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How to avoid running out of money in retirement: Final in a series

December 17th, 2014 No comments

McCune-JanetEarlier, we described three things 401(k) plan sponsors can do to help participants avoid running out of money in retirement. Offering managed risk equity funds as investment options, and incorporating them into the asset allocation glide path for the plan’s auto-investing tools, addresses two of three fundamental risks for retirement income: market risk and inflation risk. By continuing to service retirees as ongoing participants in the plan, the plan sponsor helps retirees maintain continuity between their pre-retirement and post-retirement investment strategies with lower, institutional investment expenses. But we haven’t addressed the issue of longevity risk—how can participants know how long their retirement savings have to last?

One powerful solution is to use a deferred annuity contract, which transfers longevity risk to an insurance company by starting payouts to the policyholder at an advanced age. On July 1, 2014, final Treasury regulations were issued regarding “qualified longevity annuity contracts” (QLACs) held within qualified defined contribution plans, i.e., 401(k) plans, 403(b) plans, IRAs. The regulations provide an exception to the required minimum distribution (RMD) rules of Internal Revenue Code section 401(a)(9), which require certain distributions to be made from qualified plans starting at age 70½. Without this exception, a deferred income annuity could cause the plan to violate the RMD rules, because the annuity does not begin payments until much later (usually age 80 but at least 85). The regulations state that a QLAC is not subject to RMDs until payments begin under the terms of the annuity, thus expanding retirement income options as an increasing number of Americans reach retirement age.

A QLAC can be purchased with up to 25% (maximum $125,000) of the account balance. If a participant at age 65 were to use 18% to 20% of their portfolio to purchase a QLAC that commences benefit payments at age 80, the remaining 401(k) account need only provide retirement income for 15 years, when the annuity payments would begin. Removing the uncertainty around how long the 401(k) account needs to last allows for a significant increase in retirement income. By adding a QLAC and applying the investment strategies suggested earlier in this series, we have achieved significant improvement in the sustainable withdrawal rate for the participant, while maintaining an equal probability of success!

In order to maintain simplicity and portability of the 401(k) plan, as well as to minimize fiduciary exposure for the plan sponsor, the best practice may be to encourage participants to hold the QLAC within an IRA. The participant may initiate a rollover distribution from the 401(k) to an IRA in order to pay the premium. The retiree takes installment payments from the 401(k) from age 65 to 80, then the annuity benefits provide retirement income from age 80 until death.1

This is Step 4 in helping 401(k) participants create sustainable retirement income from their 401(k) accounts (see the first three steps here). Undoubtedly, creative strategies will continue to emerge as the industry tackles this issue.


1This statement is not a recommendation to buy investment or insurance products. An individual should consult their personal adviser to determine the suitability of any investment or insurance product.

How to avoid running out of money in retirement: Third of a series

December 3rd, 2014 No comments

McCune-JanetA 401(k) plan sponsor or a financial advisor who has been following our blog series, understands these best practices: 1) offering managed risk equities within the investment fund options, and 2) providing a lifelong asset allocation tool with explicit, age-appropriate risk management. In addition, the plan sponsor as fiduciary must monitor fund performance and expenses on behalf of the participants. With all of this in place, why would you encourage retirees to exit the 401(k) plan right when they need these services the most? Isn’t the point of all of this to provide a sustainable income stream for participants embarking on their retirement journey?

As a third best practice, we would suggest that plan sponsors include an installment payment provision in their plan documents that allows retirees to use their account balance as a source of retirement income. Generally, participants are encouraged to roll their account balances into retail IRAs, or perhaps to purchase some form of annuity to guarantee a minimum income level needed to support their living expenses. However, the employer sponsored retirement plan offers significant benefits some other options cannot. First, it provides a seamless approach for their preretirement and postretirement investment strategy. The retiree continues to access a familiar website and call center and there are no new, complex insurance contracts to understand or purchase. The retiree retains flexibility and the control of his or her own assets, and does so with institutional investment expenses, which are generally lower. Finally, the entire account balance passes to the designated beneficiary upon the death of the retiree.

This solution offers benefits to the plan sponsor as well. Additional assets remaining in the plan provide economies of scale for investment and administration costs, and any additional costs may be borne by the retiree accounts. And, in a way, this feature facilitates an experience similar to defined benefit (DB) retirees, which may be especially meaningful when a plan sponsor freezes and/or terminates a pension plan in favor of an enhanced 401(k) or defined contribution (DC) program.

