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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?

A long hot summer for 401(k) loans

September 16th, 2013 No comments

Anderson-ChaseAs the weather heated up this summer, so too did the discussion on participant loans from defined contribution (DC) plans. At least a handful of financial news sites have published pieces critical of participant loans.

With information often comes misinformation and, accordingly, some clearing up is in order. Here are a few recently heard statements—in both pro-loan and anti-loan flavors, culled from participants and analysts alike—and the facts behind them.

“Since I’m borrowing from myself and paying interest to myself, taking a plan loan is actually good for my 401(k).”

Generally false. It is definitely true that, in and of itself, paying interest to yourself is better than paying it to another entity, such as a bank. Fees associated with plan loans also are often lower than those at commercial lending institutions (although those fees vary widely).

Other than the loan fee, the loan cost is the loss of the earnings of those funds if they had remained invested in the plan during the time of repayment. If by chance the market declines while the loan balance is out of the plan, the participant would have been fortunate to have taken a loan at that time. However, the reason participants choose to invest in the first place is that, on average, earnings are positive. Chances are, therefore, that the account will miss out on additional earnings during the time those funds are out as a loan rather than invested.

“Aren’t my loan payments double-taxed? The payments are taxed—and then I get taxed again when I cash out the account.”

Mostly false. This persistent (and sensible sounding) myth asserts that the participant makes loan payments with after-tax money, and the funds are taxed again upon eventual distribution. That assertion overlooks the fact that the loan funds were not taxed when disbursed. The net effect, therefore, is that “it all evens out”: with single taxation each on the funds received via loan disbursement, and on the tax-deferred contributions upon distribution of them. The interest payments, however, are double-taxed—unless distributed tax-free from a Roth account—because, unlike the loan proceeds, the participant never received the interest portion tax-free.

“You should take any other credit available to you before taking a 401(k) loan.”

Probably false, because there are a lot worse ways participants can borrow. When plan loans are offered, they must be at commercially reasonable rates of interest, and they must be the same for all plan participants. For participants without many options, therefore, plan loans might be the only accessible route to decent credit. Payday loans, credit cards, and high-interest personal loans, for example, all may be far more dangerous to long-term financial security than plan loans.

“Plans should get rid of loans, since they prevent participants from amassing retirement savings.”

Not necessarily. Plan sponsors should consider more than whether, all else being equal, participants will have less in their retirement accounts if they take a couple plan loans over the course of employment. While the answer to that is almost certainly yes, in reality all else is rarely equal. Participants may turn to withdrawals if loans are not available. Many may be more reluctant to participate at all—or may make very conservative estimates on how much they can afford to save—if they know the funds are firmly off-limits until termination or attainment of a certain age. The fear of saving in the first place may impact retirement readiness just as easily as tapping into what’s already there.

Sponsors (in collaboration with their consultants or service providers) should consider turning first to participant education and certain loan conditions that may make sense for their participant groups, before making hasty decisions to end or curtail their loan programs.

Don’t assume you are average!

September 11th, 2013 No comments

Haynes,-Roscoe_mugShotThe U.S. Department of Labor is considering issuing rules requiring plan sponsors to illustrate retirement income projections for participants in 401(k) plans. Many plan sponsors are beginning to provide retirement income projections, and financial planning websites with projections are cropping up. While the goal is admirable, some of these projections may provide a false sense of security.

Defined contribution (DC) plans place a significant level of personal responsibility on individual participants. These plans expose participants to significant risk in regard to a number of issues. One of these risks is longevity. Although the average life expectancy at retirement is approximately age 85, a significant percentage of current employees can be expected to survive until age 90, 95, or even 100. Should they determine after retirement that their survival past age 85 is likely or certain, most of these individuals will not be able physically or mentally to return to the workforce.

When discussing retirement readiness, it is not unusual to hear that a life expectancy of age 85 is assumed, because this is approximately the “average” life expectancy. This is a serious flaw. This approach leads to a false sense of security among participants who perceive that they are expected to have income until age 85 at a level they deem to be sufficient. To the contrary, they actually have a probability of approximately 50% that they will find themselves alive but without sufficient income after age 85. As they approach age 85, they and their families are likely to experience anxiety and concern over their deteriorating financial position. The goal of ERISA is to provide retirement income security; this approach leads to retirement income insecurity.

For married people the risk of underestimating the likelihood of surviving past age 85 is even greater. The probability of at least one partner in a marriage living many years past age 85 is very high. Ascribing adequacy to an income stream ending at age 85 for a married couple will be a serious impediment to the goal of providing for their retirement income security.

More and more people are living to very old ages, many to 100 and beyond. But not everyone will live that long; anyone who reads the obituaries will note that many survive only a few years after retirement. There is no easy answer to the question of “how much do I need to retire?” However, those who retire with enough to survive for an average life expectancy will face an above-average level of anxiety. Setting a 401(k) goal of having enough to last at least until an age in the late 90s will go a long way toward encouraging realistic retirement income expectations.