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How companies can help retiring employees transition from savers to consumers.
Russ Banham, CFO Magazine
February 1, 2008
Over the next dozen years, baby boomers, those trend-setting, iconoclastic, and often sharp-elbowed children of the Greatest Generation, will leave the workforce in droves. Unlike their parents, many won't get a regular pension check. Enrolled predominantly in defined-contribution plans, they'll receive a lump sum of money — an approach that will benefit some but put many others in fiscal peril.
Minus the security of a check, millions of boomers will confront longevity risk — the possibility of outliving their assets. They must manage that lump sum to last a lifetime, not the easiest thing to tackle in one's 70s, 80s, and beyond. Rising concern over employees' post-retirement welfare is prompting companies, and the federal government, to help workers in their last working years make the right decisions about their future needs.
To be sure, the emphasis is on information and communication, but some companies are taking more-concrete steps. Some are tapping new annuities that essentially convert a defined-contribution plan into a defined-benefits plan. Others are pushing programs that provide for catch-up contributions to 401(k)s. And many are helping employees make better retirement decisions.
Behind these efforts is a recognition that the elimination of defined-benefits plans comes at a cost. Given economic uncertainty and the fact that people live longer, there are no guarantees that retiree money will last a lifetime. To fill the void, says Jack Brennan, CEO of Vanguard, companies need to both develop a "philosophy" about dealing with retiree money and implement programs to help employees transition from savers to spenders. "You want your employees to be successful in retirement because they will still impact morale after they are gone," he explains. But companies must be cognizant of the fiduciary responsibility embedded in offering retirement guidance — and employees must accept the risk of a possible shortfall.
Wanted: A Stream of Income
Defined-benefits plans relieved retiree apprehension in the past, with past being the operative word. In the past two years, one third of plan sponsors surveyed by the Employee Benefits Research Institute have closed or frozen their defined-benefits plans. And McKinsey & Co. estimates that by 2012, 50 to 75 percent of private-sector defined-benefits plan assets will be frozen.
In their place, of course, are defined-contribution plans, which now hold 70 percent of the $11 trillion in boomers' invested assets, according to Prudential Financial. Many retirees tend to roll over these assets into an IRA or cash in the proceeds. But a survey of 401(k) participants by Mercer indicates that 80 percent are "less than comfortable" making retirement investment decisions. And 70 percent of preretirees in a Prudential Financial survey wished they had an "autopilot plan" defaulting them into a lifetime income program.
Such insecurities have led to the introduction of products such as target-age or life-cycle funds, which automatically rebalance 401(k)s, as well as a renewed interest in annuities. In fact, in the last year providers have taken the tarnish off the latter, restoring some luster to a much-maligned product. Whereas yesterday's annuities stopped payment upon death, for example, newer versions allow beneficiaries to receive payments. And employers are helping by leveraging their clout, offering annuities as a company benefit. "You have a lot more buying power if you're General Motors rather than John Smith," says George Castineiras, senior vice president at Prudential Financial.
Medical Associates, an 80-year-old multispecialty clinic, found a solution in IncomeFlex, which it introduced last year. Sold by Prudential Financial, the annuity not only provides a steady income for life, it guarantees that the notional value of an employee's 401(k) assets — or as much as they invest — will not be reduced by market performance. When a participant retires, he is guaranteed a steady lifetime annual withdrawal based on the highest of three values: the market value, the highest value of the assets on the person's previous birthdays, or the 5 percent income growth value. In return, the insurer will guarantee a 5 percent minimum withdrawal, starting at 65, for the rest of the retiree's life.
The plan was introduced to the 400 Medical Associates employees past the age of 50. And of the 53 who initially signed on, says CFO Jeff Gonner, most said "they'd rather have Prudential be in charge of their investments than themselves." The employees didn't go into the plan half-heartedly, either. "While they could have put a conservative percentage in the Income-Flex option, they put in 96 percent on average," the CFO notes.
Despite the improvements, annuities aren't without both downside and risk. The downside to annuities is their cost. Employees pay an annual premium, 95 basis points in this case — or nearly one percent of assets — to Prudential to manage their money. Risks include the possibility of inflation topping 4 or 5 percent or, says Joseph S. Adams, a partner at McDermott Will & Emery, "if the provider goes under." In that case, there are state insurer guaranty funds to pick up the payments. "However, there is always the risk the guaranty funds may not be able to provide 100 cents on the dollar if numerous insurers file for bankruptcy at the same time."
Whether any additional pension or 401(k) relief will be introduced by the next President remains to be seen. But the easing of certain regulations has allowed soon-to-be retirees to pad their savings. In 2001, for example, the Internal Revenue Service amended its rules to permit people 50 years and older to squirrel away more in their defined-contribution plans. For traditional safe-harbor 401(k) plans, participants can now save an additional $5,000. For simple 401(k)s, an extra $2,500 is permitted. "It's great because as you get closer to retirement you can contribute more on a tax-deferred basis," says Hess. "Our research indicates that 90 percent of employers now offer catch-up strategies."
The Boeing Co. is one. "We encourage employees age 50 or older to take advantage of catch-up contributions to accumulate more dollars on a tax-deferred basis," says Pam French, director of benefits and integration. Such plans, adds Alan Glickstein, senior retirement consultant at Watson Wyatt Worldwide, are especially helpful for "second-wage earners, where you can defer relatively large amounts of pay and take advantage of the tax benefit."
