The retirement income challenge
We begin a series on the key retirement income question of the day: how does an account-based retirement plan provide adequate income in retirement? In this introductory article we survey the issues.
What exactly is the retirement income ‘problem?’
Different sponsors and participants have different views on what a 401(k) plan is supposed to do. At a company with a robust defined benefit (DB) plan, the 401(k) plan may be viewed as a supplementary savings vehicle. Even where a company’s only plan is a 401(k), if the participants are all very young, the 401(k) may be viewed (many would say, wrongly) simply as a way to accumulate generic ‘savings’ – that is, not as a way to save specifically for retirement.
But at a company where the 401(k) plan – or a profit sharing plan or, for that matter, a cash balance plan – has become the primary retirement savings vehicle, the issue of how you turn the participant’s account balance into a stream of income supporting the participant in retirement has become a focus of increasing concern, among policymakers, sponsors and plan participants. One obvious reason why this is happening now is that the baby boom age cohort is beginning to retire, although the erosion of the DB system is also a factor.
These concerns have focused on three areas:
Payout and longevity. The most obvious issue, and the one we’ll be spending the most time on, is how the account balance should be paid out. A crude version of this issue is: lump sum vs. draw down vs. annuity. As we’ll see, the approaches to this issue are becoming significantly more nuanced and more complicated.
The retirement income target. Getting participants to understand that their account balance will have to, at some point, be turned into an income stream has taken on an increasing importance. This has become especially problematic as interest rates and returns have declined. You need a lot more now to produce the same retirement income than you did in 2000.
Rollovers and ‘retailization.’ Policymaker concern and focus on retirement plan assets leaving the ‘institutional’ system of employer sponsored plans and going into, e.g., retail IRAs at retirement is, in the end, a concern about the adequacy of retirement income.
Draw-down vs. annuity
How should the participant take distributions? 401(k) payouts are variations on three basic options: a lump sum; a draw-down; or an annuity. It’s pretty obvious how a lump sum works, but it’s worth considering the differences between a draw-down and an annuity.
Draw-down. If a participant does not take a lump sum, she can (typically) elect payment over a number of years. More recently, participants – and those who advise them – have taken a “draw-down” approach to the distribution of their benefit. A typical draw-down strategy is to withdraw 4% of the initial amount per year. The draw-down is then adjusted at the beginning of each following year for either inflation or portfolio performance. Simple example: The participant has $100,000 at retirement and ‘draws down’ $4,000 in the first year. In the second year, that amount is adjusted up for inflation, and the draw-down amount for that year (assuming 2% inflation) is $4,080.
Annuity. If all you are concerned about is providing retirement income (and are unconcerned with saving for some other purpose, such as a legacy or to provide a cushion for unexpected expenses), annuities are close to a perfect retirement income vehicle. The classic immediate single life annuity pays a fixed amount beginning at retirement and doesn’t stop until the participant dies. At current (age 65 female, 3.5% interest rate) retail annuity rates, $100,000 buys an annuity that will pay $6,944 per year.
An annuity payout typically provides a more secure retirement income, because payments are guaranteed to last to death, and it generally provides a bigger payout (more than 40% bigger in the first year in our example) because annuitants who ‘die early’ fund higher benefits for those who don’t. On the other hand, annuities are priced based on fixed income rates of return – so they don’t take advantage of possibly higher equity returns. And at death – early or late – there is nothing left for a legacy. There are products that allow more flexibility than a simple single life annuity or a drawdown, including deferred annuities and ‘Guaranteed Lifetime Withdrawal Benefits,’ annuities that allow some equity exposure and access to principal – we will be discussing these in detail in our next article.
Inside-the-plan vs. outside-the-plan
To what extent should the plan accommodate participant – or policymaker – distribution preferences? Many 401(k) plans keep it simple by encouraging participants to take a lump sum immediately on termination. For those plans, the sorts of payout issues we are discussing don’t come up – it’s up to the participant to decide (generally after rolling over his money to an IRA or similar vehicle) how and when to withdraw his money.
A number of policymakers and policy advocates have questioned whether this approach is best for participants. And some have suggested that encouraging participants to leave their money in the plan is good for the plan and the sponsor. In this regard, many think that including annuity options in a plan will increase their appeal. But there are tradeoffs – perhaps most significantly, possible fiduciary liability exposure.
Legislative and regulatory initiatives
There are a number of initiatives to address these issues, both at the legislative and regulatory level:
In 2008 DOL finalized a ‘safe harbor’ for the purchase of annuities in a DC plan, and in July 2013, Senator Hatch (R-UT) introduced legislation that would provide an ‘easier’ safe harbor than the one in DOL’s 2008 regulation.
Early in 2012 IRS released four regulatory initiatives – two revenue rulings and two proposed regulations – generally designed to encourage the use of annuities in or with respect to tax qualified retirement plans. These included:
1. A proposed regulation allowing the (limited) use of deferred annuities; Senator Hatch’s bill alsoincludes a deferred annuity proposal.
2. Proposed regulations allowing defined benefit plans to simplify the treatment of benefits paidpartly as an annuity and partly in a more accelerated form (e.g., a lump sum).
3. Rev. Rul. 2012-3, clarifying the application of QJS rules to 401(k) plans offering annuities asinvestment options.
4. Rev. Rul. 2012-4, providing a roadmap for DC-to-DB rollovers.
In May 2013 DOL released an ‘Advance Notice of Proposed Rulemaking’ proposing that quarterly statements include current and projected annuity values for 401(k) plan balances.
DOL’s (as yet to be re-proposed) re-definition of fiduciary project is widely understood to be focusing on the issue of rollovers.
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This article is intended to be a brief introduction to the topic. In the following articles we will discuss 401(k) payouts in more detail. Our next article will consider the issue from the participant’s point of view, reviewing the sorts of payout options that are available and their advantages and disadvantages. In a separate article we will consider the sponsor’s point of view, taking up the inside-the-plan vs. outside-the-plan question and issues of fiduciary liability, administrative complexity, policymaker ‘pressure’ and fees.