Feb
17
Note: we have identified websites where, in most cases, the referenced article originally appeared. Often, however, the URL for the article has changed. In this case, you can use the topic or the title of the piece to search the publisher’s site for the specific article. In other cases, you might be required to copy and paste the URL on your browser window to locate the referenced article.
(Last Update on this Post, August 14, 2010)
Chapter 3 (Life Events)
Capital Markets Slide and So Do Benefit Plans
As we point out in Chapters 4 and 5, capital markets play a key role in financing retirement benefits. The employer sponsoring a defined benefit plan relies on these markets to help finance retirement income for its employees. The employer-sponsor assumes the investment risk. In defined contribution plans, it is the employee who assumes this risk. In an economic recession coupled with huge losses in the capital markets, the employers’ and employees’ risks are significantly increased. Some estimate that $900 billion in pension assets were lost by employers sponsoring defined benefit plans during the recession of 2008-09. In an August 11, 2010 article in Forbes.com, Kenneth Hackle predicts that a coming shortfall in pension funding, and a legal obligation to properly replenish the plans will significantly affect corporate cash flows, earnings, and credit. See: Corporate Pension Bomb Set to Explode. Here are some issues that will no doubt arise in the workplace as a result of the dependency on capital markets that affect the financing of pensions and other benefits.
Add as new footnote to the top of page 88, “longevity risk”: There is a new idea to deal with the plan sponsor’s assumed longevity risk. The idea is called “Longevity Bond” that would be offered by the government and hedge the covered loss of certain cohorts such as persons born in a certain year who live well beyond life expectancy. See the Article by Mercado, D., in the June 8, 2010 edition of Investment News.
Add to page 82 at the end of Chapter 3, Exercise No. 7: As we know, many employers have terminated their DBPs and switched to DCPs (such as 401k plans). The DCPs have suffered significant losses as a result of the slide in capital markets in 2008 and 2009. Recent data from the Employee Benefits Research Institute, however, indicates that the losses between January 2008 and June 2009 for older workers with significant service were not as serious as predicted. For example, an employee between age 55 and 64, with up to 20 years of service, lost 14% of the value of his 401(k). This is not insignificant, but perhaps it indicates this group had made some changes in their investment allocations to better protect their 401(k) savings. There were some 25% to 47% losses among other age and service groups. Nevertheless, the 401(k) has become a dominant retirement plan for many employees and the uncertainty created by the losses of savings is creating some special challenges for employees and for sponsoring employers. See: “The Impact of Financial Markets on 401(k) Accounts,” EBRI, (July 2009 Chart).
Similarly, The Vanguard Group has just released its 2010 Report, “How America Saves, A Report on 2009 Vanguard Defined Contribution Plans” and concludes that many 401(k) account balances have nearly fully recovered from the 2008-09 recession, and DCPs continue to be a viable and effective source of retirement income for employees:
“Since 2007, plan participants have endured a substantial and precipitous decline in stock prices, with markets falling by more than half as a result of the global credit crisis. From its low in March 2009, the U.S. stock market gained 65%, although at the end of 2009 it remained more than a quarter below its peak of October 2007. Despite the exceptional volatility that marked the period, the saving and investment behavior of defined contribution (DC) plan participants changed only marginally. In many ways, DC plan participants’ lack of response to recent volatility is striking but, given the inertia associated with much retirement savings behavior, it is not surprising. During this interval, inertia likely benefited many participants. As we move beyond this period, the challenges remain largely the same: improving saving rates and asset allocations.”
Query: Review the executive summaries of the EBRI and Vanguard reports and identify the reasons why you think the sustained losses in 401(k) account balances were not as severe as assumed.
At Page 82, Add Exercise No. 8: What are the likely consequences of this movement away from DBPs and to DCPs on the orderly progression of retirements among older members of the workforce? With employee account balances that are subject to the volatility of the capital markets, and without a specified benefit and a prescribed normal retirement age will employers have any ability to predict the likely retirement dates of its workers? What effect will this have on staffing, succession planning, employee relations, benefit offerings, and productivity? What could an employer do to assure itself of more predictability with respect to the sequence and progression of retirements? From a public policy standpoint what are the issues and how might government help? Read this (July 2009) article from the Center for Retirement Research, Sass, S., Haverstick, K., Aubry, J., “Employers (lack of ) Response to the Retirement Income Challenge” (IB#9-13).
