Archive

Posts Tagged ‘401(k)’

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.

Crafting a well-considered loan policy

September 24th, 2013 No comments

Anderson-ChaseOver the past few months, several articles have weighed in on participant loans from defined contribution (DC) plans, nearly all with the same refrain: loans are bad. Some go a bit further: loans must be stopped. One piece, for example, opined that 401(k) loans “should not be allowed in any retirement plan other than for hardship reasons,” calling plan loans “the worst investment anyone could possibly make.”

Ultimately, for plan sponsors looking to help participants adequately prepare for retirement, one primary task is to craft plans that work best for each one’s workforce. Revisiting loan policies in pursuit of those goals—but with sufficient flexibility to encourage maximum participation in the first place—is a good way to start.

The IRS restricts loan amounts to no more than 50% of account balances (generally); repayment to up to five years (except for purchase of a primary residence); and the total borrowed over the past 12 months to a maximum of $50,000 (always). It also allows use of the funds for any purpose.

In addition to those required limits, a sponsor may craft a better-tailored loan policy for its workforce by considering:

• How much (and how often) its participants are borrowing
• Participants’ reasons for loans (if known, officially or anecdotally)
• Deferral rates and account balances
• Relative financial sophistication of plan participants
• Participant input and any other relevant factors

Here are some loan policy terms a sponsor may wish to consider:

Lower limits: Cap loan amounts to less than 50% of vested account balances. A cap of 20% of the vested balance, for example, will help ensure that a participant keeps at least $4,000 invested for retirement for every $1,000 borrowed. (The “help ensure” bit refers to the fact that participants often will qualify for hardship or other withdrawals after taking loans. On that note, plans should consider steps to cut down on hardship withdrawals; a well-crafted loan policy may be just the ticket.)

Faster repayment terms: Limit loan repayment to one year, for example, rather than five years, with a primary residence exception. Requiring faster repayment may also help reduce the instances and severity of loan defaults, under which the outstanding balance is treated as a taxable distribution.

Minimum payments: Require that scheduled loan payments not fall below a specified percentage of compensation—1%, for example.

Waiting periods: Require that any participant who pays off a loan (whether on schedule or with a full payoff) wait a certain specified time—say, 90 days or even a full year—before taking a new loan, to help minimize “revolving-door” loans.

Allow more than one loan out at a time: Although counterintuitive to retirement saving, it may reduce a participant’s urge to take more than his or her immediate need. To minimize the negative impact on retirement savings, this option may be best incorporated with other limits above.

Another approach might allow a participant more than one loan at a time, but restrict the additional loans to loans satisfying special financial-hardship criteria—either as defined by the IRS safe-harbor eligibility for hardship-based withdrawals, or as differently defined by the plan’s document or loan policy.

By taking steps to tailor the plan’s loan policy rather than doing away with loans altogether, a sponsor can strike a good balance between encouraging retirement savings and allowing participants some financial flexibility when they need it.

Tips for promoting a defined contribution plan to employees

September 19th, 2013 No comments

Employers who actively promote and communicate their retirement plans can demonstrate its importance to employees. In Jinnie Olson’s new article, she provides 10 ideas that plan sponsors may use to help employees get the most from their defined contribution (DC) plans. Here is an excerpt:

Get your employees in the plan.
Allow employees to enter the plan on day one. New employees are excited about the new opportunity so get them enrolled from the very start. Hook them in while it’s fresh on their minds so they will be used to seeing the deduction in pay right from their first check. Delayed entry dates tend to lead to employee inertia.

Consider adding an automatic contribution arrangement.
The most effective way for plan sponsors to encourage participation in their retirement plans is through plan design. An automatic contribution arrangement (ACA), more commonly known as automatic enrollment, is a feature that can be added to existing 401(k), 403(b), 457, SIMPLE IRAs, and SARSEP plans. This arrangement allows the employer to automatically enroll a newly eligible participant unless the participant makes an affirmative election not to participate.

When the arrangement is adopted, the plan sponsor selects a default contribution percentage, which is automatically reduced from employee’s wages upon meeting the eligibility and entry requirements of the plan. Participants may “opt out” of this automatic contribution. Studies show most employees will leave their contribution rate at the plan default or even increase their elections. There are alternative methods of automatic contribution arrangements; refer to your plan consultant for more information.

Offer an employer-matching contribution.
Would you walk past a $100 bill on the sidewalk? Would you turn down a work bonus? Most would answer no to these questions. Retirement in this day and age is largely going to be self-funded; offering an employer-matching contribution is like offering your employees a bonus. If your employees take saving for their retirement seriously and contribute, you’ll add free money to their accounts. As an employee it’s next to impossible to turn that down. A recent Wells Fargo survey indicated that 85% of those with a 401(k) offering a company match contributed enough to receive the maximum match. Matching is an effective way to work hand in hand with employees to fund their retirement. If high turnover/low employee retention has deterred you from implementing a match in the past, why not implement a vesting schedule?