Planet DCTM IT S A NEW WORLD IN RETIREMENT Retirees at Risk Five key challenges retirees face and the impact on their retirement benefits. Baby Boomers face a stark reality: They may not have enough money to retire, and they don t know how to make that money last for their lifetime. As a result, they may run out of money in their 80s or 90s. The possibility of running out of money is due, in large part, to the continuing shift from defined benefit (DB) pension plans to savings-based plans, such as 401(k) and 403(b) plans. Historically, DB plans, along with Social Security, provided retirement income for a large segment of the workforce. Employees had the security of a stream of pension income for life that was guaranteed by their pension plan, by their employer and ultimately by the Pension Benefit Guaranty Corporation (PBGC). In contrast, DC plans and rollover IRAs dominate today s landscape. In 401(k) plans, plan participants typically receive a lump sum of money at retirement, roll it over into an IRA and then must figure out how to invest for retirement income and how much (or how little) to withdraw each year so that it lasts for their lifetime. 1
The shift from DB to DC plans has exposed retirees to a number of risks, summarized in the following five questions: 1 2 3 4 5 How much replacement income do retirees need to pay their bills, both monthly and unanticipated? How long will a retiree (and perhaps a retiree s spouse) live? How do retirees cope with investment market downturns after they begin to withdraw from their investments? How much money can retirees safely take out of their retirement savings each month? How should retirees arrange their retirement assets to deal with impairment in their ability to make sound financial decisions as they get older? Studies suggest that retirees will need 75% to 85% of their final pre-retirement pay to live in retirement. That is more than many participants anticipate. This is primarily a savings issue, and plan sponsors can help by implementing automatic enrollment and automatic deferral increases and by offering participant retirement education and retirement income projections. There is a substantial probability that, for a married couple, both aged 65, one or both will live 30 or more years after retirement. (The probability is 25% to 50%, depending on the study.) This obviously means that their retirement savings need to last for many years. The impact of an extended market downturn shortly before or after retirement is twofold. First, it reduces the money available to live on. Second, because the losses are fully realized as investments are liquidated to provide for living expenses, it is difficult to recover, even if the market makes substantial gains in the future. Studies suggest that a withdrawal rate of 4% for a 65-year-old retiree s initial account balance is safe. (For this purpose, safe means that there is at least a 90% chance that the money will last for 30 years.) Based on a survey of retirees, some people unrealistically believe they can withdraw as much as 10% each year. This is an emerging issue. Cognitive ability, especially related to financial issues, degrades as people age, usually starting in their 80s. This exposes retirees to the potential for poor decisions or unprincipled or ill-advised promoters and salespeople, which can rob them of their savings at a time when they are especially vulnerable. 2
Identifying the Risks Facing Retirees There is a combination of factors that, taken together, can cause retirees to run out of money at a time when they have little chance of replacing it (i.e., in their 80s or 90s). The following delves further into the five key questions and provides suggestions that plan sponsors should consider (as fiduciaries keeping the best interest of their participants in mind) to help retirees face these challenges: 1 How Much to Save = Replacement Income Risk The major aspect of this replacement income risk is that workers do not know how much money they need to accumulate to provide a financial foundation for adequate income in retirement. As previously mentioned, studies indicate that the amount needed to sustain a retiree s lifestyle is between 75% and 85% of their final pre-retirement pay, including their Social Security retirement income. 1 But how does a participant know the amount needed at retirement to provide that much income? And, once participants know that amount, how can they know how much to defer each pay period in order to reach that goal? There are a number of services that help answer this question through gap analysis, which measures the amount the participant has today against their projected need, and then gives the participant an idea of how much more they should save each pay period to reach that goal. In addition, the Department of Labor (DOL) is working on a proposed regulation that would require that monthly income projections be included on participant statements: many providers already offer this service if plan sponsors ask for it. This should help participants grasp the concept of converting their account balances into future streams of retirement income. 