At page 82. add Exercise No. 9: With over 20 million baby boomers retiring over the next several years, what impact is this likely to have in capital markets? Will there be a decline in investment activity? What result will likely occur? Explain. Do most people stop investing when they retire? Will their portfolio mix change? Could other factors sustain the growth in market assets? (See: Congressional Budget Office, “Will the Demand for Assets Fall When Baby Boomers Retire?” September 2009, Publication No. 2843; (www.cbo.gov)
Add to page 119 of the text at the end of “Some Perspective:” Can we find safety in our 401(K)?
Many persons who are relying on 401(k) plans to retire have suffered losses in their accounts and are probably thinking of delaying their retirement. They are also wondering how they might go about changing the allocation of the investments in their account, or perhaps converting some of their retirement savings to an annuity. There are calls to re-think the whole idea of employee funded retirement plans some of which are outlined below.
For example, the U.S. Department of Labor is considering plans to require employer sponsors of DCPs to offer its participants the opportunity to choose either an annuity or a lump sum distribution. How would this work? Visualize such an approach and identify the relevant issues that should be considered in making such a change. See: The Defined Contribution Institutional Investment Associations’s (DCIIA) letter or May 3, 2010 to the D.O.L.’s Employee Benefits Security Administration recommending the required inclusion of a “life time income” alternative in DCPs. DCIIA Lifetime Income RFI Comment Letter
See also, the video of a recent Senate Select Committee on Aging, “The Retirement Challenge - Making Savings Last a Lifetime.” Guaranteed life time income is one of the ideas being considered by the Committee. Do some research and answer the following questions. What risks does it seek to ameliorate? What types of products are available from insurance companies that might fulfill this purported need? What are some of the issues, such as costs, disclosure, education, and liquidity that might arise with such products? Should Congress mandate DCP sponsors to provide guaranteed income for its participants? Listen to the speakers and be prepared to discuss these issues. See Congressional Committee Members Statements.
Better DCP Design and Administration: Meanwhile, more traditional efforts are being made to assure participants get the most out of their DCP. For example, IBM gets high marks for its 401(k) plan which features: (1) 100% up to 6% of pay; (2) auto-enrollment; (3)very low administrative fees; (4) one-on-one investment advice; (5) customized target date funds that adjust allocations based upon age; (6) Institutionally priced annuities to assure life-time retirement income; (7) auto-rebalancing of investment and auto escalation of employee contributions. How might this approach reduce the “investment” and “longevity risk?”
More for page 119: Hybrid 401(k) and Annuities
One new idea is to include an investment option for 401(k) participants that involves a switch from age related or life style funds to a pre-paid annuity. The option would be triggered at a later age, say 50. The current balance and then future deferrals and matches would be deposited into the annuity option and, at retirement, the participant would receive a guaranteed annuity instead of a lump sum. How does this approach change the allocation of our traditional risks: investment, inflation, and longevity? The new approach is called a “Hybrid 401(k).”
|
Chapter 4 and Chapter 9 Based upon recent legislation and IRS rules, revise and change Table 4.4 at page 118 and text at page 263.
|
|
There are two Types of Safe Harbor Designs using non-elective and elective enrollments. The purpose is to avoid discrimination testing under IRS rules. In the case of non-elective enrollment, the employee can opt out. |
|
|
|
· Employer auto enrolls non-participating employees in the plan and contributes to all eligible participants an amount equal to 3% of the employee’s income to a 401(k). The amount must immediately vest. |
|
|
|
· In the case of a plan where only elective deferrals are permitted, the employer must match 100% of the deferral up to a maximum of 3% of the employee’s income, and an additional 50% for the next 2%. The match must vest immediately. |
Add to 119: What is a DBK?
Another new idea made possible by the Pension Protection Act of 2007, is the DBk, which can be offered by employers with 500 or fewer employees after January 1, 2010. What is it? It is a minimum floor pension (DBP) of 1% of “final average pay” for each year worked up to 20 years. Then, it is combined with a auto enroll DCP of a maximum employee contribution of 4%, (unless the employee opts out or changes the contribution) combined with a compulsory employer match of 50% up to 2% of pay. ERISA reporting requirements are relaxed and the employer reports data on only “one plan.” This should generate some interest among smaller employers looking for a plan that enables them to compete in the labor market at a lower costs and less complex reporting requirements.
