Retirement Why Income Should Be the Outcome of a Defined Contribution Plan Defined contribution (DC) plan participants need to understand how their savings will translate to income during retirement. For plan sponsors, this means focusing attention on adding lifetime income projections to plan reports, thinking about how to frame (or reframe) plan communications, building an education program and determining whether retirement solutions should be considered as a component of a DC plan and, if so, in what way. Although plan sponsors have a lot to consider, the author advises keeping it simple from the participants perspective, making it easier to generate participation that will, in turn, provide regular income for a more secure retirement. by Roberta Rafaloff MetLife Retirement funding is at a crossroads. For many years, most DC plan communications have been oriented toward the need to save for retirement, the tax benefits of pretax contributions and ways to invest plan contributions. DC plans were originally positioned as extra savings programs, meant to supplement defined benefit (DB) plans, which provided guaranteed retirement income. But the much-reported shift from DB plans to DC plans has drastically altered this landscape. Today, many Americans no longer have access to a DB plan; for them, this source of guaranteed retirement income can no longer be counted on. It also means that the DC plan traditionally a savings plan now needs to be recast: Participants need to understand how their savings will translate to income during retirement. For plan sponsors, this means focusing attention on adding lifetime income projections to plan reports, thinking about how to frame (or reframe) plan communications, building an education program and determining whether retirement solutions should be considered as a component of a DC plan and, if so, in what way. Lifetime Income Projections One of the toughest challenges for a DC plan participant is figuring out how to turn retirement savings into income that can t be outlived. Most experts believe workers will need 65-85% of their preretirement income 1 in order to maintain their standard of living in retirement, but this figure can vary greatly depending on individual circumstances. Currently, however, most plan participants don t understand how their savings would translate in terms of retirement income. One of the most effective ways to address this issue is a lifetime income illustration, presented in simple, easy-to- fourth quarter 2014 benefits quarterly 21
understand language and made available from the plan sponsor. This type of illustration will both show participants the income they ll have in retirement (assuming annual contributions and a steady rate of return) and we believe begin to shift the participant mind-set regarding a DC plan from savings to income. The U.S. Department of Labor (DOL) is contemplating lifetime income disclosures as a requirement for plan participants. In May 2013, DOL issued an advance notice of proposed rule making (ANPRM) for lifetime income disclosure for DC plans. The ANPRM solicited input on a rule that would require a participant s accrued benefits to be included on his or her pension benefit statement as an estimated lifetime stream of payments, in addition to an account balance. DOL also requested comments on a rule that would require a participant s accrued benefits to be projected to his or her retirement date, assuming annual contributions and an estimated rate of return, and then presented as an estimated lifetime stream of payments. Although the ANPRM notes that DOL Employee Benefits Security Administration (EBSA) intends to consider all reasonable alternatives to direct regulation, including whether there is a way short of a regulatory mandate that will ensure that participants and beneficiaries get constructive and helpful lifetime income illustrations, the language of the proposal suggests that DOL may be leaning toward requiring the lifetime income disclosure, i.e., communicating DC plan account balances as lifetime income, in addition to the total account balance on annual benefits statements. Participants will welcome lifetime income illustrations. Eight in ten respondents (85%) contributing to an employer-sponsored retirement plan believe an illustration similar to the lifetime income estimate calculator produced by DOL would be useful, according to the 2014 Employee Benefit Research Institute Retirement Confidence Study, which polled 1,000 workers and 501 retirees. Further, research shows that retirement income projections are not routinely provided to plan participants today on statements that summarize their total and vested account balances, nor are they automatically shown to participants when they view their account balances online. According to MetLife s research, 2 only one-third of large plan sponsors (33%) and six of the 12 largest recordkeepers that service primarily Fortune 500 companies report that they include retirement income projections on participant statements. Similarly, only 28% of plan sponsors and the same six recordkeepers say that retirement income projections are automatically shown to participants when they view their account balances online. Absent a safe