Let the Retirement Pendulum Swing Freely to a Better Place for All
The movement to a DC-oriented private retirement system has raised concerns by policymakers, employees and even some of the employers who have embraced this trend. The chief concern can be summed up as the total shifting of risks to employees – the risks that they won’t save enough, the risk that they will use the savings for non-retirement purposes, the risk of unfavorable investment results – culminating in inadequate retirement savings and the prospect of outliving such savings.
No doubt government retirement policy, or the lack of a coherent one, has fed this movement. And recent attempts to push the pendulum in the other direction, are likely to be unsuccessful and indeed to continual resistance from DC-friendly constituents.
For instance, the government tried, unsuccessfully so far, to nudge DC plan sponsors to give participants some sense of how much life annuity their account balances might be able to provide. The push-back was immediate and severe from stakeholders in the DC system. Some objected on technical grounds – the annuity estimate could vary widely depending on a number of assumptions including life expectancies, market interest rates and inflation. Others viewed this initiative cynically, believing that it was just a first step toward mandating annuity availability in DC plans, thus leading to the prospect of huge sums of assets shifting from mutual funds and other asset managers to insurers.
Auto-enrollment and escalation are tactics to nudge employees to do what they otherwise might be disinclined to do – join the DC plan and contribute regularly. The policy objectives here are obvious, but the tactics are arguably coercive or at least intrusive. Surely, one can envision even more intrusion by the government or employers or both down the road in a DC-dominated retirement system.
To mitigate one of the problems with a DC-oriented retirement program, why not impose much greater restrictions on in-service withdrawals, including loans? After all, if the plan is intended to provide savings for retirement, why permit such withdrawals at all? One typical response is “that would discourage employees to participate in the first place.” And employees would view this change as a major take-away – after all they view it as their money, so “don’t mess with it.”
The best way to close this loop would be to provide a core company contribution for everyone – not just for those who are willing or able to save.
And perhaps one of the most disturbing aspects of a DC-only retirement system is the fruitless attempt to make employees into competent investors. Even if investment education works to an extent, the idea of employees spending time, probably mostly work time, to figure out how to best navigate the investment markets is an exercise in futility. When someone is sick they go to a doctor not to medical school. Investment professionals have gone to investment school – a crash course in investments does little or no more than give employees a false sense that they know what they are doing. It’s like self-diagnosing a medical issue based on information on WebMD. The response from the DC world is default investments, such as target date funds. That helps but is still leaves employees vulnerable to temptations to time the market and apply their (inadequate) knowledge to making investment choices. Inevitably, the result is wide disparity in outcomes among plan participants – those with better outcomes being the better, or more likely luckier, investors.
All of these attempted patch-ups of a DC plan is well intended but, in my view, doomed to fail. I say, stop trying to push the pendulum back toward the middle. The path is filled with land mines and other traps. Everyone should take a deep breath, pause and look for a better answer.
Ok, what might a better path be, one with less resistance and a good outcome? Let’s begin by assuring all the DC fans out there that I am also in the DC-401(k) camp. These plans are extremely good at certain things, and those features should be retained to the greatest extent possible while achieving the desired outcome.
Surely the key attribute of a DC design – the account balance orientation – has proven to be critical in its success. In my view, that attribute should be retained throughout the retirement program. Expressing all retirement benefits in terms of account balances provides great transparency – benefits are tangible, easily understood and even handed. This latter attribute – even handed – is intended to draw a contrast with traditionally designed DB plans. I do not see any comeback for those designs, especially for employers that have moved mostly or entirely to a DC-oriented retirement program. And for good reason. The opaque and economically back-loaded benefits often with features that encourage early retirement no longer make sense for most companies. The movement to DC-oriented retirement programs reflected, properly, the need to get away from those attributes. And if all of the employer’s retirement benefits speak the same account balance language, that would greatly improve communicating the growth in and total value of the retirement benefits over time.
So what is the plan design that would allow the pendulum to swing back naturally – the path of lesser resistance? It is a combination of a type of cash balance plan with a 401(k). But the cash balance portion has to be designed in a way not to have one key attribute that pushed many employers away from DB plans while promoting one other important attribute that is missing from other retirement plans. First, the CB design must deal effectively with the problem with DB and indeed typical CB designs – volatile and unpredictable employer contributions and accounting outcomes. Second, the CB plan should be designed to share key risks (and opportunities) between employees and the plan sponsor.