2 To help participants, plan sponsors should consider providing retirement income projections and gap analysis. Life Expectancy = Longevity Risk Few participants appreciate how long they will probably live after they retire. 2 The reality is that there is a 50% probability, for a married couple aged 65 years, that at least one spouse will live another 27 years after retirement and a 25% probability that one will live at least 30 years. 3 Indeed, some studies suggest that the probability of living to age 95 is closer to 50%. 4 In other words, there is a substantial probability that a participant who retires at 65 will need retirement funds to last for 20, 30 or 40 more years. Consider the following: If the typical worker begins their career at age 25, they will have worked for 40 years upon retiring at age 65. In that period, they will need to have paid all current expenses providing food, shelter, transportation and entertainment for themselves (and in many cases, their family) and will have needed to create a nest egg that may need to last for 30 years or more. The longevity risk is compounded by the fact that there is no pooling element in DC plans as there is in DB plans where the entire pool of assets is available to pay benefits so that the retiree must look solely to their retirement savings, plus any employer s contributions and Social Security, to fund retirement. As one report stated, An estimate of age 95 is a reasonable default, given today s longer life expectancies. 5 The consequences of assuming a shorter life expectancy could be disastrous. 3 Plan sponsors can help employees better understand the longevity considerations through retirement education. Some plan sponsors are offering retirement classes and seminars to their older employees (for example, those age 50 or 55 and older). Dealing with Market Downturns = Sequence-of-Returns Risk Sequence-of-returns refers to the order in which investment returns occur. Are the first few years after retirement considered good (positive returns) years in the stock and bond markets or bad (negative returns) years? This risk exists when assets begin to be liquidated to provide income to the retiree in a portfolio that is depreciating in value. Losses caused by market downturns are locked in when money is withdrawn Continued on page 5 1 Aon Consulting, Aon Consulting/Georgia State 2008 University Replacement Ratio Study. 2 See 2011 Risks and Process of Retirement Survey Report of Findings, sponsored by the Society of Actuaries, prepared by Mathew Greenwald & Associates, Inc. and the Employee Benefit Research Institute, March 2012. 3 Reish, Fred, Ashton, Bruce and Byrnes, Pat, The Problem with Living Too Long, Institutional Retirement Income Council (2010). 4 See Building Your Future, Insured Retirement Institute, 2011. 5 See Revisiting the 4% Spending Rule, The Vanguard Group, Inc., 2012 at page 5. 3
Viewing RETIREMENT with a longer lens American workers have longer life expectancies than prior generations, and our children may have a reasonable expectation of living to age 100 or older. This adds stress to a system that relies on plans based primarily on employee deferrals, such as 401(k) and 403(b) plans 6 that were not designed to be primary sources of retirement income. This is not to suggest that these plans are flawed retirement vehicles, but instead that they should evolve to take on a role that was not contemplated when they were created. Unfortunately, many working Americans approach retirement without fundamental knowledge of the risks they face in a defined contribution system some are even calling this the post-retirement crisis. 7 Government regulators and the retirement plan marketplace are only beginning to understand and address the issues created by the shift to savings plans. 8 To appreciate the changes, it is important to understand the problems that fuel the need for change, including the lengthening of retirement due to increasing life expectancies. When employees retire at age 65 or 67, they have a significant chance of living 20, 25 or even 30 more years. This means that retirees need to save more money than was needed in prior generations because the money must last longer. 9 It also means, as studies have shown, that most Americans are not saving enough to meet their retirement needs. 10 Participant awareness of the retirement dilemma has also increased, with a majority saying that they need help with these issues. The findings of a participant research study 11 indicate retirement security has increased in importance over the last three years for almost 90% of all participants and more so for participants over the age of 50. Most mid-career participants have indicated that their DC plan will be the primary source for their retirement income. As these studies and surveys indicate, 401(k) and 403(b) participants need help figuring out how much to save during their working years, how to invest their savings both before and after retirement and how to withdraw their savings in retirement. 6 Defined Contribution Plans Dominate the Retirement Plan Scene Today. LaRue v. DeWolff, Boberg & Associates, 128 S. Ct. 1020, 1025 (2008). 