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Steve Vernon, FSA, Research Scholar, Stanford Center on Longevity

Steve Vernon, FSA, Research Scholar, Stanford Center on Longevity

By Steve Vernon, FSA, Research Scholar, Stanford Center on Longevity

Editor’s Note: It’s LONG overdue for the retirement industry to focus on making lifetime income options available in DC plans. Steve recently headed a study sponsored by the Society of Actuaries on “The Next Evolution in Defined Contribution Plan Design: A Guide for DC Plan Sponsors to Implementing Retirement Income Programs” in his position as a Research Scholar for the Stanford Center on Longevity. In this article, Steve will help us get a better understanding of ways to generate lifetime income from a defined contribution plan. While this is obviously important for employees in the private sector who do not have a DB plan, it is also important for public sector employees who will need to make up the difference between the retirement income they’ll need to live on and what they’ll receive from their pension and/or Social Security.

The following article was adapted from a presentation that has been delivered at several national conferences across the country, and you see it right at your desktop!

I usually start my presentations by telling two stories.

The first story concerns my brother-in-law. He was a V.P. Finance at a Fortune 1,000 company. He retired in 1999 with no pension but with what he thought was a large lump sum of money. He kept spending where he normally spent his money. Because he was in finance, he directed his own investments in the stock market. This was 1999, remember. We had stock market crashes in 2000 and another one in 2008. Two stock market crashes later, he’s broke. His money’s gone; he’s back to work, driving deliveries to make ends meet. He lost his home because he couldn’t make the mortgage payment. Unfortunately, his golden years have rusted out. That’s one extreme of possibilities.

The other is concerning my parents. My father was a professor at USC, where he had a defined contribution plan. There was no pension, but that plan was designed with significant contributions so that workers accumulated enough money in the plan. There were no loans or hardship withdrawals along the way. Upon retiring, the account balance was annuitized. My mother and father, between the two of them, ended up being retired for 32 years. They never had to worry about running out of money. They also made some wise choices by delaying Social Security as long as they could and by living within their means.

What’s the difference between my brother-in-law and my parents? There are a couple. One is that the employer, in the case of my father, the employer set up the plan to make it easy for him to retire and get a lifetime income, and my parents also made some smart choices along the way. But my brother-in-law had absolutely no help from his employer. They just handed him a lump sum and said “Good-bye.” He didn’t take the time to plan.

These two stories illustrate the extremes that are possible. Unfortunately, I think that my brother-in-law’s story isn’t extreme, and that it happens a lot in America. That’s what motivates me to do my writing and my speaking across the country. I think that simple communication helps people get the message that their lives will be a lot better if they do some planning, or their lives might not turn out that well. In fact, here’s another expression I use: “If you don’t do any planning right now, you get the life that shows up.” That may or may not be the life that you want.

I’ve been writing and speaking about these issues for quite a while and have written several books on the topic. I joined the Stanford Center for Longevity where I’m doing research on behavioral finance. In 2012 I published Money for Life, which focused on the issue of turning savings into a reliable income. It’s very important to me that I am not affiliated with any insurance company or mutual fund company. I’m just me, using my expertise and my skills and my training; helping people with these decisions.

Challenges with Defined Contribution Plans

There are three challenges with retirement plans that are defined contribution plans. First of all, there’s not enough money being contributed. We see contributions in a lot of plans for which the company might match 3 percent of pay, up to 6 percent, with a total of 9 percent of pay going in. That’s just not enough. Experts are saying that you need about 15 percent of pay contributed consistently over 30 years if you’re going to accumulate enough money to make a difference. All of this assumes that you don’t have a defined benefit pension. Those people who do have a pension don’t need to save as much money.

Problem No. 1 is not enough money being contributed in the first place.   Problem No. 2 is that a lot of plans have loans with withdrawals, so there’s leakage along the way. Problem No. 3 is that retirees are on their own to generate a lifetime retirement income. We’ll focus here on this third problem.

