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Posts Tagged ‘401(k)’

Putting a stop to retirement plan leakage

March 3rd, 2015 No comments

Moen-AlexThe Center for Retirement Research at Boston College recently published a study that found in-service withdrawals (partial withdrawals and hardships) and cash-outs were the main reasons for leakage from 401(k) plans and IRAs. Leakage refers to the erosion of assets in retirement accounts—approximately 1.5% of retirement plan assets “leak” out every year. This can potentially lead to a reduction in total retirement assets of 20% to 25% over an employee’s working years. The phenomenon is the result of the gradual change in retirement funding vehicles over time from predominantly defined benefit plans to defined contribution plans and, in recent years, IRAs.

The impact of this 1.5% leakage is easier to grasp when the total dollar amount involved is known. The Investment Company Institute’s quarterly reports show the following numbers. Consider the total assets affected and the significance of that annual number.

U.S. assets in retirement plans

401(k) plans have three main sources of leakage:

In-service withdrawals: In-service encompasses one of two options: a hardship withdrawal or a withdrawal at age 59½. Hardships can be taken based on proof of an immediate financial need, but they are subject to an early 10% tax penalty (if applicable) on top of the required 20% federal tax and they force a participant to cease deferrals for six months. Hardships also require participants to use up their loan resources first. By the time a participant is eligible for a hardship, the account has been severely depleted. In-service withdrawals allow an active employee who has reached the age of 59½ to remove funds from the account without the 10% penalty. These age 59½ withdrawals are on the rise and the leakage arises when the funds are not rolled over. It is estimated that only about 70% are, in fact, rolled into an IRA.

Loans: Approximately 90% of actively working individuals enrolled in a retirement plan have access to some type of loan. While loans get a bad rap, they are not the leading offender in terms of leakage, but there is still some asset loss. If loans are repaid in a timely manner, the withdrawal is not taxed, but the employee no longer has the ability for gains on those assets during the repayment period. And while the participant has an obligation to repay, that does not always happen. When the loan has defaulted, it is deemed a distribution and is then subject to tax withholding.

Cash-outs: Cash-outs are the act of automatically paying out terminated participants below a certain threshold; for balances of $1,000 or less, checks are cut, whereas balances between $1,000 and $5,000 require a rollover to an IRA. And while plan sponsors do have a say in the dollar threshold and the timetable for cash-outs, virtually every 401(k) plan has this rule.

Looking at defined contribution plans only, withdrawal activity has increased slightly over the last three years, while hardships have remained steady. These numbers may seem small, but they do not include IRAs, which are considerably harder to track. And because IRAs lack the same rules as defined contribution plans, estimates suggest the percentages are much higher.

Source: Investment Company Institute

Source: Investment Company Institute

The Federal Reserve’s 2013 Survey of Consumer Finance presented some scary results—workers between the ages of 55 and 64 had average assets of only $111,000. What’s more, assets in IRAs have surpassed assets in defined contribution plans. Looking at the numbers above for third quarter 2013 and 2014, IRAs consistently have 2.5% more in assets than defined contribution plans. IRAs can be risky for long-term retirement funding, if not used correctly, which is due to the lower levels of regulations and the lack of education and promotion to “keep assets in.” A recent Department of Labor report expands on this concern that rolling funds to IRAs puts the worker at the mercy of the investment advisor and asks whether all investment advisors take their fiduciary duties seriously or not. The report discusses what they call “conflicting advice” and estimates the leakage due to this is as high as 12% of an account balance.

There is hope. Some proposals that have been suggested include:

• Raise the age requirement for early withdrawal from 59½ to 62 to match the earliest Social Security retirement age
• Limit balances for in-service withdrawals to only employee contributions
• Tighten hardship rules even more and only allow hardships in case of “unpredictable events,” for both 401(k) plans and IRAs
• Remove cash-outs altogether (this will mostly likely be met with resistance from plan sponsors because small balances can be expensive and burdensome to administer)

Plan sponsors can make many of these adjustments to their individual plans, but these proposals are working to ensure that the goal of preparing workers for retirement stays in sight.

