by Fred Reish
In my previous article, I discussed the new requirement that plans give participants “lifetime income illustrations”. The purpose of the rule is to help participants better understand the retirement income that their 401(k) and 403(b) accounts will produce. It will be critical for plan sponsors to work with their recordkeepers and financial professionals because the new rules require that the calculations be done in a way that doesn’t consider each plan participant’s age or situation. This could potentially lead to confusing and possibly misleading outcomes for employees.
The main reasons that the income illustrations will be hard to understand is because they assume that all the participants are 67 years old. (And, yes, I realize that it may take a minute to digest that, because it is so different than what you would expect.) For example, and as explained in more detail in my last article, if a plan has 3 participants who are ages 40, 55 and 67, and each has a $100,000 account balance, the government’s retirement income illustrations will show that each one will have the same retirement income (since each is assumed to be 67 years old). Obviously, though, the 40-year-old’s retirement income will be much higher than the 67-year-old's because of the additional 27 years of income and growth in the account (and not to mention future contributions).
That raises the question, what can plan sponsors do to help participants better understand the calculations? Also, can plan sponsors provide more helpful projections?
On the first question, plan sponsors should consider working with their advisors and providers to offer education about the mandated illustrations, and about how to use those illustrations. For example, employees who are participating in the firm’s 401(k) and 403(b) plans should be told that these are not projections of what they will have at retirement. Instead, the illustrations tell the employees what they would receive as income if they were 67 today—with their current account balance, and if they retired. The employees should be told that they will receive updated retirement income illustrations each year and that, over time, that will give them a sense of the impact of the growth of their account balances and of their potential retirement income.
In addition, employees need to understand that these numbers are just estimates. For example, the illustrations are about on annuities—the income that their accounts could produce assuming that the money lasted only for their lives, with nothing left over for their heirs. If a participant retires at 67 and does not use an annuity for the account balance, the actual retirement income will almost certainly be different than the annuity illustration. At the other end of the age spectrum, younger employees may get the impression that their account balances won’t produce anywhere near enough retirement income and possibly even question whether they should participate in the plan.
To better understand these points, the officers and managers who make decisions for their plans (often plan committee members) should consider meeting with their advisors and providers to review the illustrations for hypothetical participants at different ages and to review their own income illustrations. Then those officers and managers can decide if more is needed.
That leads to the second question, can plan sponsors provide more helpful information to their employees? The answer is “yes.”
As a start, almost all plan providers—the recordkeepers—have calculators on their websites. Those calculators can be used by participants to project future earnings on their accounts, future contributions, and retirement income. It allows engaged employees, most often older employees, to get a better understanding of the adequacy of their savings and the likely outcomes in terms of financial security in retirement. Plan sponsors should work with their providers and advisors to make sure that, on a regular basis, the participating employees are made aware of the calculator and are provided a link to it.
Unfortunately, though, the experience of the retirement industry is that most participants are not that engaged and do not use the tools that the providers make available.
To help the less engaged employees, plan sponsors should consider working with their advisors and providers to also provide retirement income projections to their participating employees. (The difference between “illustrations” and “projections” is that the latter considers, at the least, the likely future growth in the participant’s account between the participant’s current age and age 67. The projected earnings rate is often based on historical earnings on balanced investment strategies.)
While the government’s lifetime income illustrations are mandated, the Department of Labor regulation specifically says that additional information and calculations can be provided to the participating employees. To provide those additional projections, plan sponsors should consult with their providers about the available services and how the calculations are performed. From a fiduciary perspective, plan sponsors can rely on the expertise and experience of their providers, but plan sponsors cannot rely “blindly.” That is, they need to learn about the methodology used by the provider to calculate the projections and to decide if is logical and reasonable. A plan’s advisor can help with that.
If retirement income projections are given to participants, a possible next step would be to include “gap analysis” with the projections.
Gap analysis is a method for calculating whether a participant is on course to a secure retirement and, if not, to suggest how much more should be contributed from each paycheck. It starts with an assumption about the money needed for a financially secure retirement—a benchmark number, often in the range of 70% to 75% of a participant’s current compensation. It then projects the participant’s retirement benefits from the plan and from Social Security. If that amount is at or above the benchmark, the participant is considered to be on course to a financially secure retirement. If the gap analysis shows that a participant is below the benchmark, it suggests that additional deferrals be made to the 401(k) or 403(b) plan and it recommends how much more should be deferred.
I think it goes without saying, but the reports given to participants about their individual “gap analysis” point out that each individual’s circumstances are different (and that participants should consider their personal circumstances) and that these are just estimates and not advice. In effect, the gap analysis is a snapshot and future circumstances could change the picture.
When plan sponsors think deeply about the lack of information given to participants about retirement security and income, they may want to embrace additional services. For employees to do these calculations on their own, they need actuarial skills, reasonable assumptions about future earnings and inflation, a determination of their likely life expectancy after retirement, and an understanding of retirement investing and withdrawals. In other word, it’s not realistic to think that the typical employee would know how to do that job.
One solution is to publicize the plan provider’s website calculator. Some participants will use it, but we know from experience that most won’t. If a plan sponsor wants to help all of its participants, it seems that, for the moment, the way to do that is with additional retirement projections.
Contact HUB to speak to a retirement specialist and learn more about HUB Retirement Services.