75% 8.9% 8.3% 8.1% 7.9% 95% 11.7% 10.3% 9.7% 9.3% Investment Horizon (Years) 5% 25% 50% 75% 95% 15 15

16 Range of Expected Returns (20/80 eq./fi. income asset allocation; 6.00% average return, 7% standard d deviation) 12.0% 11.0% Average Return on Investment 10.0% 9.0% 8.0% 70% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% % 3.1% 3.9% 4.3% 4.5% 25% 4.8% 5.1% 5.3% 5.4% 50% 6.0% 6.0% 6.0% 6.0% 75% 7.2% 6.9% 6.7% 6.6% 95% 9.0% 8.1% 7.7% 7.5% Investment Horizon (Years) 5% 25% 50% 75% 95% 16 16

17 Post Retirement Risks Outliving Your Money - Longevity Life Expectancy is growing Obesity will curtail (overall) Medical Advances Who knows how long they will live? 75, 80, 85, 90, 95? How much do I need to accumulate u ate before e I retire? e 17 17

18 Post Retirement Risk - Longevity 10, , , , Number Living 6, , , , , , Age Base is 10,000 at age 1 Male Female RP-2000 Combined Table 18 18

19 Post Employment Risks - Longevity Life Expectancy from age 65 Life Percent Living Life Expectancy Expectancy to age 85 from age 85 Male % 5.5 Female % Life Expectancy from age 65 Life Expectancy Percent Living to Age 80 Percent Living to age 85 Percent Living to Age 90 Male % 41% 20% Female % 53% 32% RP-2000 Combined Table 19 19

20 Needed Assets for $1,000 of Monthly Income Years in 5% Return, 5% Return, Years in 5% Return, 5% Return, Rti Retirementt no COLA 3% COLA Rti Retirementt no COLA 3% COLA , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,700 An annuity, providing a 3% COLA, purchased at age 65, should cost about $200,

21 Other Risks Employer bankruptcy Plan change at mid career Timing of Retirement Periods of high inflation, poor prior investment performance Saving too little, retiring i too early Purchasing an annuity when interest rates are low Long term care Taking care of others Lose of spouse (death/divorce) Government policy change 21 21

22 Employer Sponsored Plans 22 22

23 Pre and Post Retirement Risks Traditional Plans Risk Assumption Defined Contribution Defined Benefit Pre-Retirement Inflation Employee Employer Investment Return Employee Employer Outliving Mortality Table Employee Employer Post Retirement Investment Return Employee Employer Post-Retirement Inflation / Large Expenses Employee Employee 23 23

24 Features of Retirement Plans Features Defined Contribution Defined Benefit Automatically meets initial replacement goals No Yes Build-up pattern Early Late Investment risk/windfall Employee Employer Accelerate benefits for early retirement No Yes Update benefits for past service No Yes Requires Employee Contribution to Participate Yes, if sufficient benefit is to be achieved No (Yes in most public plans) PBGC coverage No Yes (No for govt., church) h) Flexibility in funding No Some Distributions Lump Sum (Annuities are almost never an option) Annuity (Lump Sums are generally not an option) 24 24

25 Features of Retirement Plans Other Features Defined Contribution Defined Benefit Pay Expenses Most Paid by Employee Paid by Employer Investment Choice Employees Have Choice Employer Has Choice Bears the Cost of the Plan Employees Bear Most of the Cost Employers Bear all of the Cost Guarantee Benefits are not guaranteed Benefits are guaranteed: by plan assets, by the employer and finally by the PBGC Level of Contributions Lower overall Resulting in lower benefits Higher overall 25 25

26 Pre and Post Retirement Risks Traditional and Nontraditional Plans Risk Assumption Defined Retirement t Defined Benefit Cash Balance Contribution Shares Life Cycle Pre-Retirement Inflation Employee Employer ŧ Employee Shared, Leans to Employee Employer Investment Return Employee Employer Employer Shared, Leans to Employee Employer Outliving Mortality Table Employee Employer Employee * Employer Employee * Post Retirement Investment Return Employee Employer Employee * Shared, Leans to Employee Employee * Post-Retirement Inflation Employee Employee Employee Shared Employee Ŧ if FAC Plan * Employee Choice 26 26

27 Features of Retirement Plans Which in Less Costly? Defined benefit plans provide the lowest cost per $1 of retirement income. This is because plan funds are targeted toward retirement and distributions upon termination of employment are minimized. Which h is More Portable? With shorter vesting schedules, the pension promise is more portable. The biggest problem is employees simply do not understand the value of a pension promise

28 Alternate Retirement Plans TARGET BENEFIT PLANS Defined contribution plan where annual contribution is determined on a defined benefit basis. Intended to produce a benefit approximately equal to a pension benefit. Employees assume investment risk. Does not allow employee before tax contributions within the plan. Avoids actuarial expenses. FLOOR OFFSET PENSION PLANS The benefit under a defined benefit plan is reduced by the annuity provided under a defined contribution plan (excluding employee contributions). It can be said each employee gets the greater of the defined benefit or the defined contribution benefit. It is a good plan to transition from one plan type to the other