New Year’s resolutions for retirement plan sponsors

January 8th, 2015 No comments

For many, a new year usually means a fresh start. With that thought in mind, Milliman’s Jinnie Olson provides 401(k) plan sponsors 10 ideas that can help them administer their plans more effectively in 2015. Below are her 10 ideas.

1. Create administrative procedures and internal controls—and follow them.
2. Make sure changes to your operating procedures are well documented.
3. Audit your data.
4. Transmit contributions in a timely manner.
5. Establish a retirement committee.
6. Understand plan fees.
7. Audit your service providers.
8. Conduct an annual plan review.
9. Establish success measures.
10. Establish a strategy for the upcoming year.

Read Jinnie’s article “Top 10 New Year’s resolutions for plan sponsors of retirement plans” for more perspective.

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.

Retirement plan leakage and retirement readiness

September 10th, 2014 No comments

Tedesco-KaraThe title alone proves opposites don’t always attract. “Leakage” means outflow and outflows in retirement plans are not easily controlled. Worse yet, the impact on a participant’s retirement readiness is a big problem. Where money goes once it leaves a retirement plan is a question with many answers, some of which lead to plan sponsors feeling concerned about plan design and the choices available to participants.

In defined contribution (DC) plans such as the 401(k), participants defer money from their paychecks into the plan. The employer may make matching or other employer contributions. Most 401(k) plans are designed to allow participants to access these deferrals, as well as their other vested monies, while actively working. This access occurs through loans, hardship withdrawals, and other in-service distributions. When participants take a loan, they pay themselves back over time. In some instances, however, a participant defaults on the loan, which automatically reduces the account balance. In the case of in-service distributions, once the money is paid to the participant, it does not come back into the plan, similarly reducing the participant account balance.

Of greater concern may be the preretirement withdrawal of an account balance upon termination of employment. Participants terminate employment for a myriad of reasons, such as to start a new career path. In a defined benefit (DB) plan, it is not uncommon to see a lump-sum window option offered to participants. Plan sponsors benefit from participants choosing the lump-sum window option just as they do when terminated participants take their money from 401(k) plans. The plan sponsor’s administrative costs associated with either type of plan are reduced.

The problem? Participant account balances that are cashed out and not rolled over to an IRA or another qualified retirement plan are subject to immediate income tax and potentially burdensome tax penalties, depending upon their age. But many participants don’t know what to do with the money and will often use it right away to satisfy an immediate financial need rather than save it for retirement. An even greater, more glaring problem is that the participant’s total projected retirement savings has been compromised. Does this mean that a participant will not achieve the suggested 70% to 80% income replacement rate? Most likely, the answer is yes, especially if the participant has no other savings outside the former retirement plan.

There is no clear answer to the leakage problem in plans. A good retirement plan design can greatly influence the behavior of its participants. It has to include and encourage regular employer and employee contributions to help build retirement accounts. Withdrawal provisions and loans in plans don’t signify poor plan design, but tighter administrative controls around the plan provisions, such as allowing only one in-service withdrawal per year, helps keep money in the plan. In addition, increased participant education has to remain a focus for employers, with a special emphasis on the benefits of taking a rollover instead of a lump-sum cash distribution.

What steps can Millennials take to enhance their retirement security?

June 25th, 2014 No comments

The millennial generation has developed a reputation for not placing an emphasis on retirement, preferring to live for the moment. In the most recent issue of Benefits Quarterly, Milliman’s Jinnie Olson discusses several actions Millennials should consider to help them accumulate retirement savings. Here is an excerpt:

Taking retirement mobile
Millennials’ lives are fast-paced, hopping from an early morning yoga workout to nine hours of work, straight to a book club meeting, down the street to a softball doubleheader and then on to a late-night fraternity reunion happy hour. Retirement accounts are finally catching up with our mobile world. Recordkeepers and administrators have started to create mobile apps for smartphones and tablets to help keep up with busy lifestyles. For some, choosing to defer or increasing your deferrals is as easy as one quick touch of the screen or scanning a quick response (QR) code. When you have time to play with apps that shoot cartoon birds dressed like Darth Vader across the sky, then the excuse “I just don’t have time to save for retirement” simply won’t fly anymore.

