Will employer DC plans finally provide lifetime income?
As much time as benefits professionals spend working with employees to encourage them to save money for retirement, helping them prepare for the next phase — managing their nest egg to afford a comfortable retirement — can be considerably more challenging.
The typical 401(k) is set up as a defined contribution plan and doesn’t offer an option for taking a lifetime income distribution.
But does it have to be that way?
Researchers in the retirement space are exploring new options to help workers make the transition from being retirement savers to retirement spenders and to create a flow of lifetime income for people with 401(k)s and similar plans.
“Converting retirement savings into lifetime income is one of the most complex financial decisions that an individual has to make in their lifetime. You have a wide variety of unknowns,” David John, senior strategic policy advisor at the AARP Public Policy Institute, said at a recent conference hosted by the Brookings Institution, a Washington think tank. “The simple fact is that this is difficult.”
As defined benefit pensions become a thing of the past, many investors have turned to some form of annuity as a vehicle for providing income in retirement. But, John noted, annuities suffer from a number of drawbacks. One is perception, he said, arguing that many investors are skeptical of annuities, which, as an asset class, are “wildly unpopular” with many investors. Further, some types of annuities carry steep fees and don’t offer the flexibility many investors want in a retirement product.
So the search is on for other ways that employers can incorporate a lifetime income option into their employee benefit mix.
John, the author of a forthcoming paper on retirement planning for lifetime income, notes that a handful of other countries have been exploring non-annuity income sources. One idea under consideration is a pooled managed payout fund, in which multiple employers band together to offer an actively traded fund that aims to provide relatively consistent income. The portfolio mix would be weighted heavily toward equities, along with some countercyclical elements to serve as a hedge against market downturns.
In Canada, a coalition of academics and pension advocates are calling for changes to the law that would enable employers to add a lifetime income feature to their defined-contribution plans through a pooled-risk pension.
Under that framework, “retiring members could voluntarily choose to buy a secure pension income until death, using some (or all) of their DC savings,” Bonnie-Jeanne MacDonald, director of financial security research at the National Institute on Ageing at Ryerson University in Toronto, recently argued.
In that shared-risk model, John envisions that plan administrators would set a target payout for each year, meeting that mark with equal monthly payments. But because the risk is pooled and the fund would be tied to market movements, those payouts could vary somewhat from year to year.
“The key factor here is that payouts vary,” John said, though pension advisers and managers would seek to keep those fluctuations to a minimum.
Underlying the concerns about lifetime income are the innumerable variables that accompany retirement, chief among them the costs of healthcare and long-term care, and, of course, how long the retiree lives.
And the defined contribution plan, with its large pot of money awaiting drawdown upon retirement, might be an imperfect vehicle for confidently funding a retirement given all those uncertainties. But the promise of lifetime income carries obvious risks for insurers, whose actuaries make the grim calculation of “longevity risk.”
“You have to worry about getting unlucky and living to 100,” as Nobel Prize-winning economist Richard Thaler put it at the Brookings conference.
But the pooled model, which ideally would include participation from a broad spectrum of companies of various industries and sizes, would go a long way toward appeasing the actuaries, MacDonald argues.
“The purpose of a pension plan is to enable workers to pool their money together and protect those who live to advanced ages,” she says. “The risk of not knowing how long you will live becomes a lot less risky with a big enough group because the law of large numbers tells the actuary what to expect each year, allowing him or her to calculate the highest ‘safe’ pension income for everyone.”
John envisions a model that would include the flexibility for employees to transition out of the DC pension plan if, say, they changed jobs or some emergency arose that changed their retirement calculus. But he stressed that for those plans to be effective, it would require broad participation among multiple employers.
“The fund would hopefully include many different companies,” John said. “This is not the matter of the XYZ corporation-managed payout fund — this is a large, pooled fund ... that represents the retirement savings of hopefully hundreds and thousands of people all at once.”