Pot of Gold or Fool s Gold?

TECHNOLOGY RETIREMENT Pot of Gold or Fool s Gold? Making Workplace Retirement Savings Last By ROBIN LENNA Executive Vice President, Retirement & Income Solutions, MetLife 64 LIMRA s MarketFacts Quarterly / Number 1, 2, 2017

Anew mantra for the retirement industry seems to be taking hold: driving successful retirement outcomes for plan participants. However, there s a growing body of research suggesting participants can be their own worst enemies in enabling their pots of gold to support them and their families after they retire. Although the retirement industry has worked tirelessly to encourage greater levels of savings in defined contribution (DC) plans, the focus of these efforts has been almost singularly on investing and growing retirement assets, rather than converting them into sustainable income for consumption. Only recently has the focus begun to shift from accumulating savings to generating income with 85 percent of plan sponsors now agreeing that serving as an income source should be the core purpose of a DC plan. 1 Indeed, the pendulum appears to be swinging back in favor of guaranteed income borne, perhaps, out of a renewed appreciation for the predictable payments and retirement security that traditional defined benefit (DB) pensions once offered to many American workers. Helping plan participants achieve more favorable outcomes arguably extends beyond merely saving more The essential challenge is enabling participants to make the working their pots of gold support them and their families after they retire (or, if they continue to work in some capacity, during their active working years and then when they fully retire). and investing successfully. The essential challenge is enabling participants to make the money/benefits they accrued while working their pots of gold support them and their families after they retire (or, if they continue to work in some capacity, during their active working years and then when they fully retire). Sustaining the Pot of Gold Decisions made at the point of retirement about how retirement plan benefits will be paid will largely dictate how long the money will last and, ultimately, how successful the retirement outcomes will be. Guaranteed lifetime income was the standard form for DB benefits until the 1990s, when these plans began offering lump sums as a way to encourage early retirement. Today, at the point of retirement, all DB plan participants have the right to receive their plan benefits as guaranteed lifetime income. However, if the plan has added a full or partial lump sum as an option, the participant may elect to take the benefit in a lump sum or an income annuity (or, if a partial option is offered, some combination of both), depending on the plan design. Today, putting aside the decisions that are made when DB participants are offered a lump sum window, 2 plan design is by far the strongest determinant of annuitization (income benefit) rate. For example, EBRI research has shown that for plans with either no lump sum option or strong lump sum restrictions, annuitization rates were 99 percent and 95 percent, respectively, whereas in traditional DB plans with unrestricted lump sum payments, it was 44 percent. Cash balance plans, which are typically communicated similarly to DC plans, were 22 percent. 3 For most DC plans, a lump sum is the standard and, since 2005, typically the only distribution method. Unfortunately, a DB plan whose design permits or encourages lump sum distributions and a DC plan design that only provides for such distributions may be at cross-purposes with successfully sustaining one s financial well-being during retirement. LIMRA s MarketFacts Quarterly / Number 2, 2017 65

