DC Looks at DC Washington s Impact on Defined Contribution Plans

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1 DC Looks at DC Washington s Impact on Defined Contribution Plans A recent AllianceBernstein forum for over 100 institutional investors included a panel discussion on defined contribution (DC) trends and the federal government s current regulatory and legislative impact. Below are highlights of the comments from Dallas Salisbury, President and CEO of the Employee Benefit Research Institute (EBRI); Lori Lucas, Executive Vice President and DC Practice Leader for Callan Associates; and Dan Notto, AllianceBernstein s Senior Retirement Plan Counsel. Washington s current inactivity poses a challenge for everyone, but what implications does this have for DC plan sponsors? Dan Notto: Currently, there are two schools of thought being discussed in academia, at think tanks and among policymakers in Washington. One camp believes we should replace the whole DC system because it s not working, or reduce the amount of tax expenditures that are being given up to retain the current system. The other camp believes the system is fine, but that we need to make some targeted changes to improve participant outcomes. Approach #1: Overhaul or Replace Perhaps the most far-reaching proposal from the start from scratch group is what s called guaranteed retirement accounts essentially a government-maintained DC program, similar to Social Security. The guaranteed retirement account would call for a mandatory 2.5% deduction from employees paychecks, with a matching 2.5% employer contribution. This would go into a government-maintained account, and the government would credit that account each year with $600. At retirement, the account would pay out in the form of an annuity. Needless to say, there isn t much appetite these days for any sort of mandates. Nonetheless, this concept has been tossed about Washington for the past several years and will likely continue to be discussed in some form. That same camp that wants to replace or overhaul the DC system has forwarded various proposals to limit the tax expenditures for retirement plans meaning the tax deferrals that most retirement plan contributions receive. Some in Washington look at these retirement plan expenditures as one of the biggest pots of currently nontaxed money in the tax code, second only to employer-provided healthcare. One idea, from the Obama administration s budget proposal, is to cap the value of exclusions or deductions at 28% of contributions. Another would cap contributions Investment Products Offered Are Not FDIC Insured May Lose Value Are Not Bank Guaranteed

2 once the taxpayer s aggregate retirement plans reached a balance of approximately $3 million. And then there s the blank slate approach: what taxcode deductions would Congress include if it could start with a blank slate? Approach #2: Targeted Changes But ideas from the other camp advocates of the targeted change approach have actually made significant contributions to participant outcomes recently. I m referring to the Pension Protection Act of 2006 (PPA), with its incentives for automatic enrollment and for relieving plan sponsors of fiduciary liability for default investing, which goes hand in hand with automatic enrollment. Another targeted change under discussion in Washington is to encourage plans to increase their automatic enrollment and automatic escalation levels. Up until now, there has been a centering around an initial deferral percentage of 3% for automatic enrollment, because that number was in an old IRS revenue ruling and is also the minimum percentage in the PPA s automatic enrollment safe harbor, but it s not adequate. Other ideas look to reduce leakage from DC plans for example, allowing people who take hardship distributions to continue to participate in the plan rather than being forced out of the plan for six months. And finally, we re seeing proposals encouraging the adoption of lifetime income, from both the Department of Labor (DOL) and Congress, that would require DC plans to illustrate participants account balances in terms of future income. So, there appear to be a number of DC plan components that the DOL and Congress may likely tinker with around the edges. Dallas, how well do you think the DC system is working at the moment? Dallas Salisbury: Much of today s rhetoric claims we re in a massive, massive crisis versus the good old days, when everybody was getting a defined benefit pension annuity with a gold watch but only after spending some thirty years with one employer. The data, however, tell a different story. Percentage of Income Attributable to Pension Income for Those Age 65 or Older Percent As of June 30, 2013 Source: Employee Benefit Research Institute (EBRI) tabulations of the Current Population Survey

3 The percentage of income attributable to pensions for those age 65 or older strengthened up through 1993, in terms of proportional supplementation of Social Security and other income sources. But that percentage has been essentially flat since then. Still, the current data average is significantly more than what was being delivered to the retired population in the good old days. Is our retirement system stronger in terms of income delivery than at any time prior to the early 1990s? The answer is yes. Is it getting stronger? Maybe. Income Replacement Issues Let s look at where we stand today in terms of what s needed to supplement Social Security at different income quartiles to provide a 100% income replacement. For most workers, Social Security is likely to provide the vast majority of retirement income anywhere from 57% to 92% of their current income. For workers at the 75th percentile of income, their annual shortfall is about $14,500, and they would need roughly $210,000 in their combined retirement savings (pensions, DC plans, IRAs) to purchase an immediate annuity to offset that shortfall. How Big Do Balances Need to Be: How Much Supplementation Is Needed? Income distribution of those age 65 and older in 2010 dollars to achieve 100% income replacement with annuity purchase versus alternative income streams at noted deterministic rate of return with 95% probability of success Percentile Income SS Not SS IMA.com* 25 $10,757 92% $860 $12.5K 50 18, ,880 42K 75 33, , K 14.4% had income of $50,000 or more Historical analysis and current estimates do not guarantee future results. As of June 30, 2013 *IMA.com=Immediateannuity.com IMA.com quotes on September 13, 2011 for female age 65 in GA: not inflation indexed; no guarantee period; no survivor benefit. Source: EBRI Consequently, if one looks at what s available and being developed in the 401(k) and defined benefit system in the private sector, the amounts that participants are accumulating are actually quite significant in terms of 100% income replacement.