Add to Page 118: New Research from Wharton: Can 401(K) Plans Provide Adequate Retirement Income? Yes!
As we point out below there are a number of new approaches among retirement experts who have lost confidence in 401(k) plans as a result of the tumble in the 2008-09 stock market. Not so, Peter Brady who just completed the above titled research paper (Working Paper 2009-01) for the Wharton School’s Pension Research Council. Brady says 401(k) plans are working and that a moderate savings rate with reasonable investments can lead to adequate retirement income - 87% replacement income. With a higher risk portfolio, the replacement rate can be as high as 107%. Brady points out that a portfolio of 60% bonds and 40% stocks, the annual return on a 401(k) over the 10 period ending December 10, 2008 was 2.83%. This included a period with 2 recessions. Brady argues there is no need for Guaranteed Retirement Accounts; he demonstrates that employer sponsored 401(k) plans can work. People just need to save and contribute a moderate amount during their work career. Read the Brady paper.
Amend at page 129, Chapter 4 Exercise, Number 4 by replacing these numbers: average final pay is $200,000 and bonus is $80,000. The rest of the exercise would remain the same.
At page 131, Chapter 4 Exercise add this after the fist sentence to Number 15: What is the relevance of the following factors with respect to a waiver of the joint survivor benefit: (1) the financial risks; (2) differences in age and life expectancy; (3) allocating a portion of the higher pension amount to purchase tax deferred, income generating investments; examples? (4) Should they purchase an immediate annuity? What are the pros and cons? (5) What about life insurance? How would this help? What type? (6) Should the couple have long term care insurance? Explain. See: http://www.moneycouple.com.
Exercise No. 22 added at page 131. At page 112 of the text, we refer to life-cycle funds- commonly called “target-date funds” - that are being offered to 401(k) participants. Such funds gradually modify their portfolio as the participant moves toward retirement age. They are designed to maximize growth during the early years of saving, but as the participant grows older, the portfolio is automatically modified to include more conservative investments. This is commonly called the “glide path.” There has been some controversy over such funds because many were hit hard by the recession and, in spite of similar targeted retirement dates, they have widely different glide paths. Describe how the method and timing of the distribution of retirement funds as well as the person’s age might result in some differences in glide paths among participants who have chosen the same retirement date. See: U.S. Department of Labor, June 2009 Webcast about Target-Date Funds, and also “Regulators Get an Earful about Target-Date Funds,” Retirement Weekly at Market Watch, June 19, 2009 (vol. 7, no. 25) Subscription required.
Exercise No. 23, added at page 131: How would go about benchmarking and evaluating a company’s 401(k)? What criteria would you use to determine how well it is managed? How would you compare the plan to others sponsored by employers? Reflecting on the fundamental purpose of a 401(k), how would you measure its utlimate efficacy? One small company has begun to do this work. Check out their website at: www.brightscope.com/. Examine their criteria and scoring system and critique it. Check out several companies’ results and be prepared to discuss their scores.
Add at page 131, Exercise No. 24: Look at the basic design features of a state employee pension fund. For example, you can check the Public Employees Retirement System (PERS) in Ohio. Participants in this Plan can elect to retire at a full, unreduced pension level. Then, they return to work doing the same job and receive compensation for their active work. In an expose` of this practice, which is quite common, a participant was quoted to have said: “I contributed my money to this plan and I am entitled to receive my full pension. I resent people calling this “double dipping.” Public employers argue they want to retain the experience of the retiree, and they can maintain higher productivity by asking the participant to remain at work after electing retirement. Analyze this practice, commonly called “double dipping” among public employees. Is this the retiree’s money or is it more? What are the pension costs to the public retirement system when this practice is allowed? Is it a factor in causing some public retirement systems to experience funding deficiencies? Refer to Exercise No. 8. As we ask there, how does the University of California handle this issue? Organize a discussion of the practice and its total financial implications. (See: “An Ohio Newspapers Special Report - A Double Dipping Double Standard?” by Fischer, B., The Cincinnati Enquirer, Willard, D., The Akron Beacon Journal, June 20, 2010
Chapter 5: Add to “Retirement Planning” section at page 143: Looking for Safe Retirement Investments?
