As Australia’s Baby Boomer generation continues to retire, the country’s superannuation system enters a drawdown stage. While super funds have focused on accumulation, new legislation will make it clear that their purpose is to provide retirees with income. Under that premise, Milliman’s Jeff Gebler explains why a new retirement consultant “with a new skill-set focused on the implications of drawdown” is needed.
The following excerpt highlights the necessary skill-set.
The modern retirement consultant will need to add and co-ordinate a broad mix of skills to meet the increasingly complex needs of the superannuation industry, including:
Funds have an increasing need for actuarial skills which can help them model member behaviour, changes in legislation and the impact of the Age Pension, risk management strategies, and post-retirement product design.
The business world is now awash with information thanks to advances in technology and affordability. The data scientist can analyse and turn this ‘big data’ into practical insights in areas such as membership, investments and risk.
Funds and asset consultants have tended to focus on long-term returns generated during the accumulation phase. However, changing demographics and legislation suggest funds should increasingly focus on the risks of drawdown such as volatility and potential capital losses. With this comes an expanding list of relevant asset classes, many of which (such as derivatives) are traditionally beyond the expertise or depth of existing asset consultants.
Behavioural finance and communications
Funds need to design their products and services taking into account the behavioural tendencies of older investors. For example, financial literacy scores naturally decline by about one percentage point each year after age 60 while older investors are more prone to ‘loss aversion’ than younger investors.
Older investors are highly engaged with their super, including through digital channels. Automated-advice provider Decimal recently released research showing that older investors were the most active users of its enterprise financial advice service.
In a defined contribution (DC) world, retirees are forced to make critical decisions, often with little or no assistance. Most of these individuals choose to take a single lump-sum distribution either immediately or soon after they terminate employment.
This paper from the Center for Retirement Research at Boston College asserts that distribution provisions in DC plans are critical factors in evaluating the risk of falling into poverty in old age.
Specifically, the paper states that reliance on non-annuitized DC benefits with fairly easy access to lump-sum distributions puts elderly households at risk of not having sufficient income (or assets) to sustain themselves or, if they are not already in poverty at retirement, falling into poverty as the household members age or die off.
As workers continue to age, this will become a greater problem as those covered by defined benefit plans retire from the workforce and are replaced by those covered only by DC plans. So what can plan sponsors do to minimize the probability of their retirees falling into poverty?
Extrapolating from thoughts in the paper, the conclusion is that plan sponsors should encourage the following behaviors:
• Not taking lump-sum distributions before retirement
• Annuitizing some or all DC benefits when possible
• Choosing joint-and-survivor options when available
Retirement plan sponsors should evaluate the assumptions used by providers in their retirement readiness calculator formulas. This can result in more accurate projections that help participants make better long-term savings decisions. A recent PlanSponsor article quoted Milliman consultant Kevin Skow discussing some assumptions that sponsors need to assess to improve retirement readiness projections.
Here is an excerpt from the article:
To calculate these projections, providers have to make numerous assumptions about key variables. Some, such as future inflation rates, do not relate to individuals specifically. But many variables do, and the default assumptions a provider uses may or may not reflect reality for a plan’s participants. “In our mind, the assumptions made are critical,” says Kevin Skow, principal and consultant at Milliman Inc. in Minneapolis.
In order to evaluate readiness formulas, plan sponsors should start by looking at three key areas where assumptions are made:
Salary, retirement date and savings. Understand what salary-increase rate a provider’s model assumes, Skow recommends. “How does that equate to what’s happened historically at your company, or what is anticipated in the future?” he says. And these models assume an average retirement age in doing the calculations, he says, so in evaluating a provider’s model, it helps to know whether that number reasonably lines up with a work force’s actual retirement patterns.
The models also hypothesize about a work force’s retirement-savings rates, going forward. In its retirement readiness calculator for participants, Milliman actually asks each to input any deferral increase he plans. When it does plan-level reports on retirement readiness, the company typically takes a “snapshot” approach and does not assume a deferral-rate increase by participants, Skow says. “But if a plan has automatic increases, a model could assume that everybody who was auto-enrolled at a 5% deferral with a 1% increase, for example, will stay with it,” he says. “Most people who are auto-enrolled stay, and very few tend to opt out….”
Additionally, retirement readiness models have to make assumptions about how long people will live… The suppositions about how long people will live have a big influence on these calculations, Skow says. “In our tools, we tend to project that an individual will need income until age 95 if that person is male, or 97 if that person is female,” he says. “Many models use the normal mortality rate in the U.S. today, which is in the late 80s.” A model assuming a shorter lifespan will improve someone’s monthly retirement-income projection, but also may create false security for some who then end up outliving their savings.
People get excited about technology. There are hundreds of websites chronicling the next big thing in technology, presenting information about how a device will save you time and money while providing entertainment. Getting people excited about or even acknowledging a retirement plan is much more complex. Over the years, there have been several new features created to help participants by increasing the flexibility of how they fund their retirements. Participant inertia is a large problem and directly relates to the usage of these new features.
As retirement plan professionals we believe having a solid retirement strategy is a no-brainer. For us, it’s a partnership with the plan sponsor that leads to great results by getting them involved and sharing responsibility of communicating and educating the participants. Human resource professionals have direct contact with employees and a great understanding of the best communication mediums and incentives that drive employees to take action.
There are several tools available for participants to project their retirement income. One of them, PlanAhead for Retirement®, enables participants to input additional income sources and variables to project their replacement incomes. Through the PlanAhead for Retirement tool, there is also a retirement readiness report that provides clients a view of the expected retirement outcomes of their participants on a plan level. The retirement readiness report displays where participants fall in relation to their projected replacement income at retirement. The report allows the client to change several variables such as the target of replacement income, return on investment, and changes to employer contributions. This is further broken out by age, service, and participant contribution rate. This interactive report helps the client make the leap from using current data such as participation rate and average deferral rate to projecting the results in the future.
At a plan sponsor level, using industry-related statistics on participation rate and average contribution rates we can show plan sponsors how they compare to their peers. Any deficiencies in the peer comparison are consulting opportunities. Using their participant demographic data, scenarios can be created to determine how changes to plan design (i.e., adding or increasing employer match) or targeting communication to specific participants encouraging them to take advantage of the benefit provided will improve results.
At an employee level, the medium of communication and the timing of the call to action are also paramount. Coordinating the retirement plan education and enrollment at the same time as other benefit enrollment periods has advantages as the employee is already completing paperwork. Showing an employee general information on plan demographics can also lead to an increase in participation and contribution rates via competition. Inertia is present in all retirement plans. What better way to promote change than to make it a competition, albeit an internal one.
Getting a plan sponsor to act on a retirement plan is just as important as getting the employees to act. As retirement plan professionals, we know that developing a partnership with sponsors can help lead to great results, keeping employees on track and taking steps to more successful retirements—using that flashy new technology that makes it easier for everyone.
The 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.
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.
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.
Milliman consultants had another prolific publishing year in 2014, with blog topics ranging from healthcare reform to HATFA. As 2014 comes to a close, we’ve highlighted Milliman’s top 20 blogs for 2014 based on total page views.
17. In her blog, “PBGC variable rate premium: Should plans make the switch?,” Milliman’s Maria Moliterno provides examples of how consultants can estimate variable rate premiums using either the standard premium funding target or the alternative premium funding target for 2014 and 2015 plan years.