Defined benefit (DB) plan sponsors must keep tabs on their plans’ funded statuses for reporting purposes and to determine their required annual contributions, and they often have a very good understanding of how interest rates affect funded status.
Soon, defined contribution (DC) plan participants will see a version of their own funded status—via the lifetime income disclosures on their plan statements required by the Setting Every Community Up for Retirement Enhancement (SECURE) Act. Retirement plan industry experts say helping those participants understand how interest rates affect the numbers they see might help prevent confusion and even panic.
An article on October Three’s website explains that as interest rates go down, participants will need more savings to produce the same amount of income. “Even if your stock portfolio has done well for the year, if interest rates go down enough, you may fall behind on your retirement income goal,” the article says.
Under the Department of Labor (DOL)’s interim final rule on lifetime income disclosures, plan administrators must calculate monthly payment illustrations as if the payments begin on the last day of the benefit statement period. They must assume that a participant is 67 years old on the assumed commencement, which is the Social Security full retirement age for most workers, or use the participant’s actual age, if older than 67.
Plan administrators must use the 10-year constant maturity Treasury rate (10-year CMT) as of the first business day of the last month of the statement period to calculate the monthly payments. The 10-year CMT approximates the rate used by the insurance industry to price immediate annuities. They must use the gender-neutral mortality table in Section 417(e)(3)(B) of the Internal Revenue Code (IRC)—the mortality table generally used to determine lump-sum cash-outs from DB plans.
John Lowell, an Atlanta-based partner and actuary for October Three, tells PLANSPONSOR that the assumptions the DOL is asking plan sponsors to use if they want to escape liability will lead to confusion among plan participants, “and it will not be a happy confusion.” The lower the interest rate, the less lifetime income their account balances can buy, and vice versa, he explains. “People might see a large account balance and the small amount [of monthly income in retirement] it will buy and that will lead to panic,” he says. Lowell adds that if some individuals see a future that looks bleak, they might reason that it’s something they can’t fix and not bother trying to improve their financial situation.
Lowell says he believes the assumptions the DOL dictates in its interim final rule are a disservice to plan sponsors and participants. He notes that plan sponsors might want to develop or contract with someone to develop a modeling tool or set of tools that use different assumptions or a range of them. “I would let people reflect on what they think their future behavior might be to see some palatable moves to an achievable future,” he says.
Lowell says the lifetime income estimate could go down—it’s not necessarily what will happen but it’s not outside the realm of possibilities. “Suppose prevailing interest rates stay where they are and also assume the stock market is currently overvalued and a correction happens,” he says. “Even if a participant continues contributing to his plan, at best, the lifetime income estimate will stay the same, but it could go down.”
Tim Kohn, head of DC services at Dimensional Fund Advisors (DFA), says he breathed a sigh of relief that the interim final rule allows plan sponsors to also use other lifetime income illustrations—the DOL says it recognizes that some plan sponsors/providers are already printing lifetime income illustrations on participant statements that use different assumptions than what is prescribed in the rule. He says some illustrations that are already being provided might use more realistic assumptions.
What About Inflation?
Lowell says the purchasing power of the income participants will receive in retirement is not reflected in the lifetime income estimate on their account statement, so participants might also need more savings than the estimate shows because of inflation. “These are things that legitimately should give plan participants at least cause for pause,” he says.
Kohn sees it as a positive that lifetime income disclosures show plan participants that retirement income should be the outcome for their savings efforts. Although the assumptions might be flawed, he says, it provides a sea change in the vocabulary for DC retirement plans. However, he adds, getting participants to think about what the monthly income they see on their statements will pay for could cause them concern. DFA offers a retirement income calculator to help participants understand their buying power, and other providers have based their tools on guidance on income illustrations the DOL issued in 2013. “Some calculators take into account not only interest rates, but inflation,” Kohn says.
