Original Research for Inquisitive Investors The Future of Retirement Plans October 2013 WWW.BRANDES.COM/INSTITUTE [email protected] Executive Summary Collectively, Americans are woefully unprepared their retirement accounts. But how? We suggest financially for retirement. This retirement automatic enrollment and greater education on problem actually reflects a collection of diverse how critical contributions are. Limiting choices in issues. This paper identifies the most important DC plans to assets that better mirror professionally ones: longevity; access; contributions; portability; managed DB plans would help. Guiding workers behavioral mistakes; funded status; expenses; and to retire later also would have significant benefits. regulation. Our research focuses on solutions for Concerns over securing retirement assets are both plan sponsors and participants. not unique to the United States. We investigated The Retirement Rule, Benefits = (Contributions retirement structures in select developed countries + Investment Earnings) – Expenses, provides a and share approaches that may have relevance for good framework to evaluate the problems and the American pension community, including: less assess potential solutions to the pensions crisis. stringent mark-to-market rules to foster a longer- It also clearly identifies where the move from term investment perspective; the introduction defined benefit (DB) to defined contribution (DC) of variable benefit plans; approaches that result plans alters the balance of risk and cost from plan in higher contributions; greater education and sponsor to participant. access to annuities as a distribution option for retirement plans; “official” retirement age that Three generations of American workers have is indexed to life expectancy; and automatic experienced an amazing transformation of enrollment for plan participants. the employee benefit landscape with changes that initially provided greater wealth, but Two proposals at the national level aim to fill the subsequently led to capped or reclaimed benefit gap for workers who do not have access to an promises. With relatively little public awareness, existing DC or DB plan: NCPERS’ Secure Choice but with significant consequences, within the last and Senator Harkin’s USA Retirement Plan. Both few years DC plans have been transformed for use the cash balance plan concept and both aim many from supplemental savings to the primary to solve the issues of investment risk, longevity source of retirement income. Plan sponsors have risk and the need for professional management. experimented with “hybrid” DB plans (such as There are significant differences between these cash balance plans and adjustable benefit plans), proposals, but they could co-exist. The NCPERS but today’s landscape remains dominated by a proposal uses a state-by-state approach, while shift away from DB to DC with significant impact the USA Retirement Plan proposes a federal for participant benefits. framework. We believe both are sound, and as long as contribution rates are adequate, these Various factors are likely to hurt DC participants plans can play an important role in the industry. financially, including lower contributions, lower investment returns and potentially their own Hybrid plans may emerge as viable, long-term poor investment decisions. In the meantime, DB solutions. In theory, DB and DC plans that are plan sponsors are still dealing with underfunding well designed, well-funded and properly invested problems. The “simple” (but not necessarily easy) can deliver adequate retirement benefits. In reality, solutions include: increase contributions; retire some DB plans and most DC plans do not meet later; and increase investment returns. The real these objectives. We believe adaptations of hybrid solution for the pension community is to find plans will emerge as competitors to existing DC ways to enable participants to build adequate plans and alternatives to DB plans if the latter retirement income and to do so in a structure continue to be phased out by plan sponsors. The that works effectively for cost- and risk-conscious newer hybrid plans require various legislative plan sponsors. changes and regulatory approvals. We support moves that make these plans easier to implement as To help get to and through retirement workers they offer features that address current challenges must participate in and make contributions to for participants and plan sponsors, alike. PAGE 2 To achieve success, in our view the retirement plan of the future needs these features: • Contribution levels should be high, in the range of 15% of salary each year. • The plan design should use behavioral techniques to encourage participation and raise contribution rates. • Assets should be professionally managed. Collectively, • Plan assets should be portable across employers. Americans are • Longevity risk should be minimized by pooling individual participants’ assets with others. woefully unprepared • Retirement age should be deferred where feasible, increasing both savings and benefits. financially for retirement. This • Participants should be able to understand in simple terms how well prepared they are for retirement “problem” eventual retirement. actually reflects a The retirement train is pulling into the station; it is our collective responsibility to get passengers off the collection of diverse tracks and onto the platform. issues. 1. The Problems for Retirement Planning1 Section 1 Summary: Collectively, Americans are woefully unprepared financially for retirement. This retirement “problem” actually reflects a collection of diverse issues. This paper identifies the most important ones: longevity; access; contributions; portability; behavioral mistakes; funded status; expenses; and regulation. Our research focuses on solutions that can work for both plan sponsors and participants. Simply put, the biggest problem facing the workforce today is that collectively Americans are woefully unprepared financially for retirement. “Woefully” is the right word: there are potentially a lot of financial and social woes waiting for future generations of U.S. retirees. But retirement planning is a highly complex issue. Many factors impact the ability to provide adequate pensions: economic, political, actuarial and even psychological. “The U.S. pension industry is in crisis,” has become a widespread lament among plan sponsors, plan participants, taxpayers and politicians. Given the potential impact on society as a whole, there’s a growing understanding that there’s a big problem that needs to be fixed. This paper aims to cut through the complexity and identify the most important issues, evaluate some suggested solutions and make recommendations. In the late twentieth century over half of American workers were covered by DB pension plans.2 Most didn’t have to worry about saving for retirement. But now fewer than one in six private sector employees have access to a DB plan that’s open to new contributions, according to the Urban Institute Retirement Security Data Brief, April 2013. And as we’ll demonstrate, the DC plans that are replacing them as the main retirement saving vehicle are not filling the gap. This is a well-covered story, usually presented as a looming problem for workers, retirees and for society as a whole, with employers and plan sponsors portrayed as part of the problem, not the solution. But as we describe later, we see a flurry of innovation from plan sponsors aiming to provide adequate pension benefits at a reasonable cost. The motivation may include fiduciary responsibility but in practice stems from the need to provide competitive compensation in an open marketplace for employees. If successful, these innovations may change not only today’s apparent trend toward DC, but also reinforce the importance of the skillsets developed over the years by the DB plan sponsor community. 1 We note the difference between “pensions” and “retirement.” A pension, according to the Merriam-Webster dictionary, is a fixed sum paid regularly to a person following retirement from service. While “pension plan” and “retirement plan” are often used interchangeably, there is an important distinction. As the dictionary notes, “pension” implies a regular payment during retirement. In theory, while a retirement plan could be as simple as a decision to “go live with the kids when I retire!” More realistically, retirement plans would include investment accounts such as 401(k) or IRA defined contribution plans, which may have no pension element. So we’ve broadened the scope of this research deliberately to encompass retirement planning, not just pensions. 2 Seburn, Patrick W. “Evolution of Employer-Provided Defined Benefit Pensions.” Monthly Labor Review. Dec. 1991. PAGE 3 Can the solution be as simple as just setting aside more for retirement savings? Unfortunately not. But contribution rates are a good place to start in understanding the scope of the problem. To accumulate enough money to replace their salary at retirement, people need savings (including any company match) equivalent to 15% to 20% of their salary every year over their entire career while averaging investment returns of around 4% annually above inflation on these investments, according to Bob Maynard, CIO of the Idaho Public Employees Retirement System. And these numbers assume at least 20% of that retirement income target comes from Social Security payments. Can the solution be as simple as just The National Conference on Public Employee