Trends in Employer-Sponsored DC Plans’ Retirement Income Options

Here are some findings of the “2013 The Hot Topics in Retirement” report from Aon Hewitt showing different types of retirement income solutions that might be in employer sponsored retirement plans.

Retirement Income Options Provided by Employers

The main takeaway is that many plans are offering some modeling tools to help people.  But when you go down beyond the first bar, the second bar and thereafter, these are also possible plan features that employers could use to generate income, it’s just not very prevalent. This is one of the challenges:  employers aren’t putting features in their plans – yet – to help people generate retirement income from their savings.

When employers are asked, “Why not?  Why don’t you have solutions in your plan?” These are the answers that are typically given: We’re seeing administrative complexity, fiduciary liability, want to see the market evolve.

Barriers to Adding Retirement Income Solutions

I happen to believe that if you’re a motivated employer who wants to help your employees, that you can overcome these barriers.  Part of our role is to address these issues so that employers feel more confident that they can implement these solutions in their plans.  There is interest heating up, though, in these issues.  The Aon Hewitt survey shows that employers who express no interest in delivering retirement income solutions dropped from 57 percent to 27 percent between the 2012 and 2013 surveys.

Three Types of Retirement Income Generators

There are really three types of retirement income generators.  The first one is to invest savings and only spend the investment income, leaving the principal intact.  That’s the most conservative way of generating income.  Actually, it takes the most amount of money to generate meaningful retirement income.  Nevertheless, people who accumulate enough money could retire this way.  More likely, people will do some combination of the next two.

The second, systematic withdrawals, is where you invest savings and withdraw principal cautiously, so that you can avoid outliving your principal. But there’s no guarantee of that.  The third way is to purchase an annuity where the insurance company guarantees a lifetime income that lasts the rest of your life, no matter how long you live and no matter what happens in the stock market.  These are the three basic methods, and there are many, many variations and combinations with each approach.

Some of the variations are with systematic withdrawals.  You can withdraw a constant dollar amount.  You can withdraw a constant dollar amount and give yourself a raise for inflation every year, which is the well-used 4 percent rule.  You can use an endowment method, which is a constant percent of your assets.  You’ll just take 4 percent of your assets every year, for example.  There’s a lot of expectancy method, which is in tax qualified plans.  At age 70½, the IRS requires you to take out minimum amounts.  Actually, it turns out that the required minimum distribution is decent advice how to generate income that will last the rest of your life.  It might be highly volatile, but at least money will last for quite a long time.  You can also get a payout over a fixed period.

Annuities

You can have single premium immediate annuities, deferred annuities, variable deferred annuities.  Variable immediate annuities, GLWB or GMWB.  These are innovative hybrid annuities.  You can have longevity annuities that start at a deferred age, like 80 or 85.  The point I wish to make is that there are plenty of solutions out there.  We really don’t need to wait for the market to evolve.  That’s not saying that we won’t see more innovations, I’m just making the point that currently there are plenty of solutions out there that we can use.

Plan sponsors who want to put retirement income generators in their plan face these issues.  Do they have in-plan options?  Or out-of-plan options?   Do the assets stay in the plan in retirement?  Or do the assets go outside the plan toward some other vendor?  Products versus advice versus guidance.  The way that this could take place is that you could have solutions that are embedded in the plan which would generate income.  That’s one possibility.

You could also have just an advice that advises people how to use their savings.  Then finally, guidance.  What I mean by that guidance is that you might have software and education materials.  This is another way that employers could go.

Another issue to face is whether to deploy these solutions at the point and time of retirement?  Or do you want to have some solutions that protect your retirement in the period leading up to retirement?  There’s been a lot of interest generated in this last area.  People who were planning to retire in 2008 or 2009 got hammered in the period right before their retirement.  We realized that if you have a stock market crash right as you’re trying to retire, that’s a bad thing.  Now there’s a lot of interest in how to protect retirement income in the period immediately leading up to retirement.

