Goodbye Pension Plan, Hello Retirement Challenges
By Donna M. Massanova, CPA
American retirees have historically relied on Social Security and company pensions to sustain them through retirement. But with a changing pension landscape and Americans living longer, future retirees are facing major challenges.
The number of active participants in defined benefit plans fell from about 27 million in 1975 to about 20 million in 2006, and decreases have continued. A 2012 Towers Watson study shows a steady decline in Fortune 100 firms offering traditional defined benefit plans, from 89 percent in 1985, down to 32 percent in 2005, and to merely 11 percent in 2011. Most defined benefit plans have been frozen by their sponsors and are in maintenance mode, winding down obligations. Many plans are implementing derisking strategies by distributing lump sums to certain plan participants, purchasing annuities, or terminating completely.
The difficulty of declining defined benefit options is compounded by the inclining life expectancy. One projection from the Annuity 2000 Basic Mortality table shows a high percentage of individuals living 30 years into retirement, with a 46.7 percent possibility of one member of a retired couple reaching age 95.
Taking the place of defined benefit plans are defined contribution plans, which are gaining ground. Participation in defined contribution plans increased from about 11 million participants in 1975 to 66 million participants in 2006. As more workers shift to some type of defined contribution plan for retirement security – and the strategy of shifting to these plans from defined benefit plans in the form of lump-sum distributions – it will shift longevity risk (the risk of not having an adequate income through retirement) to plan participants. Participants now face the task of self-managing the funding of their entire retirement years, and these years are increasing. Corporate pension management will not only shift longevity risk, but also investment risk performance and inflation risk into the hands of the participant, who is not equipped, trained, nor often willing to take on this daunting task.
The growing number of defined contribution plans, along with the increasing availability of lump-sum distributions from defined benefit plans, results in participants and retirees at greater risk of mismanaging their pension and retirement savings plan assets. These participants are taking an unprecedented risk of insufficient income to maintain their standard of living through retirement.
The Employee Benefit Security Administration (EBSA) has concentrated on this concern over the past few years. In 2010, in conjunction with the U.S. Department of Labor, EBSA issued a request for information (RFI) on the topic of lifetime income or other arrangements designed to provide a stream of income after retirement in employer-sponsored defined contribution plans and individual retirement accounts (IRAs). The RFI’s purpose is to solicit views, suggestions, and comments from plan participants, plan sponsors, service providers, and members of the financial community.
The RFI should identify advantages and disadvantages to the participants and to the plan sponsor by looking at the types of lifetime income options, the costs of these types of options, the behavioral strategies used to encourage greater use of the lifetime income option, the impediments to plan sponsors, and the information provided to plan participants about fees and risks. The information gathered could provide insight into developing lifetime income options for defined contribution plans.
IRS Revenue Ruling 2012-3 outlines when a defined contribution plan can offer a deferred annuity contract as an investment option. The rule also permits the transfer of funds out of the annuity option into another plan investment at any time. Under this ruling, the plan may offer a fixed deferred annuity contract, although transfers to other plan investments are not permitted nor are lump-sum cash distributions with this type of contract.
In Revenue Ruling 2012-4, the IRS clarifies the rules in permitting the rollover of lump-sum distributions from a defined contribution plan to a defined benefit plan for the purchase of annuities. Both rulings seem to ease the inclusion of a lifetime investment option.
Currently, the inclusion of the lifetime income investment option in a 401(k) or other defined contribution plan is optional. Regulators view mandating this option as a required investment as a reduction of fiduciary risk. This is due primarily to the expected criteria built into the requirement of inclusion, much like the balanced fund requirement as the qualified default investment alternative mandated by regulators. The Assistant Secretary of EBSA, Phyllis Borzi, has implied this mandate should promote participation in this type of investment, ultimately helping to manage longevity, performance, and inflation risk for the participant and provide more security in and through retirement. This will not come without a cost. Plan participants must be educated, presented with full transparency of the cost, and provided with real projections of their retirement income with inclusion of these options within their existing portfolios.
The consequence of shifting longevity risk as less of a burden to the participant may equate to increased responsibilities on the fiduciary to include compliance, proper monitoring of expenses, periodic disclosures of projections, and concise education to their participants in respect to this new investment option of lifetime income. Although the consequence may not be welcomed by plan sponsors because fiduciary responsibility and risk is a demanding role, it is a necessary step in addressing a growing retirement dilemma.
Donna M. Massanova, CPA, is partner, employee benefit plan practice leader, at ParenteBeard LLC in Philadelphia. She can be reached at firstname.lastname@example.org.
LAST UPDATED 5/30/2014