harbor from DOL, it s not likely that lifetime income illustrations will routinely be made available to the more than 50 million American workers who are active 401(k) participants. Instead, according to the study, the majority of plan sponsors have opted for a self-service approach to modeling retirement income projections. Eight in ten plan sponsors (81%) say their plan participants have the ability to model how much retirement income they can expect based on their current account balances, and nine of the 12 recordkeepers offer this feature. Nearly all of the recordkeepers surveyed allow participants to input different projected retirement ages, future contributions and interest rate returns. Unfortunately, this do-it-yourself model has not proved effective among participants. The majority of recordkeepers surveyed estimated that only 25% or fewer of plan participants have made the effort to project their retirement income. The complexity of such modeling may contribute to its low utilization. A field experiment, conducted among nearly 17,000 employees of the University of Minnesota, reinforces this point. The research was conducted by Gopi Shah Goda, a senior research scholar at the Stanford Institute for Economic Policy Research, in cooperation with Colleen Flaherty Manchester and Aaron Sojourner, both assistant professors at the Center for Human Resources and Labor Studies, which is part of the University of Minnesota Carlson School of Management. The experiment was designed to assess the effect of retirement income projections on savings decisions in three ways: (1) whether, and by how much, workers changed their saving rates; (2) whether workers knowledge and confidence (about retirement planning) increased; and (3) whether workers personal characteristics affected their response. University of Minnesota workers 3 were provided one of three treatments in the experiment: (1) A planning treatment brochure provided general information on saving for retirement and a step-by-step guide for signing up or changing contributions to a voluntary retirement plan; (2) a balance treatment brochure added age-specific 22 benefits quarterly fourth quarter 2014
projections of how hypothetical additional contributions would translate into additional balances at retirement; and (3) an income treatment brochure added age-specific projections of how the additional contributions would increase retirement income. Key findings of the research suggest that individuals who received income projections and general retirement plan materials increased their level of saving. Additionally, employees sent income projections were also significantly more likely to engage in retirement planning, be certain about expected retirement income and report greater satisfaction with their financial condition. Impact of Reframing As the University of Minnesota field experiment shows, the frame of reference used to share information about a retirement plan has a clear impact on both how the participant views the plan and the actions participants take with respect to their retirement security. The frame also impacts how participants view retirement income. Research by Jeffrey Brown, a professor of finance at the University of Illinois, focuses on how individuals decisions about retirement income are influenced by the frame defined as different representations of the same financial choice they use to evaluate their options. 4 Professor Brown notes that when annuities are viewed through an investment frame, they appear unattractive. Since they are typically viewed as illiquid and risky, and the investor s return is based on that individual s average life expectancy, many people tend to see that trade-off as a gamble. In contrast, when annuities are evaluated through a consumption frame, annuities are much more compelling: They guarantee that the individual will receive a steady flow of income that he or she cannot outlive. The research, published in 2008 and entitled Why Don t the People Insure Late Life Consumption? A Framing Explanation of the Under-Annuitization Puzzle, found that when presented with an annuitization decision using a consumption frame, approximately seven out of ten respondents preferred the payout they would receive from an income annuity to investment alternatives. When individuals were given the same choices using an investment frame, about eight out of ten did not choose the income annuity. The paper is part of a body of research that shows that annuitization decisions are sensitive to framing. Steps Plan Sponsors Should Consider Retirement Income Education As plan sponsors seek to reframe their DC plans as retirement income programs, the creation and introduction of an educational program one that extends beyond investmentfocused topics and puts retirement income front and center can be an important first step. By including information about retirement income-related issues such as longer life spans (i.e., longevity risk), how to create retirement income, the pros and cons of taking a lump sum versus periodic payments and when to begin taking Social Security benefits in a basic retirement income education program, plan sponsors can focus participants on their long-term needs. As Brown has