4 Medical Beyond Medicare: Another Factor? Unfortunately, that picture changes quite a bit if we factor in the probabilities of catastrophic medical expenses not otherwise covered by Medicare, and the potential cost of long-term care. The worst shortfalls occur for workers with incomes in the lowest-quartile. That s because many actually don t have enough even at 100% income replacement to cover basic expenses, let alone catastrophic medical expenses. This problem is acutely true for those participants retiring today: 60% may encounter total lifetime shortfalls when considering the added potential of catastrophic medical expenses. However, the savings trends today indicate that participants with nine or more years of DC contribution eligibility have far lower shortfall probabilities. Contrary to much of the rhetoric about a massive retirement savings crisis in the US today, it s actually smaller than at most times in the past. There s an issue of long-term care. Roughly 3% of American workers, public and private sector, have access through work to long-term-care insurance coverage. That may seem small, but it s about as high as it s ever been. The long-term-care issue certainly creates a problem, but it has always created a problem. Essentially, the retirement savings system today with the voluntary, supplemental nature of DC plans as the primary savings vehicle is doing better than at any time in history. Is it doing enough for everyone? No. Can it be strengthened? Absolutely. Lori, as you work with plans, how would you characterize the situation, and what do you think are the risks of action versus inaction today? Lori Lucas: Dan mentioned the PPA, and I would add that the world of defined contribution plans has emphatically changed in a very positive way since then. I sense that many legislators and others who see a crisis situation are perhaps looking at our system prior to the PPA. But we have so much more in our tool kit that can facilitate better retirements for the majority of US workers. Things like automatic enrollment, automatic escalation and safe harbor for target-date funds: all of these are game changers. Automatic Features and Behavioral Biases (of Plan Sponsors) The Defined Contribution Institutional Investment Association (DCIIA) and EBRI Dallas s organization recently published a study noting how effective these automatic features could be if implemented robustly. In other words, instead of starting with a default contribution rate of 3%, start with a 6% default and escalate participant contributions to 15%. Combine that with a strong target-date fund, and roughly 80% of DC participants would be on track to replace almost all of their income. That s a pretty striking number. My perspective is that plan sponsors are not taking advantage of this great new system sufficiently. We know that participants are subject to things like inertia, which is why automatic features work so well. But I believe plan sponsors are also subject to certain types of behavioral biases.

5 Some plan sponsors implement automatic features with very conservative default contribution rates, like 3%. Starting there, many plan sponsors then escalate participants up only to 6% of pay. These plan sponsors may have a number of reasons, and some may believe that regulations seem to discourage higher defaults. But when surveyed, the typical plan sponsor thinks that people should be saving at least 10% of pay. That s a form of cognitive dissonance. Consequently, the way that DC automatic features typically get implemented today with such conservative defaults puts less than 50% of participants on track to replace the majority of their income. Revisiting Your Target-Date Fund Another behavioral bias that s somewhat like inertia relates to target-date funds. The 2013 DC Trend Survey released by Callan Associates, my organization, notes that more than 50% of plan sponsors use the target-date fund of their recordkeeper. I think that reflects the rush by plan sponsors to establish a qualified default investment alternative (QDIA) in their plans after the PPA was passed. At that time, their recordkeepers target-date funds looked perfectly adequate. Back then, as I remember it, there was relatively no money in target-date funds. Currently, if a target-date fund is offered in a DC plan, it typically holds around 22% of plan assets. That s already a large holding. A lot has changed. We ve seen that target-date funds are not all the same, and the range of income that can be replaced by various target-date funds can vary by 20 percentage points. That s a huge spread a huge spread in the different glide-path approaches to earning investment returns and taking on risk. That means there s a risk to plan sponsors of inaction of not reassessing the plan s current target-date fund because target-date funds are going to eventually be the largest holding in many plans. And target-date funds will likely be subject to a higher level of scrutiny because they re QDIAs. The DOL recently came out with some tips on what plan sponsors need to do to make sure their target-date funds are appropriate. The tips emphasize not only performance, but also the glide path: is it appropriate for the characteristics of the participants, such as their accessibility to defined benefit plans and other demographic considerations? With the issue of optimizing the QDIA, what steps do you and Callan Associates think plan sponsors could take? Trends Today with Target-Date Funds Lucas: From the perspective of QDIA design, we are seeing more target-date fund searches, although primarily based on performance. But we are also seeing more plan sponsors considering custom target-date funds. Interestingly, it s more often driven by the idea to leverage low-cost institutional funds rather than a reassessment of the glide path.