We cannot forget about the 401(k) providers, like the recordkeeper and the investment advisor. Servicing retirees through the plan can be a win for them as well, since the relationship with the participants continues, as do the economies of scale that keep plan expenses down. This opens the opportunity to expand the services specifically aimed at retirees, such as:

• Targeted education and communications focused on retiree needs
• Direct interaction with retirees for change of name, address, benefit amount, and status
• Expanded website tools and call center services to provide broader services
• Assistance with projections of sustainable withdrawal rates and probability of success
• Final account settlement services upon the passing of the retiree

Offering an installment payment provision in the 401(k) plan and continuing to fully service the retirees through the plan offers a win-win-win solution for participants, plan sponsors, and providers. That is Step 3 for a winning retirement solution.

How to avoid running out of money in retirement: Second of a series

November 24th, 2014 No comments

McCune-JanetOur first blog focused on the need to address the fundamental risks to sustainable income during retirement: market risk, inflation risk, and longevity risk. We identified “managed risk equities,” such as those offered by Milliman Financial Risk Management, LLC, as an important tool for managing those risks.

Plan sponsors seeking to provide a retirement income solution in their 401(k) plans are well advised to include managed risk equity funds in the 401(k) investment fund lineup. Because participants may need help with the investment decisions in their personal accounts, it’s wise to take it a step further and incorporate these funds into the plan’s automatic investing features. For example, Milliman offers a portfolio service called InvestMap that creates an asset allocation glide path for each participant, based on each one’s current age. Using the underlying core funds offered in the 401(k) plan, InvestMap adjusts the allocation each year on the participant’s birthday, and automatically rebalances to that allocation each quarter. Rather than selecting a “model,” participants elect to be enrolled in InvestMap, and their entire account balances are then invested according to the glide path. InvestMap is easy to understand, it meets the Qualified Default Investment Alternative (QDIA) requirements, and is easily integrated into the plan’s investment policy statement. In addition, it takes advantage of the best-in-class managers and funds selected by the plan sponsor and the advisor, particularly with regard to monitoring performance and transparency of fees. InvestMap is an ideal vehicle for delivering explicitly integrated, age-appropriate risk management for the individual participant.

Other recordkeepers and advisors offer similar solutions, and some provide custom model portfolios or proprietary collective funds, most of which include appropriate asset allocations for young investors, investors nearing retirement, and everyone in between. Any of these “do it for me” tools can be helpful in delivering professional help to participants. What is important is that the glide path continues to adjust for the participant, even in retirement, and includes larger allocations to managed risk equities, rather than to cash or bonds, as the time horizon shrinks. As discussed earlier, this may reduce the volatility and improve the risk-adjusted return of the portfolio. The desired outcome is an increase in sustainable retirement income.

For many years, recordkeepers and advisors have tried to educate participants into becoming good investors – with varying levels of success. A better approach would be to create good investors by providing the right tools. An automatic investment alternative, which provides a lifelong asset allocation strategy and incorporates managed risk equities at increasing amounts over time, may be the most effective way for participants to be good investors and become successful retirees in a 401(k) plan. That is Step 2.

How to avoid running out of money in retirement: First of a series

November 18th, 2014 No comments

McCune-JanetThe Schwab IMPACT 2014 conference, held this month in Denver, Colorado, was attended by independent financial advisors from around the country. Much discussion centered on how to help clients achieve financial security during their retirement years. So how can potential retirees protect themselves from the volatile markets that can quickly erode a lifetime of savings? Milliman presented some new ideas for achieving sustainable retirement income for 401(k) participants, and with applications far beyond.

First, a strategy should address the risks. We believe the key to success centers around the effective management of three fundamental risks: market risk, inflation risk, and longevity risk. Downturns in the market can erode a portfolio, and the timing of those downturns can make a significant difference. Market declines early in retirement can combine with portfolio withdrawals in a toxic way, because money withdrawn is not available to rebound when the market recovers. Conventional wisdom tries to alleviate the volatility by diversifying into bonds, but bonds generally have limited inflation protection, and the portfolio can experience a loss of purchasing power over time. Retirees must withdraw less during the early years of their retirement in order to “pre-fund” the damaging effects of inflation in the future.

Milliman Financial Risk Management, LLC offers a financial risk management strategy that seeks to reduce downside equity exposure during volatile bear markets, while minimizing drag during stable rising markets. The compelling track record of this pioneering technique for some of the world’s largest financial institutions has set the stage for application to personal retirement accounts. Available in the form of mutual funds, collective funds, and separate accounts, this simple, transparent futures-based risk management approach provides volatility management with a capital protection strategy. Any of these products are suitable fund selections for a company’s 401(k) plan.

Generally, managed-risk equities are a more effective tool to control market and inflation risk relative to bonds. We are not suggesting moving completely out of bonds or shifting all assets into managed-risk equities, but rather an incremental change that develops over time. For example, diverting 50% to 75% of the equity allocation into a managed-risk strategy, instead of increasing the bond allocation as the time horizon shrinks, can significantly improve the Sharpe ratio (the amount of return per unit of risk) for a retiree’s account. The result is an increase in the amount of retirement income that can reliably be withdrawn from the account over the life of the participant.