Let your interest compound
You hear over and over again that the longer your contributions are invested in a retirement plan, the more time they’ll have to take advantage of compounding interest. But what does that really mean? Let’s look at three different savings approaches. For purposes of this example, let’s assume I make $30,000 every year until I retire:

• Strategy 1: I decide to save 6% of my compensation, or $1,800, in a jar every year from the ages of 25 to 65.
• Strategy 2: I don’t want all of the space in my basement taken up by jars and instead enroll in my company’s 401(k) plan, contributing 6% from the ages of 25 to 45. I receive 5% interest compounded annually.
• Strategy 3: I want a new car and can’t afford to contribute now. Twenty years later, I turn 45 and realize retirement is right around the corner and decide to contribute 6% until the age of 65. I receive 5% interest compounded annually.

Which strategy will result in higher retirement savings at the age of 65?

My initial investment ($36,000) is the same in each strategy. While Strategy 1 will guarantee my contributions will not suffer any market gains or losses, it may not be the most secure retirement savings strategy. Strategy 2 more than doubles my final account balance when compared with Strategy 3 just by giving my money an extra 20 years in the market to accumulate that compounded interest. (See the figure)

Compounding interest

To read the entire article, click here.

Reproduced from the Second Quarter issue of Benefits Quarterly, published by the International Society of Certified Employee Benefits Specialists.

Guidance issued on in-plan Roth rollovers to designated Roth accounts

January 13th, 2014 No comments

The Internal Revenue Service (IRS) has issued Notice 2013-74, providing guidance on the expanded types of amounts eligible for in-plan Roth rollovers within 401(k), 403(b), or 457(b) governmental retirement plans. These amounts, which became eligible for in-plan Roth rollover treatment in 2013 under the 2012 American Taxpayer Relief Act, include sums that are otherwise not distributable to participants under the terms of the plan, such as elective deferrals, matching contributions and nonelective contributions, and annual deferrals made to 457(b) governmental plans.

The IRS’s new guidance also includes deadlines for adopting plan amendments to provide for these in-plan Roth rollovers of such otherwise nondistributable amounts, as well as rules applicable to all in-plan Roth rollovers.

For more perspective on this new guidance, read this Client Action Bulletin.

Judging tax implications of Roth 401(k) contributions

October 29th, 2013 No comments

Guanella-Jay-EContributing to a retirement plan is widely considered a no-brainer if the goal is to attain a meaningful retirement. But the decision on how to invest contributions within the plan can be daunting. Determining what type of contributions to make further complicates things. While tax-deferred contributions reduce taxable income in the year in which they are made, the taxes owed on those contributions as well as the investment earnings are deferred until a later time, possibly at retirement. Roth contributions don’t reduce current taxable income, but the tradeoff is no tax liability on the investment earnings when a distribution is taken (provided the individual is at least age 59½ and has held the account for at least five years).

The decision to contribute to a Roth 401(k) instead of deferring at a tax-deferred level is often based on an anticipation of changes to future tax rates. While this is a personal decision based on future income, several other factors should also be considered. The truth behind the decision is similar to other choices in life, more complicated than we’d like it. For example, the reduction in tax-deferred income can affect tax liability, possibly increasing refunds. If tax-deferred contributions increase a tax refund, how can the “newly found” money be taken advantage of? Depending on a person’s filing status, different advantages or disadvantages may exist.

None of us are fortune-tellers. It’s difficult to predict future income or tax brackets over a period of several years. It becomes even more complex when trying to anticipate things that are out of anyone’s control, such as politicians altering tax rates to address policy changes and deficits. Recent history underscores this fact with significant changes occurring at the top rate, ranging from 50% in 1982 to 38.5% in 1987, 28% in 1988, 31% in 1991, 39.6% in 1993, 35% in 2003, and settling at back at 39.6% starting in 2013 (with rates exceeding 90% at certain points in the last century). Accordingly, depending on when money is taken out of a retirement plan, the tax results can dramatically change over a period of years.

A diversified investment strategy has long been considered a way to optimize investment returns over time while reducing risk. A diversified tax strategy may be equally important. By utilizing tax-deferred and Roth savings options, tax liabilities may be mitigated, ultimately creating more flexibility to reduce individual tax burdens.