More retirees in DC plans? Helping plan sponsors prepare for a new reality
December 15, 2016
For decades, conventional wisdom has held that plan sponsors should encourage those participants leaving employment to roll out of their defined contribution (DC) plans as quickly as possible. Certainly, with the costs of administration and added overhead of fee disclosure and other required communications, force-outs continue to be a strategy to consider for handling low-balance accounts.
But what about the heftier balances of near-retirees and those heading into retirement? Retaining these accounts in the plan could make good financial sense for advisors — and good sense for plan sponsor clients, whose fuller coffers and longer participant rosters may position them to negotiate more attractive administration costs. It may also be a good thing, because under the Department of Labor (DOL) new fiduciary rule that is scheduled to take effect in April 2017, plan sponsors could eventually find themselves in the asset retention business whether they want to or not.
A wave of retirees
According to the Social Security Administration, every day an average of 10,000 baby-boomers are turning 65, the traditional retirement age. Increasing numbers may be considering leaving their assets in their plans.
Plans can offer fiduciary oversight
By more heavily regulating rollovers, applying ERISA-like standards to advisors who assist with them and setting up complex requirements around advisor compensation, the DOL fiduciary rule has set the stage for more retiring participants to leave assets in their former employers’ plans. As regulators have observed, investments in ERISA plans are chosen and monitored by fiduciaries, which historically hasn’t always been the case with rollover IRAs. And at least in larger plans, investments should probably cost less than those available through IRAs, providing a good value to investors. The DOL has long been trying to encourage that excess fees be wrung out of retirement plans, as costs can have an enormous impact on account values over time.
That’s why, under the rule, advisors who recommend rollovers into IRA products that cost more than those in the DC plan must document why those higher costs are warranted and how the products are in the investor’s best interest. Additional burdens on advisors, the complexities of compliance, and participant inertia are all combining to set up an environment in which more and more former employees will potentially head down the path of least resistance and leave their assets in the DC plan. Indeed, maintaining their assets in a qualified plan for as long as possible offers ongoing tax benefits to participants, adding to the appeal of staying put.
The DOL fiduciary rule aside, more employers may be seeing the wisdom of encouraging retirees to keep assets in their plan. The prospect of a large wave of retiring baby boomers, all pulling their money from 401ks, has some sponsors worried about the potentially big demographic dent it could cause, especially in some larger employer plans. As a result, some plan sponsors may be already encouraging retention of retirees’ money so that the sponsors can retain their leverage in negotiating lower fees with plan providers and asset managers.
Fundamental changes afoot?
Although the new Trump administration could possibly trigger action to change or overturn the DOL fiduciary rule, a number of commentators are assuming that the industry should prepare for its implementation, as planned, in the spring of 2017. Regardless of what transpires, the spirit of the DOL fiduciary rule, along with the demographic trends, could fundamentally change the nature of DC plans for retirees and near-retirees. DC plans could be undergoing a potential expansion from Americans’ primary vehicle for retirement savings to an ongoing source of retirement income — at least for a significant number of investors.
Switching to a focus on withdrawals
But this change presents new challenges for plan sponsors and their advisors. For starters, employees on the cusp of retirement will likely need additional distribution options. Many plans were originally designed to offer only annual lump-sum withdrawals — or even “all-or-nothing,” one-time withdrawals. Now, a number of plan sponsors could be considering additional plan withdrawal options, such as systematic withdrawals, which would make these plans more IRA-like. Under this scenario, participants could be satisfied to stay in their plans indefinitely.
Systematic withdrawal plans (SWPs), frequently seen in IRAs and taxable accounts, can offer an easy way to set up a simple retirement income system. However, because SWPs are not currently a feature offered in many DC plans, they could also present an opportunity to discuss with plan sponsor clients some practical aspects, such as revising the plan document to accommodate SWPs and how plan sponsors might communicate with participants about these programs. For example, a plan sponsor may want to caution retiring participants to seek financial advice before selecting regular withdrawal amounts, as interest-rate assumptions and the size of the plan account could have a great impact on how long the retirement income would last.
Re-evaluating the investment lineup
Perhaps more concerning than plan design issues are the investment needs of ex-employees who are within five years of retirement or already in the distribution phase. These needs could present serious fiduciary challenges for you and your clients. In all likelihood, the investment lineups you’ve constructed for your clients have been designed primarily to support accumulation. Target-date funds — particularly those designed with glide paths that resolve to income only — and other plan options may not offer what retirees need to make the transition to spend down, including:
- Generating sustainable income streams, even in low-rate environments
- Preserving wealth
- Minimizing volatility.