Including managed-risk equities as fund selection in a company’s 401(k) plan delivers professional risk management techniques previously available only to large financial institutions to the individual 401(k) plan participant. This is Step 1.

What to look ahead for in pension risk management

May 1st, 2014 No comments

Defined benefit plan sponsors are concerned about contribution and funded status volatility. Some recent pension risk management strategies have focused on liability-driven investing (LDI) and lump-sum distributions. In this article, Milliman consultants Tim Connor, Scott Preppernau, and Zorast Wadia discuss in general terms methods that plan sponsors may implement to de-risk their pensions moving forward.

Here is an excerpt:

We suspect that 2014 will see a continued trend of sponsors looking to de-risk their plans through the various methods mentioned above. In addition, we believe sponsors will investigate the benefits of a hybrid plan design such as the variable annuity plan for the reasons mentioned above.

Another trend likely to continue is the implementation of lump-sum windows or permanently increased lump-sum thresholds. These strategies have found favor with many plan sponsors, particularly in response to recent increases in Pension Benefit Guaranty Corporation (PBGC) premiums. Because PBGC premiums include a per-participant charge, and because that charge has increased substantially in recent years, sponsors will no doubt continue to take a hard look at the idea of offering lump sums if it translates into fewer participants for whom they must pay those premiums. In addition, the rates utilized to pay out lump sums have been fully phased in for a few years now, from the previous basis of 30-year Treasury rates. That old basis resulted in a period of time where lump sums were seen as costly to sponsors. That is no longer the case. On a U.S. GAAP accounting basis, plans are valuing liability at rates that are close to the rates that are now utilized to pay lump sums. In other words, there is no longer much of an accounting gain or loss to a plan that pays out a lump sum. Yet, it does accomplish de-risking by transferring management of the pension to the participant.

On the investment side, we also expect sponsors to explore some nontraditional de-risking solutions. Not all sponsors share the belief that leaving the space of equity investments makes sense in the long term. Some feel they can’t afford not to be seeking returns in the market. For them, a tail risk hedging investment strategy can be an attractive de-risking solution. A typical strategy allows for upside through equity investments, while at the same time mitigating downside losses that occur in volatile, declining markets. The concept of hedging tail risk is quite familiar to the insurance industry, which utilizes such strategies to manage its own risk in guaranteeing certain products, such as variable annuities. It makes natural sense for defined benefit plan sponsors to incorporate the approach to de-risk their own pension promises.

Read Grant Camp and Kelly Coffing’s article Making the case for variable annuity pension plans (VAPPs) to learn more about the variable annuity pension plan design. Also, for more Milliman perspective on lump-sum distributions, click here.

The risk tolerance paradox

January 24th, 2014 No comments

The risk tolerance level many investors expect to achieve over the long term rarely equals the same tolerance investors actually experience over shorter periods. This paper by Ken Mungan and Matt Kaufman describes this paradox, explores the main reason it might exist, and introduces a risk management strategy that seeks to solve the problem.

As more “low volatility” and portfolio risk management strategies hit the marketplace, it will be imperative that advisors and investors explore each strategy to uncover how risk is actually being addressed. Identifying those techniques that address both diversifiable and systematic risk is likely to provide better overall results for investors.

Strategies for reducing retirement plan risk in defined benefit plans

April 1st, 2013 No comments

This blog summarizes a presentation given by Steve Hastings and Mahrukh Mavalvala at the Mid-Sized Retirement & Healthcare Plan Management Conference in San Francisco.

The 21st century has been rough on defined benefit (DB) plans. The days in the ’80s and ’90s of pension plan “contribution holidays” have ceded to the current era of low interest rates and high market volatility, and plan sponsors face many risk factors. The types of risk inherent in defined benefit pension plans—interest, inflation, investment, longevity, and legislative risk—impact DB plans in complex ways, which may not end even if an employer has frozen its DB plan. So what is a DB plan sponsor to do? One answer is to work with its plan consultant to gain a deeper understanding of the issues at hand and the strategies available to alleviate the pain points.

Risk management strategies include both in-plan options (such as plan design changes, investment strategies, and annuity options), as well as settlement strategies (irrevocable actions that relieve the plan of benefit obligations). Plan design modifications, including hybrid and cash balance plans, can reduce longevity risk by reducing pension liabilities, and may transfer some investment risk to participants. Switching to a defined contribution (DC) plan may be another strategy, with the option of maintaining the DB plan as a longevity plan to provide annuity income at later ages. However, changing the plan design is a substantial undertaking that may include special ERISA compliance efforts and communicating what may be an unpopular decision to participants. In some cases, participants have filed lawsuits in response to plan design changes and settlement strategies.

