VOL. 17 ISSUE 3
Millions of Americans watched their defined contribution (DC) retirement plan account assets shrink through the end of 2008 and much of 2009. Although those who had the fortitude to stay in the market did see their balances rebound somewhat in the second half of this year, no one can say it has not been a wild ride, one that has shaken employee confidence to a degree where it may take a generation or more to recover. At the same time, employers have begun to ponder what they can do to return to one of the basic tenets of the employer/employee relationship: being able to help their workers attain a secure retirement.
Given what has happened, both groups now recognize the increased importance of controlling risk. Plan design approaches that better balance surety and risk for both employers and employees should be a key component of future plan design considerations. This means:
- §401(k) plans must transform their focus from cash accumulation vehicles into secure retirement plans through the application of progressive investment alternatives, including annuity options.
- Defined benefit (DB) plans must consider variable benefit formulas, including the next generation of cash balance programs and other "hybrid" approaches. (See the sidebar "Another Way of Looking at DB Plans.")
The Future of the §401(k) Plan
In the past, employers and employees viewed §401(k) plans primarily as vehicles for capital accumulation. Because these plans were initially designed to augment an employer’s traditional DB plan, little attention was paid to risk or to whether employees were accumulating enough money on which to retire comfortably or how those funds were invested. All that has changed.
First, although recent surveys indicate that a majority of employers within the Fortune 1,000 that sponsor DB plans continue to maintain open DB plans, a growing number of employers have frozen or closed their DB plans, leaving employees to depend on their §401(k) plans as the primary source of retirement income. When the crash of 2008 occurred, most §401(k) plan participants (including those using target date funds) had their account values decline by 30 percent or more. Many current retirees experienced significant reductions in retirement income, and employees who were hoping to retire in the next decade or so were left wondering whether they would be able to do so. Moreover, younger generations of workers had their faith in their §401(k) plans shaken significantly.
What is needed now is a new form of §401(k) plan that preserves the best aspects of today’s plans but performs more like a DB plan in that it significantly reduces risk and lets employees know (rather than guess) what kind of income they can expect in retirement. In short, §401(k) plans need to be transformed from capital accumulation vehicles into bona-fide retirement programs.
Proposing a Solution
One way to do this is by introducing progressive investment alternatives, including annuity options, which would work as follows: An employee would establish his or her retirement income objective and, in conjunction with an investment advisor, determine the required contribution and optimum (least risky) investment allocation necessary to meet that objective. This strategy would be continuously reevaluated, recognizing investment performance to date, and adjusted to rebalance contributions and the optimum investment needed to support the retirement income objective. For example: If emerging market performance exceeds expectations, perhaps some risk can be “taken off the table,” but if emerging market performance falls short of expectations, perhaps additional risk (or higher employee contributions) is required.
This strategy should result in progressive reduction in risk as the retirement goal is achieved. Periodically during the employee’s working years, a portion of his or her §401(k) account would be transferred into a guaranteed income vehicle. For the purpose of this discussion, we will refer to these as annuities. "Periodic annuitization" would avoid the risk of annuitization at retirement, which may not be the optimum market timing due to prevailing interest rates at the time of retirement, a concept similar to dollar cost averaging in making stock investments.
The primary benefit of periodic annuitization would be security. Once the money is annuitized, there is no investment risk. Sixty-year-old employees who already have the bulk of their §401(k) plan assets in annuities would know exactly what they would receive if they were to retire today, and they would have a good idea of what they would have to live on if they were to retire in 5 or 10 years. By the time a person retires, his or her retirement plan will be free of investment risk and even longevity risk though depending on the annuities, inflation risk may still be a concern. This new generation of annuity products, which is only just beginning to emerge, will be created and offered by the same financial institutions that are now managing employees’ §401(k) plans.
Make It Automatic
The key to making a progressive investment alternative work is to make it as automatic as possible. Ideally, an employee should not have to make any investment or annuitization decisions. What he or she would have to do is set a goal by specifying how much income he or she will want/need in retirement. (See the sidebar "The Importance of Employee Education.")
Based on the individual employee’s goal, the plan will determine the amount of assets that must be accumulated by the time he or she retires, to support that income. Further, ongoing analysis will determine how much money the employee needs to contribute (factoring in employer matching funds) and where that money needs to be invested with the optimal amount of risk the employee needs to accept to meet his or her goal.
As an employee’s §401(k) plan assets accumulate (and are periodically annuitized), it will become evident whether the plan is on track to meet the employee’s goals. Is he or she saving enough and taking enough risk to generate the needed savings? Adjustments will be made automatically, both to the amount being saved and to the risk being taken the objective being to meet the goal with the least possible amount of risk.
Employers that offer progressive investment alternatives will create a true retirement program for their employees as opposed to a capital accumulation vehicle. Employees will gain a secure retirement fund and peace of mind.
Ultimately, the reemergence of retirement as a realistic and attainable goal will benefit both employees and employers. Employees will be able to retire when they want to and when they should, which will help employers with workforce planning. A workplace that is full of employees that want to and should retire, but cannot, will be avoided.
About the Authors:
Stewart D. Lawrence is a senior vice president and national retirement practice leader in the New York office of Sibson Consulting. He can be reached at 212.251.5315 or firstname.lastname@example.org.
Robert McAree is a senior vice president and New York retirement practice leader in the New York Office of Sibson Consulting. He can be reached at 212.251.5368 or email@example.com.