Over the last couple decades, defined benefit (DB) plans have in some cases been replaced by simpler employee-funded 401(k) plans. But the fact is, for many people, 401(k) plans won’t provide a sustainable retirement income. And what happens if you outlive your savings? That’s when a few smart actuaries at a forward-thinking company called Milliman came up with a really good idea. (There’s a very good white paper by Danny Quant, Zorast Wadia, and Daniel Theodore here.)
Enter the “longevity plan!”
A longevity plan is a proposed new kind of DB plan, intended to provide lifetime income for retirees who live beyond their assumed life expectancies. The benefit would be calculated based on pay and service, like a traditional DB plan, but it would only pay benefits to people who live past 75. Longevity plans would be much less expensive for employers than traditional DB plans for several reasons:
• There would be no subsidized early retirement benefits
• There would be limited death benefits
• Annuities would only be paid to the half of retirees who live beyond their life expectancies
• Benefits would be paid over a shorter remaining lifetime
For participants, a longevity plan would provide them peace of mind because they could not outlive their savings, which in turn could allow them to be more risk-tolerant in investing their 401(k) contributions. It would also allow them to better plan how to live on their savings because they would know the longevity plan safety net would kick in at age 75.
Administration would also be simplified. Fewer options would be available and no early retirement or death benefits would be calculated.
There are a few aspects of the proposed longevity plans that are not compliant under current rules (such as plan entry at age 45 and payments beginning after age 70½), but the concept is sound. It would provide a lifetime income when retirees need it most and it would be much less costly and volatile for employers.
Longevity plans could one day address some of the financial uncertainty associated with longer life spans. The concept is designed to offer retirees a supplemental defined benefit (DB) pension (i.e., a longevity plan) alongside their defined contribution (DC) plan.
This article in Retirement Income Journal (subscription required) highlights the Milliman paper “Longevity Plan,” explaining how such a plan may reduce longevity tail risk while providing retirees sustainable income past 80 years old. Here is an excerpt from the paper outlining the plan’s features:
In order for the DB plan to be viable in its role as a supplementary retirement vehicle, its structure will have to be different from that of the traditional DB plan with which many are already familiar. The DB plan that is being proposed here is essentially a longevity plan. Key features of the proposed longevity plan include:
• Unit-accrual pattern such as in a career-average plan or a plan based on flat dollars per years of service
• Simplistic retirement options: No ancillary death, disability, or early retirement benefits would be offered (other than perhaps a lump-sum death benefit between termination and the pension actually starting)
• Life annuity options only: A single-life option for single participants and 75% joint and survivor option for married participants
• Participants would not begin plan participation before age 45 (although this could be extended to age 50)
• Participants would not commence benefits earlier than age 75 (and this could be extended to age 80 or 85)
Presently, ERISA prohibits employers from postponing pension payouts later than age 65 generally. Bill Most and paper co-author Zorast Wadia were quoted by Retirement Income Journal discussing the rule.
Here’s an excerpt from the article:
This “unit-accrual design” is still just a concept, not a product. But the authors of the paper think the only thing that prevents it from widespread adoption is an outdated ERISA regulation against delaying pension payouts past age 65.
“Everyone’s talking about this and lots of new products has been proposed,” said Bill Most, a Milliman principal who worked on the paper with principals Zorast Wadia and Daniel Theodore and consulting actuary Danny Quant.
“But we don’t need new products, we need changes from government. And the results will hopefully give us something that employers might embrace. We’re not kidding ourselves. We don’t deny that there’s a lot of bad faith toward defined benefit plans. But from a cost perspective, this makes sense.”
…“They’ve relaxed certain rules related to required minimum distributions starting at age 70½, but they have not made changes in the terms of defined benefit plans,” said Zorast Wadia. “If you’re no longer working, you must begin payments from a defined benefit plan no later than age 65. If you’re still working past age 65, they won’t force you to take benefits. But ERISA won’t let the company purposely delay payments beyond 65 if you’re retired.”
For more perspective on longevity plans, click here.
Living to 100 years old is considered by many to be a record benchmark. But a recent article by Matthew Sparks in the Telegraph, “Pension firms preparing for customers to live to 125,” reminded us that, for insurers, the age of 100 is where things start to get interesting. That is because life expectancies have steadily increased over the past few decades and, projecting ahead, people living to over 100 years old will soon be the norm. After all, based on projected mortality table assumptions, the probability of a 65 year old living to at least age 90 is 38% while the probability of a 65 year old living to at least age 100 is 5%. Either of those probabilities coming to fruition could have some nontrivial financial implications for retirement plan sponsors and insurance companies. Insurers taking on the obligations of providing life annuities need to account for the possibility of people living well beyond their average life expectancies. In fact, it’s not uncommon for many pension models and retirement savings products to be valued under the assumption that its users could live to be up to 125 years old.