TECHNOLOGY RETIREMENT Behavioral Finance on Decision-Making: Many Shades of Gold There is no shortage of behavioral finance research on the decision-making process when making a retirement distribution choice. From the lottery effect and the hierarchy of retirement needs to framing and even procrastination, the individual s perceptions of the sustainability of retirement assets in relation to their anticipated duration and level of spending in retirement heavily influence their distribution decision. And the wrong decisions can have a devastating impact on their well-being throughout retirement. Behavioral economics has shown that the lottery effect the idea of suddenly being offered what is perceived as a large sum of money can be tempting. Even though most people are accustomed to gearing their spending to the income they earn during their working years, the lottery effect can cloud decisionmaking. It can stand in the way of carefully considering the guaranteed lifetime income they would forego in retirement by taking a lump sum. A hierarchy of retirement needs, similar in many respects to Maslow s hierarchy of needs, 4 must be satisfied in the proper sequence 5 with the desire for current income and assets being satisfied first, followed by the need for future income. This hierarchy also can stand in the way of annuitization, even though Michael Kitces acknowledges that outliving retirement assets is routinely cited as retirees biggest fear. 6 An investment-focused approach to workplace retirement savings has conditioned participants to focus on account balances, rather than on equating those balances to retirement income. An investment-focused approach to workplace retirement savings has conditioned participants to focus on account balances, rather than on equating those balances to retirement income. Research shows that the way the choice is framed between a paycheck (i.e., annuity payment) or a pot of gold (i.e., a lump sum) influences an individual s decision. If an annuity is presented through a consumption frame (i.e., encouraging individuals to focus on the end result of what they will be able to spend over time ), then it is viewed as valuable insurance. In contrast, when it is framed in terms of investment risk and return, an annuity is viewed as a risky asset because the individual s exact life expectancy is unknown. 7 The analogy to the benefit choice typically presented to a DC plan participant or even to a DB cash balance participant is clear. Further, new empirical research measuring the effects of procrastination on financial planning for retirement 8 also shows that procrastinators (e.g., those who sign up for health benefits on the last day of open enrollment) contribute less (or nothing) to retirement plans. They are also less likely to annuitize when a choice is offered, especially when the decision is framed in investment terms. Procrastinators tend to underweight future consumption and overweight near-term consumption. Lump Sums Can Be Depleted Prematurely Adding to this body of knowledge, MetLife commissioned research by Harris Poll to gain deeper insight into consumer attitudes on workplace retirement plans (DB and DC) and what motivates their decision to take distributions in a lump sum versus an annuity, when offered. The study also explored the success of those decisions. About the Research For its recently released, MetLife surveyed 1,069 U.S. adults aged 18 or older online between June 16, 2016 and July 11, 2016. This included 712 adults aged 50 to 75 who received a lump sum of at least $25,000 if they had a DB plan, had a balance of at least $25,000 upon retirement in their DC plan, or received monthly annuity payments of at least $500 from a DB or DC plan. The full study can be viewed at metlife.com/paycheckstudy. 66 LIMRA s MarketFacts Quarterly / Number 1, 2, 2017

A key finding shows that when DB and DC participants take their distributions as lump sums rather than annuities, for many, their money is depleted in a relatively short period of time. One in 5 individuals (21 percent) who took a lump sum (either from a DB or DC plan) say they depleted their lump sum. Of those who depleted their lump sum, they did so in an average of five and a half years (Figure 1). When isolating depletion rates for DC participants who were not also receiving separate DB pension income, the money was depleted even more quickly in just four years. 9 Since future generations of retirees will be significantly more likely than previous generations to rely solely on assets from a DC plan to sustain them in retirement, this four-year depletion timeframe is alarming. It should be a wake-up call for the retirement industry. Figure 1 Of Those Who Took a Lump Sum 1 in 5 depleted their lump sum in an average of 5.5 years. Source: MetLife (2017) Lump Sum Recipients Have More Control, But More Regrets When retirement plan participants take a lump sum, many make major purchases and give money away decisions some later regret. Sixty-three percent report they had major purchases/spending within the first year, and 22 percent say they gave away a significant portion to an individual and/or a group (e.g., friends, family, or charity). Thirty-one percent regret spending the money, and 23 percent regret giving it away. While 80 percent of those who chose a lump sum over an annuity believe they have more control over their finances as a result, more than half concede that if they would have taken the annuity, their budget would be more predictable. Additionally, 41 percent of DC plan participants say they would not be concerned with outliving their assets, 10 and 38 percent of DB plan participants would not be afraid of running out of money, if they had taken the annuity. Annuitants Are Happy With the Decision and Believe They Are Better Off Nearly all participants who took an annuity are happy with their decision and believe they are better off financially than if they had taken the lump sum (Figure 2). Given that it is human nature to compare oneself to others, annuitants were also asked several questions on how they believe they fared compared to friends and neighbors who do not have steady income from an annuity. Fifty-eight percent of DB and DC plan annuitants believe they are more financially secure than their friends and neighbors who don t have steady income from an annuity, and 56 percent say they feel more confident in their financial decision-making. The Role of the Workplace: Employers, Policymakers, and the Retirement Industry For retirement savings to serve as an income source, employers must play an important role in designing DC plans that enable participants to convert all or a portion of their savings into guaranteed income that they cannot outlive. It is also important for plan participants to understand the choices presented to them, since key information about longevity and the risks of running out of money is often lacking. Participants should know that if they opt for a lump sum, their investments will be subject to market fluctuations that could increase or reduce the value of their assets, particularly if withdrawn for spending needs during down market cycles. If they live longer than average, then they risk running out of money in retirement. LIMRA s MarketFacts Quarterly / Number 2, 2017 67 LIMRA SRI SRI Retirement Review / / Issue 1, 1, 201467 67

