Turning 401(k)s into a Paycheck for Life
There’s a certain appeal in having your retirement plan turn into recurring income, but is it a good idea for plan sponsors to allow that as a feature in their plan? That’s the topic I discussed with Glenn Dial of American Century during a recent LinkedIn Live.
History
The defined benefit plan, or the “old school” pension plan, was great for employees: they would work a certain number of years for the employer and receive a paycheck for life. The risk was all on the employer, who would have to invest a pool of pension money to support these payouts.
With the defined benefit plan going the way of the dodo, employees were then left to make their own contribution and investment decisions - good for some, not so good for others. This was the rise of the defined contribution plan (aka 401k or 403b).
The 401(k) (or 403(b), depending on which applies to your organization) has historically been an accumulation tool - a way for people to save money for retirement. Baby boomers, the first generation to be able to use this type of plan, are retiring now, and are using it as the underpinning for their retirements.
As a result, two different investor strategies came about to make it easier on the employees: the do-it-myself strategy and the do-it-for-me strategy.
For the do-it-for-me strategy, target date funds (TDF) - a portfolio of investments that are managed to a certain date in the future - became the most popular way to invest for retirement.
About Target Date Funds
There are a lot of good things about TDFs. According to studies by John Hancock and others, participants will see about a 3% higher return per year compared to what a do-it-yourselfer will see. They’re also generally low-maintenance, and offer a hassle-free investment option. We’ve written about these before.
Back in 2008-2009 when the market declined during the Great Recession, however, employees invested in TDFs found that their investments had dropped by anywhere from 9% to 41%. Many of them panicked and sold out, locking in those losses forever. As a result, the DOL and SEC held hearings on TDFs, and those who were not specialists in the retirement industry found they needed to focus a lot more on how these funds were built.
TDFs are not one-size-fits-all. Employees are diverse - you have to pick a default investment that fits “enough” of them (however you define “enough”). In that scenario you need to know about your employees - their average age, average balance, etc. - and how those characteristics align with how the TDF is constructed.
The DOL released guidance with information on those characteristics that should be considered to determine if a TDF is a fit (and we covered some other considerations in the past here):
Participant Characteristics
Age
Retirement Date
DB Plan
Salary
Turnover Rates
Contribution Rates
Withdrawal Patterns
Behaviors
TDF Characteristics
Investment Strategy
Risks
Glide Path
To Retirement
Through Retirement
Income Assumptions
Asset Allocation
Having said all that…the next thing you need to know is that according to a recent American Century study, about 48% of retirees retire earlier than planned, some by as much as 10-15 years. Most of the time employees are forced into early retirement due to adverse events (laid off, health care concerns). Additionally, research from JP Morgan shows that the majority of participants leave the plan within 3-5 years of retiring. What does that mean for the choice of TDF for your plan? Bottom line: you need data about your group and their behavior, and it’s important to look at risk starting 10-15 years before the normal age 65 retirement date.
Our industry has done a good job of getting participants enrolled in 401(k) plans and increasing their contributions, says Dial; basically we’re a really good supplemental savings plan industry. We’re not really a “retirement plan” industry; in reality, most retirees roll their money out and turn to a financial advisor to help them turn that money into income.
So what happens if you retire early, or in a down market? How can we solve for market risk, transition risk, and longevity risk? Unfortunately, TDFs as they exist today don’t solve for these risks which is why guaranteed retirement income has been added to the mix, and why it was included in the SECURE Act of 2019. It’s the last piece of the puzzle to help transform a 401(k), 403(b), etc. from a supplemental savings plan into a primary retirement plan without leaving the corporate sponsored plan.
In-Plan Income Solutions
Plan sponsors will now have the ability to add an in-plan income solution to their retirement plan to allow employers to turn their retirement savings into a paycheck straight from the plan. This decision might seem pretty black or white, but in-plan income products vary widely. There are different mechanisms, fees, fee structures, etc. So how do you compare products that are very different? Dial states it’s like buying a car - first you need to decide which type of product you want, then decide on the features that you and your employees want (or don’t want).
Looking for a tool that will make it easier to compare these products? You’re in luck - American Century is developing a tool coming out at the end of the year that will do just that. (And Retirement Planology gets first crack at it!)
Currently 5 to 9 percent of plans already have guaranteed income - Dial believes that in 2022, many plan sponsors will begin the education process, and in 5 years over half of all plans with over 100 employees will have instituted guaranteed income.
Communicating with employees about the benefits of these products will be key - they are complex and plan sponsors will need to cut out the jargon and simplify their message in order to educate employees about these products. Anecdotally, from what we’ve seen in the past, the only participants that have decided to use these types of products have been the committee members that chose them! Education about the option has been a significant deterrent for adding these types of products.
Takeaways
Here’s what plan sponsors need to consider regarding TDFs and in-plan income:
Suitability - Do you have the right TDF? There are 40+ different options in the marketplace, and you need to get that suitability analysis done to protect yourself and do right by your employees.
Get some data about your employees - Are they retiring early? Are they taking their money elsewhere? Are they interested in guaranteed income?
Start learning about in-plan income solutions - Contact us to start the conversation on all of this and more!
Related Blog Posts
https://www.retirementplanology.com/blog/moving-target-with-target-date-funds