Retirement Weekly at Market Watch, (May 22, 2009, Vol. 7, No. 21) outlines some interesting approaches but points out underlying hidden financial risks of what appears to be a conservative approach to saving and investing for retirement. The Weekly reviews corporate bonds, preferred stock, Treasury Inflation Protection Securities (TIPS) and others. The advice: keep commitments short, buy U.S. Treasuries, bank money market accounts and bank certificates of deposit.
Add: Exercise No. 25, at page 131: Check the interesting article from Vanguard Research about a host of new innovative products that attempt to deal with the longevity risk and retirement. For example, the paper discusses Systematic Withdrawal Plans (SWP), time horizon funds, immediate annuities, and payout funds and describes the risks and costs associated with each. See: The Retirement Income Landscape (May 2010), Vanguard Research. Check out the hypotheticals in the article and be prepared to discuss the longevity, investment, and other risks and costs associated with these new ideas.
Add at end of Chapter No. 5, at page 150:
Congress and the IRS provide relief due to the recession -2009:
In chapter 4 and 9 we discuss certain legal requirements pertaining to the employer sponsor’s obligations relating to DBPs and DCPs. Some needed to be relaxed due to the economic recession of 2008-09. Refer to page 93 and 117 of the text and incorporate these changes into your notes.
Minimum Funding Requirements
Congress in 2006 passed the Pension Protection Act which required employers to meet more stringent funding requirements for their defined benefit plans (See also Chapter 11). Due to the recession and the losses in the stock market, Congress in December 2008 passed legislation that relaxes the funding requirements of the PPA for a temporary period. This period ends in 2011, and as referenced in the notes to Chapter 3 (above), and employers must resume their statutory obligation to properly fund their pensions. Some experts predict, that there is a “Corporate Pension Bomb About to Explode.”
Not so Required Minimum Distributions for 401(k)s
We also discussed the Required Minimum Distribution (RMD) rules for retirement savings plans. These rules require persons over age 70.5 to begin distributing the funds in their 401(k), IRA, other tax favored retirement account. The amount is based upon the value of the account ion December 31 of the previous year as well as the retiree’s life expectancy. Since the value was probably significantly higher last year than this, the required distribution could drain a disproportionate amount of funds out of the account. Congress decided to suspend the RMD rules through 2009, but not for 2008. So, RMDs for 2008 must be made by April 2009. Should Congress have done more? We should note that President Obama had earlier suggested that any withdrawals after age 70.5 made within the RMD amount, would not be taxed. What tax changes can you think of that would help both employers and employees continue their sponsorship and participation in DBPs and DCPs during a period of economic recession? For an interesting analysis of the linkage between distributions and life expectancy see the December 2008 issue of the Journal of Financial Planning, (Click on “current issues” and then “table of contents,” and look for the article titled “Joint Life Expectancy and the Retirement Distribution Period.”)
IRS - Distress Relief for employers sponsoring non-elective Safe-Harbor 401K) plans
On May 18, 2009, the Internal Revenue Service published proposed regulations that would provide relief to employers who sponsor a safe harbor plan providing for nonelective contributions and who incur a substantial business hardship. Provided certain conditions are met, the proposed regulations would permit such employers to reduce or suspend nonelective contributions instead of terminating their plan. See; Internal Revenue Service.
Obama Administration Pitches In
At page 135: President Obama’s IRS is adding some legitimacy and simplicity to several current pension practices by streamlining the process for auto-enrollments in DCPs including SIMPLEs, allowing unused vacation and paid leave to be contributed to a DCP, and permitting the deposit of tax refunds into IRAs and other plans. The IRS also has introduced new clarity on the rules for “rollovers,” and offers employers help on selecting the right plan. See a summary at: http://www.irs.gov/retirement/article /0,,id=212061,00.html
As you are aware the financial risk in most DCPs is on the employee-participant. Again the recession has affected the account balances of many and here are some ideas being offered that attempt to mitigate the financial impact of the recession on participants’ DCPs. Add these notes at page 118 of the text.
Some Broad Policy Issues for Page 150: Should the federal government run your 401(k)?