6 But our recommendation is that a thorough review of the appropriateness of the glide path within the plan should be done on a regular basis, just as you look at the appropriateness of every fund in your plan on a regular basis, and that review should be documented. Are you seeing a growing market for customized multimanager target-date funds or requests for allpassive target-date funds? Lucas: Interestingly, there was a lack of clarity in the recent DOL tips in reference to custom or nonproprietary target-date funds. The wording seemed to refer to open architecture, but was unclear whether that meant customized or multimanager funds. And proprietary funds might refer either to the proprietary fund of the recordkeeper, or a fund that holds all proprietary funds of the investment manager who also manages the glide path. What we re seeing is a trend among target-date fund managers to expand their diversification. That could mean going into a multimanager solution, or it might mean adding components such as exchange-traded funds (ETFs) or index funds if the investment manager doesn t happen to have certain capabilities from an actively managed perspective such as alternatives or other diversifiers that aren t necessarily proprietary or the manager s area of strength. We re noticing more target-date funds in large plans that offer either index funds or a mix of index and actively managed funds. The interest in index funds is clearly aligned to the fact that these are QDIAs that are held to what is perceived as a higher level of scrutiny and that scrutiny is strongly associated with fees. Among plan sponsors with custom target-date funds, we re seeing a tension between a desire to add alternative investments to improve diversification, but also a desire to be careful not to increase costs too much in doing so. Alternatives in Target-Date Funds Lori, you noted that there s increased interest in having alternative investments included within a custom target-date structure. Is that interest translating into action? Lucas: It s a challenging issue for several reasons. The first obstacle is fees: sometimes fees are performance based, which makes them difficult to administer. Another evaluation issue is liquidity. So the industry is currently taking baby steps in a lot of ways. Real estate, for example, is often in the form of REITs. The industry knows that s not a perfect substitute for direct real estate, but liquidity issues for direct real estate are difficult to overcome within DC plans. Alternatives for target-date funds may include something like emerging-market debt. That may not sound like an alternative for a foundation, endowment or defined benefit (DB) plan, but emerging-market debt isn t often present in DC plans. For the most part, today s target-date funds are only taking gradual, incremental steps into the alternatives space, until some of the operational and administrative issues are overcome.

7 Customization and (More/Less?) Fiduciary Risk Does the DOL s recent guidance advocating customized solutions implicitly expose plan sponsors to a greater level of fiduciary risk, since they now have to not only choose underlying holdings but also be responsible for the glide path s shape? Notto: As Lori pointed out, plan sponsors should ask their providers whether custom or open architecture is available and whether that might be the right solution for their participants. We ve always taken the position that you should be looking behind the target-date fund structure and understanding the performance of the components whether off-the-shelf, all single-manager or customized. We believe that custom target-date funds actually would tend to reduce a plan sponsor s fiduciary risk. Let s take an example where you have a proprietary target-date fund in which one of the underlying components is also a standalone option on your menu. Suppose you remove that option from the standalone menu because of performance, and yet you still have it within your target-date fund. That would be hard to justify. With a custom target-date fund, you could review the components individually especially if you re also using some of those same components in your defined benefit plan. So we think that the additional fiduciary scrutiny for a customized target-date fund is more or less connected to the glide path, which is a fiduciary responsibility even if it were an off-the-shelf, single-manager product. All Quiet on the Legislative Front? Some in Congress want to simplify the tax code and eliminate tax preferences. Others are pushing to reduce entitlements in order to lower federal spending. It would be hard to have it both ways. How will this conflict ultimately be resolved, and what implications does this have for the retirement savings system? Salisbury: Considering the number of bills passed so far this year, it seems unlikely that we ll see anything happen on tax reform or pension legislation for the next few years. So action is most likely to come from regulatory agencies. For example, there s increasing sensitivity at the DOL about the types of requirements that should be deemed essential for appropriate fiduciary decision making on target-date funds: some of these requirements may be possible for very large funds but extraordinarily difficult for thousands of smaller 401(k) plans. Balance will play a part in determining these issues. Target date in a fund s name refers to the approximate year when a participant expects to retire and begin withdrawing from his or her account. Target-date funds gradually adjust their asset allocation, lowering risk as participants near retirement. Investments in target-date funds are not guaranteed against loss of principal at any time, and account values can be more or less than the original amount invested including at the time of the fund s target date. Also, investing in target-date funds does not guarantee sufficient income in retirement.

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