Workers can’t retire? Take 401(k) plan design to the next level

Employees have been retiring later and later due to well-known factors: people are living longer, full Social Security benefits are starting later, inflation is eroding the purchasing power of most employees and retirees, health care costs are high and rising, and defined contribution balances need to cover increasing portions of retirement living expenses.

Defined contribution retirement accounts (e.g. 401(k) or 403(b) plans) have significant investment risk and don’t necessarily last a lifetime as defined benefit annuities did prior to their decline. Indeed, the shift towards defined contribution plans as the primary vehicle to support retirement expenses for life is a key factor pushing employees to work longer. Employees concerned about outliving their retirement savings often choose to continue to work rather than retire and rely on their accumulated balances.

Later voluntary retirements can have significant negative unintended and costly financial consequences for many employers. Many organizations rely on building key talent from within, focusing their hiring on lower, entry levels and using career development and advancement to help percolate talent up into the higher ranks.

Such build-from-within strategies are predicated on recognition of the unique value that can come from homegrown talent. From a rewards standpoint, this strategy is best sustained by an inherent promise of promotion opportunities for higher performers and higher valued talent. In effect, tenure is rewarded through the mechanism of strong and consistent career value. This requires an ample level of velocity of talent movement through promotion and lateral moves.

Delayed retirement can make it challenging for employers to maintain sufficient talent velocity to support the build-from-within strategy. The retirement-eligible population tends to hold a significant portion of higher grade level positions. Unless the organization is in high growth mode, delayed retirements among this population can reduce the number of open positions and opportunities for promotion for up-and-coming talent.

The resulting career “choke points” reduce talent velocity overall, weakening incentives and engagement for those whose careers have stalled out. This can also lead to loss of talent at the levels below these career choke points, likely those with the greatest opportunities on the outside, with negative cost and productivity implications for the employer.

Traditional defined benefit pension plans provided inherent incentives for retirement-eligible employees to retire “on time,” averting choke points and the reduction of internal velocity. Most defined contribution plans, as currently designed, are subject to macro-economic and sectoral volatility, leaving retirees subject to market risks and employers with little to no control over the timing of employee retirement from their workforces.

This loss of predictability around retirement choice is another cost imposed on employers by the flight from defined benefit pensions. In addition to these workforce mobility costs, delayed retirements can lead to increased health and welfare costs and time loss costs that come about due to an aging population.

This raises the question: are there ways to provide defined benefit-like lifetime income and financial security within a defined contribution environment, providing retirement eligible employees with the security needed for timely retirement and helping employers to avoid the challenges noted above?

Why current solutions aren’t providing the financial security needed to retire

As stated above, the risks of outliving an account balance due to inflation, longevity, and investment risk are too great for most employees. While converting some portion of an account balance to lifetime income may make sense and can provide needed security, the common offerings are simply not working. Anecdotally, defined contribution plan sponsors have offered in-plan insurance company annuity conversions but the percentage of employees that actually use them has been very low (less than 5% and many say less than 1%).

At a high level, insurance company offerings through the retail market or within a defined contribution plan tend to not be viewed as competitively priced. In addition, the products offered may have bells and whistles that sound good but are not well understood – causing a general consumer stigma against jumping into an insurance product. For those employees that work with a financial advisor, there may also be a reluctance to convert some of the retirement account to lifetime income as it may adversely affect the advisor’s compensation. But many employees do not even get as far as seeking out annuity pricing on their own or with assistance.

So how can you get employees comfortable that they are getting a fair deal on a lifetime income product?

A lifetime income solution for defined contribution plans that works

A life annuity that increases with inflation and covers living expenses above Social Security gives a high level of financial security to retiring employees -enabling employees that are hesitant to retire to make the leap.

Volumes of data exist showing that retiring employees actually do want lifetime income at least to cover basic recurring living expenses above Social Security. This data exists in abundance in the defined benefit world. Thousands of defined benefit plans have terminated and have gone through election periods for retirement-eligible employees. During these election periods, employees are offered lifetime income annuities to be provided from an insurance company or a lump sum account balance to be managed by the employee in an IRA or a defined contribution plan.

Approximately 34% of the dollars offered in these elections, representing 28% of the population, were taken as lifetime income annuities in a survey of 14 recent defined benefit plan terminations conducted by Agilis, an actuarial and investment consulting firm specializing in the retirement income plan space. Note that this compares to the very low conversion rate of annuities taken from defined contribution balances through the retail market or in-plan defined contribution offers quoted earlier in this article.

So, how do you get these results using your defined contribution plans to ensure sufficient workforce velocity and manage costs?  Several factors need to be included:

• A time-sensitive window election with a specific competitive offer is critical. Current lifetime income options are typically passively offered or left to employees to research and find on their own.
• An employer-run competitive insurance bid is a must. This ensures fair pricing and apples-to-apples annuity amounts. The employer also vets the quality of the insurer and their safety from a fiduciary perspective. Employees are understandably not comfortable and in almost all cases, not equipped, to do this due diligence themselves.
• Offering various annuity features can enhance the number of employees that elect a lifetime income option. For example, straight life annuities, joint and survivor annuities, and the option of inflation indexing.
• A communication package that addresses common risks, answers questions about fair pricing and helps with planning will also lead to a higher proportion that take the lifetime income offer.
• The cost to the employer of implementing a window election does not need to be anything other than running the process of offering competitive and secure pooled retirement risks for their employees. Much of the process can be outsourced.

Related: Delayed: 25% of pre-retirees push back retirement, 15% unsure if they’ll ever retire

Few employers understand the workforce effects of their retirement plan designs including decisions to move away from traditional defined benefit pension plans. There are often significant and costly unintended negative consequences for many employers.

Lifetime income options are of interest to retirees and employers alike, as they can provide financial security and help get employees comfortable making the leap into retirement.  The design, approach and substance of the offer can make a huge impact on the actual utilization of any offer.

The reward of a secure lifetime income in retirement for an employer’s retiring employees and the resulting increased promotion opportunities for up-and-coming talent in the organization, can be a true and game-changing win/win for employees and employers.

David Rosenblum, FSA, FCA, EA is a Managing Director at Agilis, consulting on employer retirement programs as a pension actuary with over 30 years of industry experience. Haig R. Nalbantian, a labor/organizational economist and experienced consultant to leading organizations, is co-leader and founder of the Workforce Sciences Institute and former Senior Partner at Mercer.