Longevity also a factor
Even retirees who have saved a substantial amount face unprecedented challenges in achieving these goals. For one, they are living longer. In 1960, the average life expectancy for an American man was 66.6 years — just one to two years past his retirement at age 65. That same year, a woman could expect to live an extra eight years, to about 73.1 By contrast, a man who reaches age 65 in 2016 can expect to live, on average, until age 84.3. And a woman who reaches age 65 can expect to live, on average, until age 86.6. And consider this: One out of every four 65-year-olds today will live past age 90, and one out of 10 will make it beyond 95. That means today’s retirees must plan to fund retirements that could last 20 or even 30 years.2
In addition, retiring Americans must be prepared to meet ever-increasing healthcare costs. A healthy 65-year-old couple who retired in 2015 would spend nearly $395,000 in healthcare costs over the balance of their lives, inclusive of Medicare premiums and all out-of-pocket expenses. At the present rate healthcare costs are increasing, a similar couple retiring in 2025 would need to plan to spend nearly $464,000.3
Finding solutions for lifetime income
To help retirees generate adequate income over their lifetimes, some plan sponsors are considering offering managed accounts and in-plan annuities. But many are still finding it more palatable to focus on supporting retiree needs through expanded fund lineups. Ideally, any investments added to the lineup that are geared to retirees should be easy to communicate to self-directed investors — and easy for them to implement.
As you’re screening potential investments to fill this gap, keep in mind that self-directed retiree investors can fall prey to common pitfalls, such as focusing solely on income generation to the exclusion of seeking the growth needed to sustain a lifetime portfolio. For example, the low interest-rate environment that has persisted in recent years has led some income-seeking investors to abandon bond holdings in favor of high-yield equities, not realizing that these investments can be highly sensitive to widening credit spreads. Indeed, in the wake of widening spreads in 2015, some higher yielding income-focused funds significantly underperformed, creating serious unintended consequences for retired investors.
By selecting an investment with a focus on total return, you can help mitigate these types of risks for your clients and their retired participants. For example, you might offer a risk-managed, multi-asset allocation fund designed to deliver both growth and income that can fit into a retiree’s portfolio — either as a standalone core holding or as a complement to a broader set of investments.
A fund made up of a widely diversified mix of fixed income, growth and income, and growth-oriented securities could provide an easy way for retirees to balance their need for income and growth, while lowering downside risk. Look for mandates that provide the flexibility to hold a wider range of securities than may have been traditional in the past, including real estate investment trusts (REITs), emerging market bonds, municipal bonds, and more. This added diversification has the potential to work harder in challenging environments while tamping down risk.
Facing the QDIA dilemma
With more participants close to or entering retirement, one investment aspect that plan sponsors may want to consider is how to handle the plan’s Qualified Default Investment Alternative (QDIA) for retirees. Many plans’ QDIAs are target-date funds, which in turn are often “to” retirement vehicles — that is, they are designed for investing until the date of retirement and not beyond, as in “through” target-date funds. Assessing specific investment lineups for a retiree plan population may also necessitate considering whether the plan’s QDIA would still be appropriate for those near-retirees and retirees who were originally defaulted into the investment.
Steps you can take now
With the effective date of the DOL fiduciary rule near, it can be a good time to work with your plan sponsor clients to discuss changes that may be needed. Here are some steps you can take:
- Assess your clients’ exposure. How large are their near-retiree and retired populations? What actions are those participants taking? What are your clients hearing from their employees who are nearing retirement?
- Help clients understand the potential win-win of a retired participant base. By retaining the larger balances of retired participants in the plan, your clients gain economies of scale that position them to negotiate attractive administrative costs. Retired participants win too — just one reason is that they can enjoy the tax benefits of sheltering their assets in a qualified plan for as long as possible.
- Review distribution options. Systematic withdrawals, when pegged to a set amount, are like applying the principles of dollar-cost averaging to distributions. And that can add up to significant benefits for retirees over time. Talk with your clients about amending the plan document to add this option, if necessary.
- Evaluate investment options. Does the fund lineup offer options designed to deliver the income and growth needed to support decades-long retirements? If not, consider adding a risk-managed, broadly-diversified multi-asset fund.
- Consider whether the plan’s QDIA works for retirees. Many participants nearing or in retirement may still be invested in the plan’s QDIA — often a target-date fund. But if that fund isn’t designed for use throughout a long retirement, it may not be the safe harbor they think. Discuss with your clients about potential options of how to handle QDIA participants who are retiring. Keep watching this website for more insights on retiree QDIAs.
Whether or not your plan sponsor clients are considering plan design changes, help them understand the importance of expanding their investment lineups to include products designed specifically for near-retirees and those who are already retired. Even if those employees elect to stay in the plan for only a few years, it’s still incumbent upon the plan fiduciaries to provide investments that are in their best interests.
1National Center for Health Statistics, National Vital Statistics Reports, Web: www.cdc.gov/nchs.
2Social Security Administration.
3Healthview Services: 2015 Retirement Heath Care Cost Data Report.
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