Evaluation Criteria for Retirement Income Generators in DC Plans

If you’re a plan sponsor thinking about having a retirement income program in your plan, this is a list of criteria that you might want to consider when looking at different retirement income solutions.

  • Amount of income
  • Lifetime guarantee
  • Pre-retirement protection
  • Post-retirement potential for increases
  • Post-retirement protection
  • Access to savings
  • Inheritance potential
  • Investment control
  • Withdrawal control

In the ideal world, the employee would receive a small number of choices – three or four choices.  You’d say, “Here are different retirement income generators.  Here are the features that they have.  Here is the amount of retirement income that each of them generate.”  That way, employees can make a decision about the different features in their retirement income generators.  But most importantly, I think, the amount of income is one of the most important features.

Is the income generated guaranteed for life or not?  With some solutions it is, and with some solutions it is not.  Is there protection in the period leading up to retirement?  Is there protection after retirement?   Is there potentials for increases due to inflation?  Is there protection after retirement?  Can your income drop if the market goes down?  Or is it protected against market decreases?  Do you have access to your savings in case you want to withdraw money for emergencies?  Is there potential for inheritance with any money that’s left over?  Who has the control of the investments and withdrawals?

These are all the criteria that plan sponsors might want to consider when they’re putting retirement income programs in their plan.  It’s also the criteria that a financial advisor might want to consider when they’re devising solutions for their clients.

We have a chart comparing some common retirement income solutions.

How Different RIGs Meet Various Criteria from Retiree Perspective

Does the retirement solutions have the necessary features?  There are very few solutions that can check “yes” for each feature all the way down.  What you see are systematic withdrawals and annuities tend to complement each other with the yesses and the nos.  So really, the point of this graph is that there isn’t a one-size fits all solution.

Direct your attention to the column at the right, GMWB annuity.  It does have yesses all the way down.  But if you look at this closely, you’ll see footnotes.  Yes, these plans have all these features, but they also have contract restrictions and fees that demand attention.  A GMWB annuity can be one good solution, but it’s one of the most complicated insurance products out there, and you really do need to understand all of the restrictions and fees before you decide whether or not that’s a solution that can work for you.

Should Employers Encourage Employees to Stay in the Plan or Roll Money Out?

Right now, most plans in the private sector offer a lump sum payment to their employees. The message is, “Go take your money elsewhere.”  Large employers are waking up to the idea that, maybe that’s not the best approach.  Maybe we want our employees to stay in our plan.

With large employers we’ve seen equity index funds with two basis points expenses.  You can’t get that on a retail basis.  I’ve seen stable value plans that are earning 3 percent per year, with full liquidity.  But once again, if you’re on a retail basis with CD’s, you’ll be lucky to get 1 percent.  Transaction fees with single premium annuities of 2 percent with competitive bidding, on a retail basis you’re going to be paying far more in transaction fees and you may just get one insurance company.  You may not get competitive bidding.

With GMWB annuities, we’re seeing insurance and investment fees totaling 150 to 200 basis points.  Whereas on a retail basis, you’re probably going to be paying 350 basis points for this.  Employers are waking up to the fact that they can offer their employees a good deal and maybe it’s in the best interest of the employees and the plan sponsor to have solutions in the plan for retirement.

On the other hand, there are small employers that don’t have the wherewithal to put these programs in their plans.  I’ve seen 401k plans that have 150 basis points in their plans.  In that case, rolling out of that kind of a plan into a low cost environment is a smart move.

Institutional pricing can make a big difference.  What we’re seeing with competitive bidding, with single premium immediate annuities, you have the potential to increase your retirement incomes by 10 to 20 percent compared to just taking one insurance company’s annuity.  With GMWBs, if you get the institutional pricing I was talking about earlier, that can increase retirement incomes by 12 ½ percent, initially.  It can be even 20 percent higher, later on in retirement.

