Let’s Operate 401(k) Plans as True Retirement Plans

A defined-contribution retirement plan should not be just a savings vehicle. It should also generate retirement income.

Opinion_Bug7The long-term trend away from traditional defined benefit pension plans in favor of 401(k) and other defined contribution (DC) retirement plans has succeeded in its mission: improving companies’ financial standing. It has also resulted in massive numbers of workers who are facing a retirement of meager means or will have to work years longer than they’d expected.

It’s time to shift how both workers and employers view retirement plans. Inadequate savings levels are just the tip of the retirement iceberg.

Anna Rappaport

Anna Rappaport

Let’s start with employees. They face three challenges to giving themselves a chance at a secure retirement.

The first is to get enough money into the system. To have a chance for a comfortable retirement, many analysts recommend total contributions — employer and employee combined — that range from 12 to 18 percent of pay or more, contributed consistently for 30 years or more. According to a recent report from Vanguard, in 2012 the median contribution rate for employer and employee contributions combined was 9.5 percent of pay.

The second challenge is to minimize savings leakage during the working years due to loans, hardship withdrawals and early distributions. A report prepared for the ERISA Industry Committee shows that more than one-fourth of DC plan participants have outstanding loans, and 69 percent of such borrowers default on their loans when they terminate employment. At termination, only 57 percent leave the money in the plan or roll all of the money to an IRA, while 43 percent take cash distributions.

Even if workers arrive at retirement with sufficient savings, they face a third challenge: converting their hard-earned dollars into reliable, lifetime retirement income. The most common practice among employers is to pay them a lump sum, send them into the retail financial world and wave good-bye. Hopefully that will change, as financial institutions develop retirement income products and services that are becoming available on the platforms of many 401(k) administrators.

Steven Vernon

Steven Vernon

What can employers do to help? A recent paper from the Stanford Center on Longevity and the Society of Actuaries offers plan sponsors a guide for implementing a program of retirement income in a DC plan.

Employers can help older workers generate reliable retirement income because they often have the resources to complete the necessary analyses and due diligence on effective retirement income generators without any economic biases in those decisions. That task is beyond the abilities of most U.S. workers. When they have to rely on their own ability to generate retirement income, many withdraw amounts that are too high and exhaust their retirement savings prematurely. Others withdraw low amounts out of fear of exhausting savings, forcing financial cutbacks that may not be necessary.

A program of retirement income can be a low-cost benefit improvement that can help employers manage their older workforces while significantly improving the lives of their workers in retirement. Here’s the most critical point: Employers that offer group pricing for annuities or other retirement income products, instead of leaving employee to get individual price quotes, will increase participants’ retirement income. Not only will they get volume-based pricing, they also will benefit from reduced transaction feels.

According to a study by MetLife, 91 percent of DC plan sponsors view their plans as savings plans, while only 9 percent view them as vehicles for providing retirement income. A cultural shift is needed: Employers must commit to operating their plans as true retirement plans.

Why should companies care? Some might be motivated by the desire to do the right thing for their employees, to be good corporate citizens. Others might be concerned about the prospects of millions of citizens reaching their older years without income other than Social Security, which will barely keep people out of poverty. But if those reasons aren’t compelling enough, many employers are waking up to the reality of older workers who can’t afford to retire and are staying around longer than anybody had planned.

Employers have a unique opportunity to help all their workers face these important retirement challenges. Their businesses, employees and society will be the better for it. It’s time to take the next step and operate defined contribution plans so they have a chance at successfully meeting their workers’ needs in retirement.

Steve Vernon is consulting research scholar for the Stanford Center on Longevity. Anna Rappaport is chair of the Society of Actuaries’ Committee on Post-Retirement Needs and Risks.

3 thoughts on “Let’s Operate 401(k) Plans as True Retirement Plans

  1. My 401(k) used to have an annuity program. However, between litigation and legislation, it was removed in 1985. That is, compliance became an issue – and we removed the payout option.

    Simply, we need retirement income programs that allow not only for group pricing (in terms of tgransaction fees, volume pricing, etc.), but also for pricing that reflects the true risks (such as are available in the individual annuity market where pricing is specific to that individual), as well as flexibility for the individual to choose the survivor benefit she/he wants to provide.

    However, so long as the litigation and legislation we suffered in the 1980′s are in place, and so long as the plan sponsor/fiduciaries are at risk for the selection of annuity providers, don’t expect much action here. Given all the litigation surrounding employee benefit plans today, and particularly 401(k) plans, how do you suggest we encourage CFOs and others to add new exposures?

    The better alternative may be to facilitate the introduction of deemed IRAs into 401(k) plans (actually, an IRA sidecar linked to the 401(k)), to extend 401(k) pricing and investments (and fiduciary protections with respect to investment selection as well) and to introduce additional savings opportunities. On the IRA side of the compliance firewall, perhaps an intrepid insurer will come up with IRA (Individual Retirement Account, Individual Retirement Annuity) – compliant retirement income products on the other side of the firewall that the courts and regulatory agencies will accept without the litigation such decisions may otherwise trigger.

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