29 Alternate Retirement Plans CASH BALANCE PENSION PLANS A defined benefit plan where the benefits are expressed as account balances. Employees assume same risks as under a defined contribution plan except for the investment risk which under this plan is guaranteed by the employer. Like a defined contribution plan, its benefits are earned over a career (as opposed to being based on the last few years of earnings). Employer makes entire contribution, thus providing all employees with deferred income. Makes a good basic pension plan where employer wishes to control costs and to shift the inflation risk to the employee. Unlike a defined contribution plan, allows an employer to grandfather certain existing employees. ees Like defined benefit plans, past service credits can be granted, pension plans can be merged, early retirement windows can be created and employer enjoys funding flexibility. 20% of Fortune 500 have adopted these plans. LIFE CYCLE PENSION PLANS A defined benefit plan where the benefit is expressed as a lump sum. For example, a participant earns 1/10 th of his final average salary for each year of service. Under this example, the employee receives a lump sum of: 1 x salary at 10 years or 2 x salary at 20 years, etc. This type of plan, while simple, can be quite expensive

30 Alternate Retirement Plans Retirement Shares A defined benefit plan where the benefit is expressed as an annuity. Participant earns a retirement unit each year (example an annuity of 1% of pay). The employee (or employer) chooses from two or three investment mixes. At the end of the next year, the rate of return on that mix is determined and compared to the target rate (say the target rate is 4% and the actual return is 7%, then the prior annuity benefit is increased by 3% (7% - 4%)). This continues even after retirement. Generally, early retirement is not subsidized. Employer cost is more stable under this type of plan design because the employee is taking most of the investment risk. Employees can also receive cost of living increases under this plan. Example: 1% of pay might be $ per year(or $45.00 per month). If the share value is then $13.50, the employee receives shares. At retirement, the shares are converted to a benefit (but never less than the $540.00). If the share value was then $18.00, the initial pension would be $ per year. Each year, the number of shares would be multiplied by the share value to determine that year s pension

31 What Should Employees Do? Save sooner and save more Have a retirement plan / strategy Manage your debt Pay back 401(k) loans, especially at termination of employment Be realistic about the age of retirement Stay current with job skills Let the professionals manage your retirement nest egg Don t be too conservative, even after retirement 31 31

32 What Should Human Resources Do? Save sooner and save more Provide lots of education Provide auto enrollment / auto increase Consider making 401(k) loans hard to get Be realistic about the age of retirement Include a review of job skills in annual reviews Help to manage employee expectations Let the professionals manage your retirement nest egg Provide lots of education 32 32

33 What Can Employers Do? When making plan changes, carefully consider the options Keep a DB plan, but make it more modest annuity / installment options in DC plans Allow transfer into DB plan from DC plan Remember - What employees want is not always in their best interest Balance financial and human resource objectives Shift some, but not all risks to the employees If DC only, contribute more than to DB since employee is assuming all risks Educate, educate, educate Retirement planning statements and online planners Supervisor training followed by employee training Investment advice Printed materials Websites Seminars Get involved in the debate 33 33

34 There is no Difference between DB and DC plans Purpose of each is the same Target income is the same Benefits must be paid for the same length of time If investment income is deficient, contributions must increase 34 34

35 Retirement Risks Pre-Retirement Post-Retirement Inflation Inflation Investment General Disability Medical Death of Spouse Investment Absences from Work Longevity Employer plan changes Death of a Spouse Long Term Care Needs 35 35

36 Thank You for Your Interest in this Critical Subject Come see us in booth 328 if you desire further information

37 References Managing Longevity Risk in U.S. Retirement Plans Through Mandatory Annuitization, Beverly J. Orth, North American Actuarial Journal, July, A Potential Decline in Life Expectancy in the United States in the 21 st Century, S Jay Olhansky, et.al., NE Journal of Medicine, 532;11, March 17, Post-retirement Risks: Changing Needs and Resources, Society of Actuaries, January, 2007 Boston College An Issue on Brief,p.2., Alicia Munnell, Francesca Golub-Sass & Anthony Webb. Recommended Reading Shifting Risk, (Workers today near retirement more vulnerable and with lower pensions), Lee Price, EPI Issue Brief #213, Economic Policy Institute, July 21,

38 Lane B. West FSA, MAAA, FCA, EA Senior Vice President Consulting Actuary Stanley, Hunt, DuPree & Rhine, Inc. (a subsidiary of BB&T) Lane is a graduate of Georgia State University with a Bachelor of Business Administration in Actuarial Science. He holds a Masters degree in Business Administration from the Virginia Commonwealth University. He has been with BB&T since Lane is a Fellow of the Society of Actuaries, an Enrolled Actuary, and a Member of the American Academy of Actuaries. He is a member of the Pension Committee of the American Academy of Actuaries, a group that evaluates retirement proposals and provides input to Congress, Agencies and the Administration. He has expertise in all areas of post employment benefit plans including: plan design, employee communications and administration of qualified and non-qualified pension plans and defined contribution plans. Lane started his actuarial career with a major Mid-western insurance company. He also served as Senior Vice President Product Development (Group and Pensions) at Life of Virginia and worked for 23 years as a consulting actuary at a major consulting firm.

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