On the systematic withdrawal schemes, if you’re paying 50 basis points versus 150 basis points, your money lasts longer – and we’re projecting that it can last two to three years longer with a strict application of the 4 percent rule.  If you have a retirement income generator that just takes a percent of assets along the way, then ten years later you might have 10 percent higher income.  Twenty years later, you might have 21 percent higher income.  It makes a difference.  If we can give our retirees institutional pricing, it goes to their bottom line and gives them a higher retirement income.

In reality, we’re seeing that combinations where some of your money goes into a systematic withdrawal scheme and some of your money goes into an annuity, that actually may be a reasonable compromise that produces the best outcome for retirees.  One example of this is that you may cover your non-discretionary expenses by guaranteed sources of lifetime income.  So rent, mortgage payment, utility bills, food, these are things that are your non-discretionary living expenses.  Make sure they’re covered by Social Security, pensions, annuities, so that you don’t have to worry about having to move out of the house if the stock market crashes.  Then, with whatever savings you have left over, you might cover your discretionary expenses like vacations, gifts and so on.  So this is one possible strategy that people could use that makes a lot of sense to me.

If you do, that might justify a more aggressive asset allocation with the remaining savings or a higher withdrawal rate.  This is one example of where combining different retirement income generators might work. I want to mention that the Stanford Center for Longevity is kicking off a project where we will focus on combination solutions that follow up on the prior study showing how these different income generators operate.  Based on that analysis, what are packages of strategies that might work for a lot of people?

Another possibility is to use defined contribution assets to enable delaying Social Security to age 70. If you delay your Social Security benefit you get an increase in your income.  A professor at Stanford, Dr. John Shoven, did a paper that showing that the delay of Social Security and the increase in your Social Security income can be viewed as an annuity purchase, at a rate that is far more favorable than what you can get in the open market.  One possible good use of savings is to use that money to live on between age 65 and 70, to enable you to delay taking Social Security until age 70.

Here’s a chart which I show at my retirement planning workshops for companies that have cash balance retirement plans.  I know that cash balance plans are becoming more prevalent at state and local governments.  The cash balance plan looks like a defined contribution plan and often they pay a lump sum at retirement, but you have the option to convert your lump sum to an annuity within the plan.  That is a feature of any cash balance plan.

Putting it All Together: Retirement Income Strategies 

A lump sum from employer-sponsored defined benefit plan may not be the best choice.  This chart just shows that if you have $100,000 in savings, what’s the amount of income you could generate?

RIG Comparisoins

Notes:

  • Amounts shown are for single life annuities.
  • Comparisons similar for joint and survivor annuities.

If you took the 4 percent rule, you’d get $4,000.  If you kept your money in the cash balance plan, you’d get $7,800.  Whereas, if you took the $100,000 and went out into the open market and bought an annuity, you’d get $6,458 if you’re a male and $6,006 if you’re a female.  This is the kind of information I show employees so that they can make an informed decision, looking at the amount of tradeoffs they get versus the other features of the retirement income generators.

My concern is that a lot of people just aren’t shown this tradeoff.  They’re just shown one solution.  Or they’re just told one thing to do.  Today, they don’t have the ability to make this tradeoff decision.



Steve Vernon, FSA – Expert in Strategies that Integrate DC Plans, Social Security, QLACs

Steve Vernon, FSA – Expert in Strategies that Integrate DC Plans, Social Security, QLACs

About the Author

Steve is also President of Rest-of-Life Communications. In both roles, Steve is active with research, writing, and speaking on the most challenging issues facing retirees today, including finance, health, and lifestyle.  Previously, he worked for over 35 years as a consulting actuary, helping Fortune 1000 Companies design, manage and communicate their retirement programs.

Steve is one of the most sought-after retirement experts in the country.  He is quoted frequently in such publications as The Wall Street Journal, New York TimesLos Angeles Times, USAToday, BusinessWeek, Fortune MagazineKiplinger’s, and Money Magazine.  He writes occasional columns for Retirement Weekly, and a regular blog column for CBS MoneyWatch, titled Money for Life.  He is a prolific author having published several other books.  His focus is to help people with important life planning – to help them live long and prosper!’