There is also a proposal being discussed in Congress to transfer the management and control of 401(k) accounts to a government agency that will invest the funds in government bonds and better assure preservation of the employee’s account. The idea, promoted by Professor Teresa Ghilarducci at New York’s New School for Social Research, would also value the account at the pre-September 2008 economic downturn amount. The proposal is occasioned by the loss of value incurred by many 401(k) participants recently and seeks to minimize the investment risk that currently rests on the employee. For more information, see: http://www.sharedprosperity.org./. The Brooking Institute recently published a report recommending that lower income employees be given a tax credit to save in their 401(k). What do you think would be the advantages and disadvantages of such a policy?
What happens when all your eggs are in one basket?
What about ESOPs? What happens to employees’ retirement income when a company sponsoring an ESOP goes bankrupt or its stock tumbles in value? See: Schulz, E., (December 10, 2008) (Chicago) Tribune Filing Exposes Risks of ESOPs. The Wall Street Journal, B6. The ESOP, invented more than 50 years ago was designed to allow hourly workers to participate in the growth of the company. Leveraged ESOPs were intended as a corporate financing or corporate takeover defense. But the original and continued overall strategy is to get alignment between managers and employees and to offer the opportunity for wealth accumulation for all employees. There are 11,000 ESOPs in the U.S. today. For an interesting analysis and history of ESOPs see: “Fifty Years of Utopia: A Half-Centtury After Louis Kelso’s The Capitalist Manifest, a Look Back at the Weird History of the ESOP” by Andrew W. Stumpff, The Tax Lawyer, Vol. 62, No. 2, at 419 (2010). What’s your opinion? Are there occasions when ESOPs make sense? What are some specific circumstances when they do? What about the investment risk? What type of company would be most likely to use an ESOP? Does it serve its intended purpose using the Benefits Model as a template?
Some other 401K) Fixer Uppers
For an excellent summary of some new ideas and approaches with respect to 401(k) plans see:Tergessen, A. (December 13-14, 2008) How to Fix 401(k)s, The Wall Street Journal (R1).
A related approach is a DCP investment option called “Stable Value Funds.” These funds generate a stable return for their investors by investing in diversified bond portfolios and then contract with banks and insurance companies to mitigate major market shifts. For an excellent article on these instruments see: Laise, E., “Stable Funds in Your 401(k) May Not Be,” The Wall Street Journal, March 26, 2009, D1. The article points out that bond returns have suffered and the Stable Funds have not fulfilled their intended purpose.
Supplement to Chapter 5 Exercises at page 151-152:
No. 9 (Add to): What would be the principal reason one would want to convert a regular IRA to a Roth IRA? What are the rules for making such a conversion? See: Retirement Weekly, August 28, 2009, vol. 7, number 35, “Check your Roth Conversion,” (www.marketwatch.com/retirement)
No. 14. IRAs, 403(b)s, 401(k)s, Roth IRAs, supplemental retirement, deferred income plans, etc. etc. An idea that is being discussed among policy makers is to create one supplemental retirement account that has uniform tax rules and requirements. This will end the confusion over a variety of “IRA -type” retirement accounts that have varied deferral and contribution limits, create confusion among savers, and add expense to the private saving effort. How would you design such a proposal? What basic rules would apply? The current administration in Washington is considering requiring all employers to offer some type of IRA based retirement account that would insure a source of retirement income in addition to Social Security. Give some thought as to how such a proposal should be designed so as to achieve concurrent goals of avoiding additional expense especially on small employers but achieving a meaningful source of retirement income.
Number 15. Some employers offer certain higher paid management an opportunity to voluntarily defer more of their income than the 415 limits allow They are called Deferred Income Plans. If the election to defer a part or all of their bonus, for example, is made before the precise sum is known, (See footnote 24 at page 93) they can avoid income taxes until the money is distributed usually at retirement age or separation. Many typically defer 50% of their salary and 100% of their prospective bonuses. The amount deferred earns a stated interest rate. The deferral plan is not considered a tax-qualified plan and is subject to creditor claims in bankruptcy. Some preliminary data, indicates that the number of elections to defer income has declined since the 2008-09 recession. What factors do you think could be causing this decline?