Fortunately, there is a CB design that accomplishes both of these goals: a “market-return” CB plan. The distinguishing characteristic of a MRCB, as compared to a typical CB plan, is that interest is credited based on real market investment returns – rather than on high-quality bond yields. The basis for crediting market returns could simply be the actual returns on the plan’s assets each period. Alternatively, returns on a specified subset of the plan’s assets could be used. Or, accounts could be credited with the returns on one or more specified outside funds, such as mutual funds. The result would be account balances that move with market returns. While returns likely would be negative in some years, the law provides a floor return of 0%, cumulatively – meaning that the participant’s account ultimately paid out (or applied to provide an annuity) cannot be less than the sum of the participant’s pay credits.
The MRCB will provide much better cost control than a typical CB design – because account balances will tend to move in tandem with the plan’s assets, and regardless of changes in market interest rates. The employer can tune the degree of investment risk it is willing to share with employees by providing more downside protections, possibly in exchange for retaining a portion of the upside investment returns. By providing some of the employer benefits through a MRCB, the employer is accomplishing all of the goals that the government and some employers are trying to achieve by changing DC plans to be something they are not meant to be. Employer pay credits would automatically be provided to all participants – no dependency on employee contributions. There would be no diversion of the benefits during employment – no loans or withdrawals. Annuities would be provided directly by the plan – thus avoiding the extra cost of retail insured annuities. Yes, that means the employer retaining some long-term longevity risk – but even that is controllable by how the factors are set and managed over time to convert accounts to annuities. The MRCB typically would allow employees to elect lump sum distributions upon termination or retirement (equal to account balances – with spousal consent), although the ability to elect lump sums can be restricted by plan design to the extent the employer considers that to be desirable.
Where would this leave the 401(k)-DC plan? Just where it should be – as a short-term and supplemental long-term savings vehicle. Matching employer contributions could continue, encouraging employees to save. Investment choices can continue, thus allowing employees to adjust their overall investment portfolio, taking into account the kinds of assets underlying how their MRCB accounts are credited. And the program could even be designed to allow the employee to transfer some or all of their 401(k) balances at retirement to the MRCB to provide additional annuity benefits.
I believe that the resulting program would be better for employees and employers that a total DC-oriented retirement program. And the US government would be relieved of having to force or cajole employers to make their DC plans look more like DB plans. The 2006 PPA paved the way for MRCBs and indeed some employers have adopted these designs. Now that we finally have IRS regulations that provide a clear path for these designs, isn’t it time for more employers to explore that path?
Author: Larry Sher
Larry is a highly sought after expert and advisor and, in August 2014, was appointed to the New Jersey Pension and health Benefits Commission by Governor Chris Christie. Larry has been an actuary for over 35 years, specializing in defined benefit plans issues. Larry has focused on cash balance and other hybrid defined benefit plans ever since his firm (at the time), Kwasha Lipton, developed the first cash balance plan in 1985. Larry has long believed, and continues to believe, that cash balance plans offer the best hope to salvage the U.S. private sector defined benefit system. He strongly feels that the consequences of continuing on the path toward a defined contribution only private retirement system will be bad for employees, their employers and the government. While many practitioners and firms seem to have thrown in the towel, Larry sees October Three as an environment where creativity can once again thrive.
Larry is a Fellow of the Society of Actuaries (FSA), a Fellow of the Conference of Consulting Actuaries (FCA), a Member of the American Academy of Actuaries (MAAA) and an Enrolled Actuary (EA). Larry received a B.A. in Mathematics from Rutgers University. He has been a Board Member and Vice-Chair of the Actuarial Standards Board, the group that establishes actuarial standards of practice for all US actuaries. Larry has also been on the Boards of the American Academy of Actuaries and the Conference of Consulting Actuaries, and was recently President of the Conference.
Larry has written several articles on cash balance and other defined benefit plan issues and is a frequent speaker at industry and professional seminars.