The Treasury and Labor Departments recently released
regulations and guidance that at least partly address a major flaw with
most 401(k) plans: Most of these plans lack methods to convert savings into
reliable retirement income. First, let's look at why this is a critical flaw,
and then why the new regulations are important.
The long-running U.S. trend away from traditional pension
plans to 401(k) plans imposes significant responsibilities and burdens on
employees. They must be their own investment portfolio managers, deciding how
to invest their savings. They must also be their own actuaries, figuring out
how much to save and how to deploy these savings during retirement to make
their money last.
Recent innovations, such as auto enrollment and target date
funds (TDFs), have addressed some of the challenges inherent in the current
design and delivery of 401(k) plans. Now, the retirement industry is turning
its attention to the remaining challenge of generating income in retirement.
In theory, retiring employees could work with financial
advisors to get help in deploying their savings in retirement. For many
middle-income retirees, however, it's hard to find advisors who are
trained in the complexities of generating retirement income and aren't biased
by the way they're compensated.
A significant improvement would be if retiring employees
could simply choose among retirement payment options that their
employer has selected for 401(k) plan participants.
Large plan sponsors often have the resources to shop for
efficient retirement income generators (RIGs) and can negotiate low-cost
services that aren't available on a retail basis. A recent study by the
Stanford Center on Longevity estimates that institutionally priced
programs have the potential to deliver incomes that are 10 to 20 percent higher
than retail programs.
The recent Treasury regulations address one possible
solution: TDFs. The new rules allow for deferred annuities to be phased in as
the fixed-income portion of a TDF as participants approach their retirement
years. This would allow TDFs to generate a lifetime income in retirement with a
portion of a retiree's savings. Presumably, the remainder of the TDF would be
invested in equities, and the retiree would use systematic withdrawals to
generate additional retirement income.
TDFs are often used as the default investment option of a
401(k) plan, and experience is showing that many participants allow the default
investment option to become effective. The recent Treasury regulations help
define how TDFs can be used in retirement. In this case, it's possible that a
retiring employee may simply allow the TDF to be the default option.
The Department of Labor's guidance addresses the due
diligence process that plan sponsors should follow to select insurance company
products to offer in 401(k) plans. Given that large employers often have buying
power in this arena, Labor's guidance is intended to make employers feel more
comfortable with offering such products in their plans.
The Treasury regulation follows regulations it issued in the
summer on a different type of RIG: a qualified longevity annuity contract,
or QLAC. Taken together, the two Treasury regulations and Labor's guidance show
progress toward addressing this major flaw of 401(k) plans. Both agencies are
to be applauded for taking these steps.
Still, many other RIG types are valid methods for generating
income in retirement. For example, as an alternative to annuities, retirees
could invest their savings in their 401(k) plans' investment funds and use a
systematic withdrawal method to generate a retirement paycheck.
The various types of RIGs each have their pros and
cons, and each generate different amounts of retirement income. A very
significant improvement would be if a 401(k) offered a limited menu of RIGs,
some using guaranteed approaches, such as annuities, and some using investing
approaches, such as systematic withdrawals. This would allow retirees to
select the RIGs, or combination of them, that best fit their goals and life
circumstances.
To date, regulatory and legislative support for such a
robust offering has been lacking, but a number of dedicated professionals are
working to make this happen. Let's hope that in five to 10 years, most 401(k)
plans will be operated this way.
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