7 See Allianz of America, Behavioral Finance and the Post-Retirement Crisis (A Response to the Department of the Treasury/Department of Labor Request for Information Regarding Lifetime Income Options for Participants and Beneficiaries in Retirement Plans), prepared by Prof. Shlomo Benartzi, UCLA, at page 4 (April 29, 2010) (the Allianz RFI Response ); see also, Jack VanDerhei and Craig Copeland, The EBRI Retirement Readiness Rating TM : Retirement Income Preparation and Future Prospects, EBRI Issue Brief, no. 344 (July 2010). 8 See, for example, Rev. Rul. 2012 3, Rev. Rul. 2012 4, and proposed Treasury Regulation amendments regarding longevity annuity contracts. 9 See, Cantore, Tara, MetLife Finds Too Many Pre-Retirees with Faulty Math, Plan Adviser (October 2011). 10 See, for example, Workforce Management and Retirement in a 401(k) World, Watson Wyatt Insider (September 11, 2007). 11 See American Workers Seek More Security In Retirement and Health Plans, Towers Watson, Feb. 2012. 4
Continued from page 3 for living expenses. It is impossible to recoup the losses on the money that was withdrawn and spent, even when the market goes up again. So, for example, if a participant retired during the market downturns in the early part of 2000 or in 2007, their retirement savings would have been reduced by both the withdrawals for income and the losses in the markets, endangering the stability of their income for life. Therefore, retirees need to consider the sequence-of-returns risk and protect against it. 4 Plan sponsors should consider educating older employees about the sequence-of-returns risk and also consider whether the design of the plan s targetdate funds appropriately mitigates that risk. Accessing Retirement Savings = Withdrawal Rate Risk Conventional wisdom is that a 4% withdrawal rate (4% of a retiree s initial account balance) is safe. This is based on studies that show there is a 90% probability that, if retirement savings are withdrawn at a rate of about 4% per year, inflation adjusted, the withdrawals will have at least a 90% probability of lasting for 30 years. 12 Other studies suggest that the rate needs to be lower than 4%. 13 Regardless, the fact remains that there has been little participant education about withdrawal rates. As a result, participants are at risk of withdrawing their funds too quickly and exhausting their retirement savings. In fact, one recent study showed that more than 33% of those interviewed had no idea how much they could safely withdraw and roughly 25% expected to be able to withdraw more than 10% of their retirement savings each year. 14 Given this failure to understand sustainable withdrawal rates and the need for a disciplined approach in spending retirement savings, there may be a tendency for retirees to take withdrawals at a rate that will exhaust their savings when they are in their late 70s or in their 80s. 5 Decision-Making There are several potential solutions to this problem, one of which is for plan sponsors to provide greater education on the withdrawal rate issue. Another is to use products with a built-in withdrawal rate discipline that mitigates or eliminates the risk of withdrawing funds too rapidly. Deterioration = Cognitive Risk This is a problem that is only beginning to be recognized in the context of retirement income. Cognitive risk is the probability that, as we age, we become more prone to dementia or other cognitive disorders. 15 In the context of retirement savings, studies have shown that as people age, they experience some degree of decision-making deterioration, affecting their ability to make sound financial decisions for themselves, such as those involving investments and sustainable distribution rates. 16 Retirees are more prone to suffer cognitive impairment as they reach their mid-80s. 17 This suggests that difficult or complex decisions (e.g., how to invest and withdraw retirement savings so that it lasts for 25 to 30 years, while protecting against sequence-of-returns and inflation risks) should happen at or near retirement versus waiting too long. It also suggests that, where possible, retirees should select insurance products, investment vehicles or investment management services that reduce or eliminate the need to make new investment and distribution decisions at a time when they may be less capable of doing so, in order to minimize the risk of running out of funds. Plan sponsors should consider educating their older employees on the issues and the risk. Plan sponsors should also consider including retirement income services in their plans or as distribution alternatives from their plans. That could include, for example, mutual funds designed to provide retirement income through regular distributions, investment management services that specialize in retirement and income investing and insurance products that guarantee retirement income. 12 William P. Bengen, Determining Withdrawal Rates Using Historical Data, Journal of Financial Planning, October 1994, pages 171-180. 