Liability-driven investing (LDI) and tail risk management strategies have grown in popularity as in-plan strategies to manage risk via the plan’s investment policy. However, LDI strategies must balance reductions in volatility with hedging interest rate exposure and meeting asset return objectives—not always easily achieved. Tail risk management strategies, such as the Milliman Managed Risk Strategy™, can protect against debilitating investment losses over a short period of time.

Settlement strategies are another option for pension plan sponsors looking to reduce risk. One strategy is offering participants a one-time, irrevocable option to receive the present value amount of their benefit as a lump sum. Another strategy is purchasing an annuity contract where the insurer will provide the remaining annuity payments; in purchasing such contracts, the plan sponsor has a fiduciary obligation to select a financially strong, solvent insurer. Without plan termination, settlement strategies are only available to cover terminated and retired participants (and their beneficiaries). Ford recently implemented a single lump sum settlement strategy. GM recently terminated a frozen plan and purchased annuities to cover some of the pension liabilities. Verizon also recently purchased annuities for a block of retirees. In light of these and other events, this is an excellent time to reevaluate pension plan risk and risk mitigation strategies with your plan consultants.

Variable annuities see a resurgence in popularity

August 8th, 2012 No comments

This article in The Wall Street Journal (subscription required) takes a look at how life insurers have restructured variable annuities in recent years. Here is an excerpt from the story:

In a trend gathering momentum, the life insurers that sell these tax-advantaged vehicles for investing in funds are competing on the basis of investment choices. That’s what they did in the 1980s and 1990s, before launching an arms race of escalating promises of guaranteed-minimum lifetime income, even if underlying funds tanked.

That competition cost the industry dearly when markets slid in 2008 and early 2009, leading to price increases and less-generous features as insurers sought to repair their balance sheets. With the new offerings, insurers are drawing on the past but adding a twist: They are pitching variable annuities as a smart way to load up on alternative investments.

While many insurers did see losses in 2008 and 2009, those with sufficient hedging in place fared better. Milliman research indicates that hedging strategies saved insurers $40 billion in September and October of 2008.

The Milliman Managed Risk Strategy offers similar risk management techniques to pensions through hedging strategies that seek to maximize clients’ asset growth in bull markets while defending against losses in down markets.

For Milliman’s insight into the variable annuity industry, click here.

Managing risk in the face of uncontrollable situations

April 20th, 2010 No comments

A new article in Financier Worldwide looks at risk management in the financial services industry:

In the lead up to the credit crunch, [financial institutions] were generally guilty of overestimating the upside and underestimating the downsides of a given opportunity. “When recent experience of risk-taking is positive and when the rewards are perceived as high, this is an intoxicating mixture that can lead to unwise exuberance,” says Neil Cantle, a principal and consulting actuary at Milliman. “All too often, people think that they are controlling a situation which they really have not taken the time to understand properly. When trouble hits, it can unravel very quickly and the critical ‘point of no return’ is passed. The problem in complex situations is that time-lags in information flows and action-taking can make it exceptionally difficult to know where that critical limit is – and once you have passed it, then that’s it.” Firms that can interpret complex scenarios and predict their consequences more accurately have a much better chance of reducing risk where possible, and responding effectively to risks that do become a reality.

Read the full article here.

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Beyond caveat emptor for risk managers

April 1st, 2010 No comments

According to a recent article in the Wall Street Journal:

As companies assess the lessons of the global financial crisis and look for ways to safeguard their firms against the effects of another one, demand has surged for risk managers—professionals who analyze the risk in transactions, from investments in treasury bills to credit default swaps, and make recommendations about whether to move forward.

Who will guard these modern guardians of our financial health and well-being, or at least certify that they’re up to the task?

That question is apparently driving a burgeoning movement toward certification for risk managers, owing in large part to the complexity and sophistication of the financial environment. Think “global financial crisis.”

More from the WSJ:

With the profession in the spotlight, several industry organizations are vying to provide a standard certification for the field, which the U.S. Bureau of Labor Statistics predicts will grow in the next several years, in part due to the increasing complexity of financial transactions.

While no certification is required to practice risk management—and many companies don’t require one—there has been a jump in the number of people signing up for certification exams.

Certification not only serves clients—by assuring that their risk managers know their stuff—but also risk managers. It introduces a timely process for keeping up with the changes, and challenges, of the profession.

Certification is not new to the profession, as the article points out. But it’s becoming more relevant given the need to distinguish oneself in the marketplace and, perhaps more important, because of increased legislative, administrative, and media scrutiny of the profession.

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