suggested, plan sponsors have an opportunity to educate participants about how they can benefit from retirement income products, not just by letting them know these products exist, but by thinking about the lifelong consumption consequences of their decisions instead of focusing on point-in-time account balances. Lifetime Income Solutions Once a retirement income education campaign has been introduced, a logical next step for a sponsor is determining whether or not retirement income solutions should be considered as a component of a DC plan and, if so, in what way. Plan sponsors approaching this stage should answer the following questions for their organizations: Would you like to offer your employees the guaranteed retirement income benefits of a DB pension but cannot incur the liabilities of doing so? Or, if you currently offer a DB plan, have you made, or are you planning to make, changes to your plan that would create a greater need for DC plan participants to create retirement income? Do you agree with the notion that part of the core purpose of a DC plan should be to serve as an income source during retirement? Are you open to the idea that offering only lump-sum or systematic withdrawal distributions may not always be in the best interest of your retirees, given the likelihood they could outlive their savings? If the answer to any of these questions is yes or even maybe, then it may be prudent for a plan sponsor to consider adding a guaranteed income form of benefit payment to its DC plan. fourth quarter 2014 benefits quarterly 23
Evaluating Retirement Income Approaches MetLife s research 5 indicates that two-thirds of plan sponsors (62%) believe it is very or extremely important for their plan(s) to offer options that help workers create sufficient retirement income. An evaluation of the various ways in which a retirement income benefit can be offered as a component of a DC plan today includes: The plan sponsor s understanding of its participants preretirement income levels and retirement savings The company s optimal retirement patterns The role the DC plan would need to play to facilitate participant retirement. Each type of retirement income option available today represents a mixture of characteristics, and it may be helpful to think of them along a spectrum that ranges from maximum income flexibility to maximum income guarantees. On this spectrum, for example, a systematic drawdown program would be at one end of the spectrum, and an immediate or deferred fixed income annuity would be at the other end. On the guaranteed income end, deferred and immediate income annuities provide individuals with an income stream that cannot be outlived period. This type of guarantee can only be achieved with an annuity. Like all insurance products, annuities work on the concept of pooling risks, which, in the case of retirees, include longevity, investment and inflation. The pooling of risk is not new to most people. For generations, Americans have held the majority of their retirement assets in a risk pool. Social Security and corporate DB pension plans are both examples of mortality pools. When an insurer pools longevity risk for a large group of retirees, money that is left over from people who die earlier than the average life expectancy is used to continue to pay people who outlive the average age. Pooling works because everyone shares a common risk and, while it can be accurately predicted how many people will be adversely affected by the risk, it is not possible to know in advance which specific individuals they will be. Pooling enables significant financial efficiencies. For example, an average retiree would need to save about one-third more to replicate the protection a large group makes possible. An annuity should be considered to fill any gap that exists between the level of projected fixed living expenses and the amount of guaranteed income provided by sources such as Social Security or a monthly pension payment. As an income annuity is first and foremost an insurance product, its insurance elements are critical to its fair evaluation. An income annuity should not be viewed as an investment alternative, but rather as an insurance product providing guaranteed retirement income. As such, the role it plays in retirement security complements the roles that mutual funds and other investments play in providing liquidity for unexpected needs and possible asset growth that can help offset inflation. However, investments of this type are vulnerable to market volatility and are not guaranteed to last a lifetime. A combination approach with part of retirement savings placed in a fixed income annuity and the rest invested at the participant s discretion may provide the best solution for ongoing income and easy liquidity. Keeping It Simple In recent years, the qualified retirement plan industry has seen the emergence of many new products along the retirement income spectrum, as providers seek to find features and positioning that will meet emerging plan needs and participant preferences. This has consequences both intended and not: There are higher levels of innovation in the industry, but there is also greater potential for confusion among both sponsors and participants. The two most