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Forty years after the passage of the Employee Retirement Income Security Act - ERISA – it seems like we are far removed from the issues it attempted to address. In 1974 40% of private sector employees were covered by employer-sponsored defined benefit (“DB”) pension plans. These DB plans provided workers with a lifetime income annuity upon retirement. These plans provided a high level of income security – if the employer met funding requirements. However, many of these plans were only partially funded and plan failures were not uncommon. ERISA required tighter funding requirements for these plans, thus improving workers’ income security. A more fully funded plan was more likely to meet future obligations.
The new ERISA funding requirements were imposed at the same time that the economy tanked, oil shocks spiked inflation, and we entered the now infamous period of “stagflation.” As the economy bottomed out in 1979-80, the 401(k) plan was invented, giving employers a lower cost way to provide employees with retirement benefits, just as executives were looking to reduce costs in a tough economy. The trend away from the traditional (and more expensive) DB plans accelerated. Today, less than 15% of private sector employees are covered by DB plans.
Today, 401(k) plans and IRAs are the primary vehicles for most employees to build wealth for use in retirement. These plans are an outstanding way to build wealth but, unlike the DB of old, employees focus on asset balances, not lifetime income. This focus on asset balances may seem trivial, but the effect on the security of retirement income – especially for lower-wage 401(k) plan participants – is huge.
Account Balance versus Income Stream
Account balances are easy for employees to understand. Income streams are more difficult to conceptualize. Even with free and robust retirement income calculators widely available (check out this excellent income calculator from Vanguard), few take advantage of the opportunity to estimate retirement income streams. Savvy Wall Street marketers understand this bias toward asset balances. The result is an avalanche of marketing brochures and sales presentations centered on assets and performance. Think about your plan. Did you buy on income or asset performance?
Two other factors contribute to retirement income insecurity. First, most plans are designed to allow and even encourage lump sum cashouts. You’ve likely seem the advertising. Financial firms push the rollover. Employees, typically unaware of cashout options, choose the glossy brochure pushing for higher returns over the less understood income stream. Or worse yet, see the lump sum payout as the preferred over an income annuity.
The other major factor has been the odd, strange use of annuities in 401k plans. Annuities can be an excellent and efficient way to covert wealth into secure lifetime income. Within small business 401k plans, however, variable annuity “products” have become synonymous with larded, hidden fees and punitive surrender provisions. But it need not be that way if can open up our annuity markets and incent more competition in the industry. It’s not the investment vehicle that’s the problem, it’s the way it is being marketed. To paraphrase an old NRA mantra: “Annuities don’t kill retirement plans, annuity providers kill retirement plans.”
Moving toward income-based retirement planning
Here are some specific actions government and industry can take to nudge plan participants toward better retirement income results:
Require 401(k) plan participant quarterly benefit statements to address income potential as well as asset balances. Current reporting requirements place an exclusive emphasis on point-in-time asset balances. This information tends to reinforce many participant’s (erroneous) view of asset balance as the only measure of value. Result: Novice investors – practically all lower wage workers – tend to overreact to market downturns, selling low when markets temporarily turn south. Income reporting would instead show that short-term corrections have little effect on long-term outcomes, giving participants the potential encouragement to stay the course with their financial plan.
Reform lifetime annuity purchase restrictions for plan sponsors. Currently, plan sponsors have additional, burdensome requirements for those choosing to offer annuity purchase options. The result of the regulation is that plan sponsors (and practically all small business 401(k) sponsors) opt for mutual funds or similar investments for their plan. Because there is little demand for these investment vehicles, Wall Street has little incentive to create and market competitive products. Revise the regs and level the playing field for sponsors and providers. Competition will drive us to an efficient solution.
Tweak ERISA to promote income security as a number one priority. We need to realize that the DB train has left the station. Instead, we need to adapt ERISA to incent income security in a DC world. Employees are ill-equipped to fight this battle on their own. Government needs to recognize the realities of today’s retirement savings landscape and enact regulations that promote more competition while limiting predatory marketing techniques.
Imagine a world where low-cost annuities are marketed by plan fiduciaries whose sole objective is to assist employees in establishing a secure retirement without conflicts of interest or hidden agendas. Welcome to 1974!