Number 16. In view of the slide in capital markets and the 2008-09 recession, would this be a good time to consider moving retirement assets to a Roth IRA or Roth 401(k)? Why? Explain how these factors might affect your decision: (1) suspension of RMDs for 2009; (2) the lifting of the $100,000 income limit in 2010 for Roth IRAs. (See June 22, 2009 article on this change in the Wall Street Journal.) (3) Increased tax rates for higher income persons. (4) Capital markets will start recovering generating significant returns in the next 5-10 years. (5) If you are nearing retirement, higher earnings may lead to higher taxes on your Social Security benefit or reduce your early retirement benefit. (6) Also, the Patient Protection and Affordable Care Act imposes an extra 3.8% tax on certain net.earnings. (7) Again, for future retiree, your Medicare Part B premium will be increased based upon your annual income. (See: Retirement Weekly at Market Watch, May 22, 2009, Vol.7, No. 21; and also see: “Roth Conversion - Why Accelerate Income?” (by J. Kilroy), Retirement Weekly at Market Watch, July 9, 2010, Vo.8, No. 28.
Number 17. With respect to individual retirement planning, what impact would the fall in the price of housing and other related recession factors arising in 2008-09 have on those retirees who planned to use reverse mortgages as a source of retirement income?
Number 18. f you annuitize all typical retirement income sources at age 65, the Center for Retirement Research at Boston College estimates that with health care expenses incurred after age 65 as well as the risk of Long-term care expenses, 61 percent of U.S. retirees will be unable to maintain their standard of living in retirement. What does this mean with respect to retirement planning and the possible purchase of long-term care insurance? See: Munnell, A., Webb, A., et al (March 2009) Long-Term Care Costs and the National Retirement Risk Index. CRR (No. 9-7).
Number 19: Due to the economic recession of 2008-09 the IRS is considering lowering the 2010 Section 415 limits to properly reflect the lack of inflation during this period. The revised limits are indexed to inflation. Is this a good idea? Develop a list of potential (intended and unintended) consequences this change might have on retirement. See: American Benefits Council’s Letter of September 8, 2009 to the IRS, “Effect of Potential Decline in CPI-U on the 2010 Retirement Plan Limits,” (www.americanbenefitscouncil.org/)
Number 20: Some employers have a “use it or lose it” policy with respect to Paid Time Off (PTO). A new IRS rule allows the employer to contribute unused PTO into the employee’s 401(k) account. There are specific circumstances that must be present in order to make this deferral. See the June 2010 article in Employee Benefit News that describes how this will work. What are some of the issues? For example, should the amount be considered a deferral by the employee or a “non-elective contribution” by the employer? What circumstances should control? Be prepared to discuss.
Number 21: Based upon the economic recession of 2008-09, the lack of sufficient savings by many employees, and the migration of employer sponsors from DBPs to DCPs, what percentage of the Baby Boomers are at risk of having inadequate retirement income? See: Employee Benefits Research Institute (EBRI), Issue Brief No. 344 (July 10, 2010) and No. 326, February 2010). Go to their site at: http://www.ebri.org
Add to Chapter 5 (Small Employers and Retirement Planning) at page 147: There is a new annuity product available that is worth mentioning - a longevity annuity. A person retires and lives off retirement income, savings, and Social Security. He is not sure, however, he will have enough to live on if he survives past age 85. So, he buys a “longevity annuity” that will commence payments at age 85, and he will comfortably live off the annuity and his other sources of retirement income until his death. Another approach is to “ladder” your annuity purchases, buying several immediate annuities over perhaps 3 years. Then you can minimize the lower interest rate that will be earned on your annuity during a bear market year. (See: www.retirementoptimizer.com/) Finally, one can buy a variable annuity that is purchased in advance of retirement and will earn a variable rate of interest depending upon the market. You can be protected on the downside and guaranteed an annuity payback of your principal investment regardless of market results. This is a guaranteed minimum benefit. This product can also include a life insurance benefit guaranteeing your beneficiaries with income when you expire. Thus, Joe Jones can buy an immediate $600,000 annuity that will pay him a life benefit of $50,000 per year. He alternatively buy a $1 million variable annuity with a 5% withdrawal guarantee, paying him at least $50,000 per year or more. For a great summary of annuities see: Tergesen, A., and Scism, L., (April 18-19, 2009), Getting Smart About Annuities, The Wall Street Journal (R1).
Last Revised: August 5, 2010
Comments
Leave a Reply