commonly given reasons for designing complex solutions are that the features are needed (a) to overcome expected participant objections and (b) to achieve a good financial outcome. While it may be tempting for plan sponsors to believe they should alleviate potential participant objections by offering complex products, simplicity may be a more effective guiding principle. First, studies show that participants react to a complex option offering a dizzying array of choices by doing nothing. Second, a simple approach with a clear goal may result in more income for more participants and be more appropriate in a qualified plan setting, as contrasted to a highly customized solution such as might be developed by a personal financial planner. Clearly, beginning with a backto-basics approach when considering guaranteed retirement income options may be a constructive strategy. The majority of plan sponsors agree with 24 benefits quarterly fourth quarter 2014
this approach, according to MetLife research. When asked about their philosophy toward retirement plan design, 77% of plan sponsors believe it is better to keep it simple and avoid over-complication vs. 23% who prefer to provide maximum options and flexibility. 6 The simple solution of income annuities is being given serious consideration by plan sponsors at Fortune 1,000 TM companies. Among plan sponsors that do not currently offer a lifetime income annuity from a DC plan, two-thirds (65%) have taken some important preparatory steps for a future addition of guaranteed lifetime income to their plan s distribution options, including: 42% that have discussed options with their company s DC plan recordkeeper 39% that have explored the lifetime income solutions available in the marketplace 13% that have already conducted due diligence about the providers of these solutions. The most revealing statistic: Only 1% of plan sponsors have reviewed and decided against offering a lifetime income annuity option. 7 By reframing DC plans and adding a guaranteed retirement element, plan sponsors can provide the options to help participants achieve their retirement income goals. Keeping it simple and not getting caught up in too much flexibility will make it easier to administer and easier for plan participants to understand. As a result, it will be easier to generate participation that will, in turn, provide regular income for a more secure retirement. Offering a guaranteed retirement income distribution option to enable plan participants retirement savings to last their lifetimes is easily accomplished from an Employee Retirement Income Security Act (ERISA) 8 plan amendment perspective by adding an income annuity as a distribution option in a company s plan. When the plan fiduciary offers this option, the selection of the annuity provider is a fiduciary decision and is subject to ERISA rules. Endnotes 1. The Retirement Crisis and a Plan to Solve It, U.S. Senate Help Committee, 2012. 2. MetLife Retirement Income Practices Study SM : Perspectives of Plan Sponsors and Recordkeepers for Qualified Plans, June 2012. 3. Compared with the national population, the workers included in the experiment are more highly educated, and they have more retirement savings because they are covered by Social Security and one of two employer plans. They can also contribute to a tax-deferred voluntary retirement plan (VRP). The experiment tested the effect of providing employees with agespecific projections of the additional retirement income they could get if they were to make additional contributions to a VRP. 4. The Income Issue, The Participant, State Street Global Advisors, Summer/Fall 2013. 5. MetLife s Qualified Retirement Plan Barometer study was introduced in 2011 and recently updated in 2014. 6. 2014 MetLife Qualified Retirement Plan Barometer. 7. Ibid. 8. ERISA. AUTHOR Roberta Rafaloff is vice president of institutional income annuities in MetLife s corporate benefit funding group, which focuses on income annuities purchased by plan sponsors and their participants. Rafaloff is responsible for sales support, client management, product development and management. In her more than 25 years with MetLife, Rafaloff has held a variety of sales, client service and management positions, all in the retirement and savings business. Rafaloff has a B.A. degree from Kenyon College in Gambier, Ohio, where she majored in English and sociology. International Society of Certified Employee Benefit Specialists Reprinted from the Fourth Quarter 2014 issue of BENEFITS QUARTERLY, published by the International Society of Certified Employee Benefit Specialists. With the exception of official Society announcements, the opinions given in articles are those of the authors. The International Society of Certified Employee Benefit Specialists disclaims responsibility for views expressed and statements made in articles published. No further transmission or electronic distribution of this material is permitted without permission. Subscription information can be found at iscebs.org. 2014 International Society of Certified Employee Benefit Specialists Metropolitan Life Insurance Company, 200 Park Avenue, New York, NY 10166 LO516466624 [exp0517][allstates][dc] fourth quarter 2014 benefits quarterly 25