This article was originally published in October 2014. It was updated in January 2017 to reflect nomenclature change. Thanks go to Jessica Gardner, Scott Preppernau, and Frank Thoen for these updates.
The retirement crisis
“After a lifetime of hard work, people deserve the opportunity to live out their golden years with dignity and financial independence. But for most of the middle class, the dream of a secure retirement is slipping out of reach. We are facing a retirement crisis.”
—Senator Tom Harkin, from his 2012 report “The Retirement Crisis and a Plan to Solve It”1
Senator Harkin says this is directly attributable to the loss of pension plans and the resulting breakdown of the three-legged stool of retirement security—pensions, savings, and Social Security.
Impact on retirees
According to the Employee Benefit Research Institute (EBRI),2 between 1979 and 2013 the percentage of Americans working in the private sector who had a defined benefit (DB) plan declined from 38% to 13%. During that same time, the percentage of these workers covered by a defined contribution (DC) plan increased from 17% to 44%. It may seem that, because the percentage of people covered by some form of retirement plan is about the same in 1979 and 2013, people’s retirement security is similar. It isn’t.
DC plans can be an effective way to help people with the savings leg of the retirement security stool but they do not substitute for DB plans because they do not provide the protection of a secure stream of income for life. Employees in DC plans find themselves acting as their own investment managers during their working years. Many are ultimately faced with inadequate retirement income, which they must continue to manage in retirement while facing the very real possibility of outliving their assets.
Consider the following statistics from Senator Harkin’s report:1
- The retirement income deficit—i.e., the difference between what people have saved for retirement and what they should have at this point—is $6.6 trillion.
- Only one in five people in the private sector workforce has a defined benefit pension plan.3
- Half of Americans have less than $10,000 in savings.
- The poverty rate in 2010 for older households lacking pension income was nine times greater when compared to households with pension income.
- In 2010, nearly 6 million Americans aged 65 and over were living in poverty or near-poverty.
It is not only Senator Harkin who is concerned.
- A 2012 Aon Hewitt4 survey of human resource professionals indicated that only 4% of employers are very confident that their employees will retire with sufficient assets.
- According to the Social Security Administration:5
- Among elderly Social Security recipients in 2013, about half of all of married couples and three-quarters of unmarried persons receive 50% or more of their income from Social Security.
- Further, a quarter of all married couples and half of unmarried persons receive 90% or more of their income from Social Security.
Impact on employers
For those employers sponsoring traditional defined benefit pension plans, contribution (funding) and balance sheet (accounting) volatility have made for more than a decade and a half of difficult trade-offs, balancing pension funding against other business needs. As a result, many plan sponsors have frozen or terminated their DB plans.
While the DC plans that have become the prevailing retirement plan design in the United States address employer concerns about contribution and balance sheet volatility, they do not do a good job of helping employers manage their workforces through the orderly retirement of aging workers. A participant’s ability to retire in a DC plan is highly dependent on early participation in the plan, good investment choices during their career, and, most unpredictably, fortuitous market timing. Whereas a DB plan helped participants move into retirement when desired by the employer, a DC plan can result in unpredictable and undesirable retirement behavior.
Employers and their employees need a retirement plan alternative.
A retirement solution
Milliman Sustainable Income Plans™ (SIPs) are just such an alternative. They have controllable employer costs and stay fully funded at all times like DC plans, providing funding and accounting consistency. They maintain a balanced investment portfolio—like a DB plan—that is not overly weighted toward bonds, generally resulting in higher expected investment returns. They provide employees with both lifelong retirement income and expected inflation protection.
SIPs do this by balancing retirement risks in a way that better meets both employer and employee needs. Unlike a traditional DB plan, SIP benefits increase and decrease with plan asset returns, keeping the plan’s liabilities in balance with the assets invested to support them. Benefits earned under a SIP increase and decrease for all participants, even retirees. This shifts investment risk from the employer to the employee, which is similar to a DC plan, but keeps the longevity risk pooled within the plan, which is similar to a DB plan. Because benefit decreases would be difficult for retirees, SIPs have stabilization reserves that help prevent benefit declines without adding any risk to employers.
SIPs have the following design features:
- Because benefits adjust to changes in the market, the employer’s annual contributions and accounting statements are stable.
- Because longevity experience is pooled, the employees do not risk outliving their retirement assets.
- Professionally managed assets in a balanced investment portfolio have higher expected returns and lower expected expenses. This means larger benefits can be provided for the same expected cost.
- Retirees do not have to manage assets in old age.
- Initial monthly benefits are set assuming a low future rate of return. Actual returns larger than that amount cause the benefits to grow, providing expected inflation protection over time.
- Stabilization reserves help prevent benefit declines without adding any risk to employers.
Employers should consider the benefits of including a SIP as part of their retirement packages, regardless of whether they currently offer a traditional DB plan, a DC plan, or no retirement plan at all. SIPs provide participants with greater retirement security than DC plans, while meeting the business objectives of employers (including workforce management and contribution and accounting stability).
1 Sen. Tom Harkin (July 2012). The Retirement Crisis and a Plan to Solve It.
2 Employee Benefit Research Institute (2014). FAQs About Benefits—Retirement Issues: What are the trends in U.S. retirement plans?
3 Senator Harkin and EBRI show a slightly different percentage of Americans in the private sector with a DB plan: Harkin about 20%, and EBRI 14%.
4 Aon Hewitt (2012). 2012 Hot Topics in Retirement: Waning Confidence and the Need for Continued Innovation. Survey highlights.
5 Social Security Administration (June 2013). Fact Sheet. Beneficiary Data.
* A variable annuity plan (VAP) sometimes called a variable annuity pension plan, is generally the same as a SIP. SIPs tend to have additional features that minimize benefit reductions to retirees.