The increased longevity could of course turn out to be both a blessing and a curse for retirees. It’s a blessing if one is able to spend more time with one’s family while still being able to live comfortably and draw from one’s savings. On the other hand, not being able to afford necessary healthcare services or not having adequate retirement income could make longevity a living nightmare.
What has been observed so far is that living beyond one’s average life expectancy can be costly and problematic. What is needed is a way to address this longevity risk. One possible solution is the creation and acceptance of a longevity plan. This is a setup where one’s personal savings and accumulations from a defined contribution (DC) plan is meant to carry you through the initial retirement years leading up to average life expectancy. Then, a longevity defined benefit (DB) plan would commence at the later stages of retirement and continue for the rest of one’s remaining lifetime. The allowance for a later commencement age would help keep the costs of this product down.
The concept of longevity plans is expected to get increased attention as Baby Boomers begin their retirements. Hopefully, legislative action can occur soon to legalize and promote longevity plans so that we can avoid a retirement crisis in the future. To read more about longevity plans, please see the article “Longevity risk and retirement,” available here.
Longevity poses a challenge for retirees with defined contribution plans, because there is always risk of someone outliving his or her savings. A new application for defined benefit plans as a supplement to defined contribution plans may help provide longevity protection.
In his new article on MoneyManagementIntelligence.com, Zorast Wadia outlines this approach, known as a “longevity plan.” Here’s an excerpt explaining how such a retirement model would work:
“In order for the longevity plan concept to succeed, it will need to provide annuity protection to plan participants, be relatively easy to understand and administer and be affordable to plan sponsors. To accomplish the goals of longevity protection and cost reduction, some changes will be necessary to current pension laws including allowing employers to limit plan participation to later ages (e.g. age 45 and beyond) and defer benefit commencement to later ages (e.g. age 75 and beyond). To allow for ease of administration while still offering longevity protection, forms of payment would need to be limited to life and joint and survivor annuity options. The longevity plan would also eliminate investment risk since annuitants would receive guaranteed employer-funded benefits from the longevity DB plan. With the longevity DB plan in place, participants would be free to adjust their investment strategy with respect to benefits accruing from their DC plans. Participants with a higher risk tolerance could invest more aggressively with respect to their individual savings accounts.”
For more on this concept, check out another article by Wadia, “Longevity Risk & Retirement,” which first appeared in the spring 2012 issue of the Actuarial Digest.
Previous Milliman Insight articles have also assessed longevity plans. “Saving for retirement: What can employers do?” discusses how a “layered longevity plan can potentially ensure that people do not outlive their retirement balances for an uncertain duration.”
For more perspectives on longevity risk and retirement planning read our four-part retirement landscape series, where our team of Milliman consultants accesses the array of risks facing retirees and plan sponsors, and provides feasible solutions to them.
Over the last 25 years, defined contribution (DC) plans have replaced defined benefit (DB) plans as the primary retirement plan sponsored by employers. In the long run, this remarkable shift is problematic because having benefits from a DC plan as a primary retirement source subjects plan participants to longevity risk—the risk of running out of money during retirement.
Based on average life expectancy statistics, we know that half of the population will survive beyond its life expectancy and half of the population will not. This creates challenging circumstances for people to manage withdrawals from their retirement accounts. In addition, there is the added challenge of managing investments.
This article from the Spring 2012 issue of Actuarial Digest is not meant to compare the advantages and disadvantages of DC and DB plans; rather, it is meant to promote a new retirement paradigm where both types of plans can coexist and complement one another. This paper offers this new retirement model as a solution to the longevity risk problem.
Our recent Retirement Landscape Series introduced the idea of a “longevity plan.” What’s that? Here’s a description:
A layered longevity plan is one potential way to ensure that people do not outlive their retirement balances for an uncertain duration—due to the fact that no one knows their precise longevity. In the layered longevity plan scenario, employers would fund a DB plan that is specifically designed for longevity protection. The longevity plan would come into effect later than today’s retirement plans (e.g., age 80) and would provide lifetime income throughout the duration of an uncertain longevity horizon. Because fewer employees would live long enough to claim benefits compared to traditional DB plans, longevity plans would be less expensive to fund. Longevity plans are not allowed today because employer-provided retirement benefits are required to come into effect no later than age 65.2 If the regulations change, the combination of an optimized DC plan for the bulk of retirement with the security of a longevity plan could provide a very attractive retirement solution.
Interestingly, such a scenario would represent a reversal of the historical pattern. DC plans began as a supplement to DB plans and later became the rule rather than the exception. This solution would have DC plans as the main retirement funding model with limited DB plans for longevity protection. The retirement funding challenges facing the aging U.S. population cannot be solved by employers alone, but they cannot be solved without them, either. Creative thinking and an analytical approach are both required if employers are to play a leadership role in the retirement landscape of tomorrow.