New regulations regarding automatic enrollment also help cushion savings. The IRS now permits employers to automatically enroll employees in defined-contribution plans, provided employees are notified in advance and permitted to opt out. Companies can even enroll existing employees in a target-date retirement account. "While it costs companies more to automatically enroll because their matching contributions go up," says Hess, "from an altruistic standpoint they're helping the workforce have the means to retire." Still, there are some indications that the savings rates of aggressive investors could be adversely affected, since the default rate may be less than their previous savings rate.
The Aerospace Corp., a Los Angeles–based defense contractor, has found another way to help retirees ease into retirement: phased-in retirement. "We allow our employees who retire to come back and work up to 999 hours a year, which we understand is allowable under ERISA and Department of Labor guidelines," says CFO Dale Wallis. "We draw upon their valuable skills; they conserve more of their retirement money and get paid to boot."
Phased-in retirement plans, however, are still in their infancy because of government regulations. For instance, an employee covered by a defined-benefits plan cannot participate. Nearly two-thirds of employers in a survey by the Employment Policy Foundation said they were stymied by regulations when offering such programs. But they are invaluable in certain industries. "If you're running a hospital and have a group of nurses all reaching retirement at the same time, it may not be in your best interest to have them all retire at once," says Glickstein. "[Under these programs,] you can give them a smaller workload and they can partially tap their retirement funds, preserving the remainder for full retirement."
Back to the Future
Aerospace did something even more radical: it reinstated its defined-benefits plan. "It's in our customers' best interests that our employees stay a long time, to give corporate memory to the government's space and missile programs," Wallis says. "We didn't want to lose workers to competitors offering a more secure retirement package."
The nonprofit unveiled a defined-contribution plan in 1993, the year it put its traditional pension in a soft freeze, meaning it was closed to new entrants but current employees could continue to accrue benefits. Employees hired before 1993 could rely on the usual bimonthly check; those hired after would accrue a lump sum upon retirement based on contributions made to their plan. "Many plan on living 20 more years after retiring," says Wallis. "But what if they live another 30 years? What do they do those last 10 years?"
The company answered those questions by partially thawing its pension plan for new employees. "New employees now get a 50/50 plan that is half defined-benefits and half defined-contribution," the CFO explains. "They get both the lump sum at retirement plus a pension check for the remainder of their lives."
The new plan also offers significant retention benefits. The government's Base Realignment and Closure Act almost caused the relocation to Colorado of Aerospace's primary customer, a U.S. Air Force base in Los Angeles. "The base represented more than half of our revenues, and we were across the street," Wallis notes. "Had it moved, they would have wanted Aerospace's people, our intellectual capital, to move with them. A defined-contribution plan doesn't give you the handcuffs to do that, whereas a defined-benefits plan provides far more incentive to pull up stakes."
Focus on the Fiduciary
Don't expect a rush of companies to follow Aerospace's lead. Instead, Vanguard's Brennan believes that demographic realities will prompt financial-services firms to develop new products at a "fast and furious" pace. With them, however, will come some fiduciary risk.
"Although plan sponsors have no obligation to deliver a certain amount of retirement income to participants, if they help employees plan their retirement-income streams, they should be careful not to run afoul of fiduciary duties under ERISA," says McDermott's Joseph Adams. "No good deed goes unpunished. Once companies begin to offer things like target-age funds, annuities, and [predictive] tools, there is an element of risk."
Consider the fiduciary obligation linked to offering an annuity. When an employee rolls over a 401(k) or cashes out, employers can rest easy from a fiduciary standpoint — they no longer must monitor the assets — whereas with the annuity, Adams says, they may need to continue to ensure the provider is delivering what it promised. "Similarly, if the plan sponsor decides to add a mutual fund with fixed payouts, companies will need to ensure that they comply with fiduciary duties of prudence in selecting the fund and monitor performance for as long as the fund is an investment choice."
Adams suggests that companies wield the "disclaimer" word often. "You need to inform employees that the predictive modeling tools are simply that — predictive," he says. Still, adds Glickstein, "there is plenty of room for employers to provide customized information and programs to help employees through this."
Russ Banham is a contributing editor to CFO.
Smoothing the Transition
Products and Services for the Soon-To-Be Retiree
Life-cycle funds. These funds automatically reallocate as an employee ages. For someone in the last five years of employment, UBS Global Asset Management advocates a broadly diversified portfolio comprising both U.S. and non-U.S. equities; exposure to emerging markets (both debt and equity); real estate (including real estate investment trusts); high-yield bonds; and Treasury inflation-protected securities, with equities slightly outweighing bonds at 55/45 percent.
Retaining retirees' 401(k)s. Employees can often opt to leave their 401(k) balance with the plan sponsor instead of rolling it over. The advantage is that the company has a fiduciary obligation to monitor the assets, and the employee has access to lower-cost funds.
Web-based tools. Companies and plan administrators have introduced a slew of tools to gauge retirement costs versus savings. At The Boeing Co., for example, one tool models the defined-contribution plan over time, based on different savings rates and investment strategies. Another models the participants' pension and invested assets at different ages of retirement.
In-house advice. Some companies are offering specialized human-resources advice for employees nearing retirement. At Boeing, a retirement advocacy service in human resources walks employees through the retirement process. There is also a separate team of HR specialists who help employees understand different financial strategies for a secure retirement. — R.B.