In its comments on the DOL’s interim final rule on lifetime income illustrations on participant statements, DFA urged the agency to require inclusion of numerical illustrations showing inflation’s impact on a portfolio to help participants understand how it diminishes the purchasing power of retirement income. “The department acknowledges the importance of inflation in the preamble accompanying the interim final rule, but strives to avoid ‘complex methodologies for what should be a simple hypothetical illustration,” the comment letter says. “In keeping with the department’s emphasis on consistency and simplicity, a single inflation rate could be used for illustrations. The Federal Reserve has an explicit inflation target of 2%, which provides a useful starting point.”
DFA says an example would help, such as explaining to participants:
“Unlike Social Security payments, the estimated monthly payment amounts in this statement do not increase each year with a cost-of-living adjustment [COLA]. Therefore, as prices increase over time, the fixed monthly payments will buy fewer goods and services. For example, with a 2% inflation rate, $1,000 would buy $820 worth of goods and services after 10 years, and $673 after 20 years.”
Mathieu Pellerin, senior researcher at DFA, says the DOL-prescribed assumptions simply tell participants how much in lifetime monthly payments they could get if they were to annuitize their savings at age 67. But he also says participants need to think also about that income’s purchasing power.
On the positive side, plan sponsors can explain to participants that the monthly income number is more meaningful than their total balance, because most of them need to think about how to replace income in retirement, Pellerin says. However, the illustrations participants will be given are in nominal dollars and there is no accounting for inflation going forward. “The illustrations are expressed as what a participant could buy at age 67 using the current balance. The purchasing power of that retirement income will be lower by the time they reach 67 and will continue to drop during retirement due to inflation,” he explains.
Avoiding Panic and Helping Participants Prepare
Lowell says the more paternalistic plan sponsors—and those that do not also sponsor a DB plan as the predominant vehicle that will give employees retirement security—might want to actively communicate more information than what the law requires about the lifetime income disclosures.
“In addition to explaining what the government-required disclosures are and what they are not, plan sponsors should explain that when thinking about retiring, employees need to consider all sources of income,” he says. “And maybe they want to offer employees some realistic modeling tools.” Kohn notes that the S&P’s “Cost of Retirement Income” dashboard, for example, can illustrate how a change in interest rates could affect investment portfolios.
Kohn adds that plan sponsors can help by providing much more detailed calculators that take into account inflation and other factors affecting expected income in retirement. “Inflation has a corrosive effect on savings,” Kohn says. “What we want is for someone entering retirement to have that same standard of living as they had in year one at year 25.”
As such, he says plan sponsors, advisers and providers need to help participants face a trinity of risks: market risk, interest rate risk and inflation risk. “The DOL’s rules are going in the right direction, but participants should have the ability to work with other provider tools that home in on their unique situations,” Kohn says. “Some participants have a DB plan and some don’t. Some retire at age 67 and some don’t. But we can’t predict what things will cost, say, 50 years from now.”
Additional education will help participants plan a retirement based on the spending behavior of the lifestyle they want to lead, Pellerin says. And participants will need help finding resources to help them achieve that goal.
“Social Security is one and now they will see a nominal annuity, but it doesn’t take into account inflation,” he says. “It will show resources in the first year of retirement, but as time goes by, that amount will lose its purchasing power. It’s like comparing apples and oranges and doesn’t give clarity about what they can expect in future years.”
But, Pellerin says, once participants are aware of their risks, they can take steps to prepare, such as investing in assets that help control inflation, saving more and using savings as a Social Security bridge so they can wait to claim.
Lowell says plan sponsors should have counsel review any communications or additional disclosures they add to their statements. For additional disclosures or modeling, he also suggests that plan sponsors get participants to sign a release saying they understand these are estimates that might or might not come true.
“Perhaps these [lifetime income disclosures on] statements will create a call from participants for more guaranteed income, and maybe DB plans of one type or another will become more of a recruiting tool for employers again,” Lowell says.
In a recent FAQ document providing clarity on the timing of providing lifetime income illustrations, the DOL said it will issue a final rule “as soon as practicable.” So, for now, the industry waits to see if the agency will provide more flexibility on assumptions used to provide estimates and whether disclosures will take into account how inflation affects the purchasing power of estimated retirement income.
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