TECHNOLOGY RETIREMENT Figure 2 Of Those Who Took an Annuity... 96% 95% 96% of annuitants are happy that they chose an annuity over a lump sum. 95% than if they had taken a lump sum. Source: MetLife (2017) They must also consider that any investment skills they have today may change with age and a potential decline in cognition. The Government Accountability Office notes: the lump sum is exposed to potential erosion over the years, as the participant assumes all the risks inherent in managing both the investment and drawdown of their lump sum amount. Regrettably, such challenges may become more acute as the participant ages and the effort required for sound financial management becomes more burdensome. 11 Participants should also be made aware that when individuals need help making the most of their retirement assets, annuities have the unique ability to generate dependable income now, while covering the risk of running out of money later. Income from an annuity can be used to cover monthly expenses, including basic necessities. With their remaining assets, participants can be more confident in making future investment and/or discretionary spending decisions. Policymakers can help ensure that retirement plan participants have tools they can use to achieve successful retirement outcomes. While much has been accomplished in recent years to advance awareness of lifetime income, the regulatory framework required to support and enable guaranteed income options is still a work in progress. Having employers communicate a DC plan participant s current and projected account balance as an estimated lifetime income stream of payments is a critical first step in changing the conversation from assets to income. Making it easier for employers to offer income annuities by clarifying the safe harbor for annuity carrier selection is also crucial to this effort. It should pave the way for more widespread offering of income annuities as DC plan distribution options. Policymakers could also consider exempting elimination of lump sum benefit forms from anti-cutback rules for DB plans if employers believe the design change is in their plan participants best interests since lump sums can easily undermine an individual s financial security. Finally, the retirement industry has an important role. DC plans are at a crossroads. Time will tell if the DC plan experiment was a success, especially once the entire generation of Baby Boomers the first to be meaningfully affected by the decline in DB plans has retired. With the youngest Boomers now in their early 50s, there is still a window of opportunity to ensure that the promise of a secure retirement can be achieved. To help fulfill that promise, the uncompromising investment versus income mindset perpetuated by the industry must be recast to allow for each to take its rightful place in a prudent retirement plan. Otherwise, a generation left with fool s gold may pay the ultimate price. 68 LIMRA s MarketFacts Quarterly / Number 1, 2, 2017

Robin Lenna is Executive Vice President, Head of Retirement & Income Solutions (RIS), the company s institutional retirement business, which has historically generated over 20 percent of MetLife s operating earnings. She is also Chairman of General American Life Insurance Company (GALIC) and Chairman of Metropolitan Tower Life Insurance Company. Lenna joined MetLife in 2004 as Chief Risk Officer, bringing over 20 years of experience in structured risk products in financial services. She was appointed Head of RIS in 2006. In her current role, she has profit and loss responsibility for defined benefit pension de-risking, annuity and investment products for defined contribution plans, corporate- and bank-owned life insurance, funding for post-retirement benefits, and structured settlements holding leading market positions in many of these businesses. As a demonstration of its commitment to customer centricity, RIS was awarded MetLife s first J.D. Power award for outstanding customer service in 2016. Prior to MetLife, Lenna was Head of Structured Finance Products at FleetBoston Financial and held various credit and lending positions at Citigroup. She represents MetLife on various industry advisory boards, including the American Council of Life Insurers (ACLI), the LIMRA LOMA Secure Retirement Institute, and the Employee Benefit Research Institute (EBRI). Lenna earned a bachelor of arts from Swarthmore College and a master of business administration from Temple University. 1 MetLife 2016 Lifetime Income Poll. 2 A lump sum window is a temporary, one-time cash-out opportunity for DB plan obligations while reducing their liabilities as a way to de-risk their plans. 3 4 Maslow s hierarchy of needs is a theory in psychology proposed by Abraham. 5 Eye View, www.kitces.com, February 1, 2017. 6 Ibid. 7 Brown, Jeffrey R., Kling, Jeffrey R., Mullainathan, Sendhil, and Wrobel, Marian V.,, National Bureau of Economic Research, May 2013 and?, National Bureau of Economic Research, March 2008. 8 Brown, Jeffrey R. and Previtero, Allesandro,, National Bureau of Economic Research, October 2016. 9 Very small base (n<40); directional in nature only. 10 Small base (n<100). 11 Private Pensions Participants Need Better Information When Offered Lump (GAO 15-74). The uncompromising investment versus income mindset perpetuated by the industry must be recast to allow for each to take its rightful place in a prudent retirement plan. Metropolitan Life Insurance Company, 200 Park Avenue, New York, NY 10166 L0317493562[exp0318][All States][DC] LIMRA s MarketFacts Quarterly / Number 2, 2017 69