13 See Bruno, Maria A., Jaconetti, Colleen M. and Zilbering, Yan, Revisiting the 4% Spending Rule, The Vanguard Group, Inc., 2012. Some studies have suggested that higher withdrawal rates may be acceptable, but also may require that the rate be cut in some situations or that caution be used in applying the concepts. See, for example, Lieber, Ron, How Retirees Can Spend Enough, but Not Too Much, The New York Times, August 28, 2009; and Skinner, Liz, Research Supports Withdrawal Rate of 4% or Higher, Investment News, March 25, 2012 (interview with Joseph Guyton). 14 See, Lee Barney, Americans All Over the Map on Retirement Drawdown Rates, Money Management Executive (October 13, 2011). 15 See Allianz RFI Response, at page 9; see also BMO Retirement Institute, Financial Decision-Making: Who Will Manage Your Money When You Can t?, July 2011, which reached similar conclusions based on studies of the Canadian population. 16 See, David Laibson, Cognitive Impairment: Precipitous Declines in Cognition Can Set the Stage for Poor Decisions About Retirement Finances, which appears in the Allianz RFI Response, http://www.dol.gov/ebsa/pdf/1210-ab33-617.pdf. Professor Laibson s research showed a significant decrease in analytic cognitive functioning as people age and that older adults make financial mistakes. In effect, older people are less able to make cogent financial decisions, to analyze financial data and properly consider risks, which suggests that they are less able to make sound decisions about their financial security once they reach their 80s, a point when they may live another 10 or more years. 17 Id. 5
Possible Solutions The retirement community has devised a number of product and service approaches to address the risks that aging Americans face. Some are investment-based, some are annuity-based and some are a blend of both. Managed payout and retirement income mutual funds and investment management services These investment products and services offer a partial solution to the withdrawal rate issue, in that they provide for specific distribution amounts or a specified rate of distribution and may offer inflation protection when the stock market advances. However, they cannot guarantee that the funds will last for the retiree s lifetime, since only an insurance company can offer such a guarantee. Traditional and deferred annuities Traditional annuities provide solutions for longevity, withdrawal rate and cognitive impairment risks and, in some cases, may address (or partially address) inflation risk. A perceived drawback of an annuity is that the retiree loses control of their funds; that is, the retiree is locked into the annuity arrangement and cannot withdraw additional amounts if needed. Also, when the retiree dies, the payments stop. In the case of a joint and survivor annuity, the payments would only stop at the death of the spouse, while the payments would continue until the end of the fixed period for an annuity with a fixed period guarantee. Another approach is the deferred annuity, sometimes referred to as longevity insurance. Here, annuity payments begin, if but only if a retiree reaches a specified age, often 85. The premium cost for a deferred annuity is lower than for an immediate annuity, but if the retiree dies before the specified date, the benefit of the annuity is lost. Of course, there is an additional cost for the insurance guarantee. Guaranteed Minimum Withdrawal Benefit The blended solution is an insured Guaranteed Minimum Withdrawal Benefit (GMWB) product, where a participant s money is invested (e.g., mutual funds) and is wrapped by a GMWB guarantee. At retirement, the retiree begins to take withdrawals from their account at a specified rate (for example, 5% of the highest value of the investments). The actual rate will depend on the retiree s age and whether the guarantee also covers a spouse. If the money in the investments is fully withdrawn, the insurance company will continue to make payments at the same rate. The GMWB: Solves the longevity issue by providing a guarantee of lifetime income. Helps address the withdrawal rate issue by establishing a rate at which funds may be withdrawn without penalty. May address inflation if investments increase in value. May help address the cognitive risk issue by establishing a pattern of withdrawals that are put in place when the participant retires. And, if the retiree dies before the account runs out, the balance can be left to their beneficiaries. This alternative combines the benefits, but also the costs, of annuities and mutual funds. 6
Summary Plan participants face real risks as they near or enter retirement. These include concerns about how much savings are needed to retire comfortably; how long the funds will need to last; how to manage the investment and withdrawal of the money to increase the likelihood of it lasting for a lifetime; how to guard against inflation and sequence-of-returns risks; and how to protect oneself against later-life cognitive impairment. Fortunately, the retirement community has recognized that these risks exist and is taking steps to address them through education, services, investments and guaranteed products. 7
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