Life after work: The future of retirement security

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By Ken Mungan | 01 November 2006

James Nestegg faces a quandary. At 50 years of age, he has accumulated a little more than $200,000 as a semi-regular contributor to ABC Corp’s 401(k) plan—a total he feels is respectable, though not sufficient to meet his long-term needs. He knows he’s probably 15 years from retirement, and he’d like to use that time to grow his account. Yet he doesn’t want to imperil the money he’s already put away by being overly aggressive. How does he build on what he’s got without risking it all? Equally frightening is the possibility that he won’t have enough. What is he supposed to do to ensure that he won’t outlive his savings?

Nestegg's concerns mirror those of pre-retirees all over the country. Since just 21% of American workers have access to a corporate pension plan, most people must address these issues on their own1. People saving for retirement build up a substantial sum of money with the long-term goal of maintaining a certain standard of living through the end of their lives. A significant, sustained decline in the stock market can quickly alter those expectations.

Currently, 401(k) plan participants can invest in funds that range from low risk (such as guaranteed interest contracts and bonds) to balanced funds to a broad range of higher-risk equity funds. These investments can be combined to create portfolios with different levels of risk. Many participants struggle over tough questions: Do I invest more in equities for their upside potential—and take on the risk of a market downturn? Or do I invest conservatively to avoid losses—and miss out on market gains?

But what if you could do both? Nestegg and others like him will soon be able to combine the security of a long-term guarantee with the higher upside potential of an equity vehicle. This hybrid is known as a 401(k) guarantee—a guaranteed withdrawal balance that allows investors to take withdrawals over a period of time from a guaranteed balance. This unique plan feature provides for an ongoing stream of stable benefit payments upon retirement, regardless of market performance. Account holders retain the growth potential of a diversified portfolio, and the ability to make regular withdrawals is protected against market downturns.

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Financial institutions offering such guarantees are basically providing insurance against sustained market declines. An insurance company provides the guarantee, purchasing hedges in the capital markets to provide this protection.

 

Guaranteed retirement products are already prevalent in the $1.4 trillion2 variable annuity market. The same principles that underlie these products can be applied to 401(k) plans, not to mention 403(b)s, 457s, and IRAs—the vehicles that make up most of the $14.5 trillion national retirement savings pool3.

The implications of a 401(k) guarantee are significant for the various stakeholders associated with 401(k)s, a roll call that includes plan sponsors, corporate executives, and, most importantly, plan participants.

On guarantees

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A 401(k) guarantee provides a "floor" under the total amount that a participant can withdraw from the 401(k) account. This protects against severe market declines while still allowing the participant to receive upside gains. The guaranteed withdrawal balance increases each time a deposit is made.

 

The "ratchet" is a key aspect of the 401(k) guarantee. With an annual ratchet, the guaranteed withdrawal balance will increase to the current account value once per year—thereby capturing any increase in account value due to market gains. On the other hand, if the account value drops below the guaranteed withdrawal balance due to market losses, the guaranteed withdrawal balance remains unchanged.

To provide these benefits, guarantee providers must hedge their exposure to declines in the stock market. A hedge, which is a financial instrument whose value goes up as the stock market goes down, provides protection similar to a fire insurance policy on a home. Major market declines, like fires, are relatively unlikely events, but if they happen to someone who is unprepared they can be financially devastating. Hedging a retirement account provides protection against catastrophe.

Guarantees such as these are already sold on a retail basis to millions of people saving for retirement. Taken collectively, they represent a large pool of market risk. That risk is aggregated by an insurance company and hedged on a wholesale basis. Insurance companies benefit from an economy of scale by conducting this activity in the aggregate. Insurers manage a large portfolio of futures, options, and swaps for the benefit of millions of individual accounts. The individual investors don’t have to think about all this—they simply rest assured that their investments are protected.

The plan sponsor perspective

Just down the hall from James Nestegg, Sally Sponsor has a problem of her own. As ABC's Director of Human Resources (HR), she is responsible for administering her company’s benefit package. Recently, her job has not been much fun. Last year the company decided to freeze its pension plan, the latest in a series of cutbacks that have tried employees' patience. There is no help on the immediate horizon, with healthcare costs continuing to climb.

These dynamics are beyond Sally's control. Senior management has tried to help, but costs must be cut and benefits retained. Sally needs to find a way to make this work. Her bosses seem to expect her to pull something new out of her hat—while simultaneously cutting costs.

Then one day, Sally Sponsor has lunch with a peer from another company that has faced similar challenges. She learns that they are taking a new approach to their retirement benefits—with a 401(k) guarantee. "The best thing about it is that there is no additional cost to the company," says the friend.

Sally recognizes this is true—and sees an added benefit. She knows that the people in senior management are serious investors with very large 401(k) accounts. Several of them are within 10 years of retirement and would love to see their own retirement savings protected from a significant market downturn. It would be a huge win for Sally to introduce a 401(k) guarantee to ABC, since it would benefit both the rank and file and the people who sign her paycheck.

So Sally brings the idea to her boss, ABC's chief financial officer, Fiona Fiducia. Fiona recognizes how a 401(k) guarantee might improve her own retirement package, but that consideration is secondary to the value that such a plan enhancement could add for the company at large. As a member of ABC's board, Fiona knows that fiduciary scrutiny is at an all-time high. She has been worried about how the benefit decisions that are made today will impact ABC Corp tomorrow. A 401(k) guarantee is a good way to protect employees' retirement savings, thereby exercising her role as a corporate fiduciary. And the 401(k) guarantee not only makes investment sense, but also has the potential of boosting plan participation. Finally, the guarantee is paid for not by the company as a whole but by those employees who elect to participate. With Sally’s help, Fiona takes the idea to the Board for consideration.

Electing the guarantee

Assuming ABC decides to install a 401(k) guarantee, what does this mean for James Nestegg?

As it turns out, the process is pretty straightforward. By electing a benefit guarantee on his 401(k), all of the money in his account is included in the guarantee except for any assets he has in the ABC Company Stock Fund (since this is a single security, it cannot be included in the guarantee). The only requirement for the remaining assets is that Nestegg cannot have more than a maximum percentage of his account invested in equity funds, typically in the 60% to 70% range. Guarantees require a reasonable level of portfolio diversification, similar to the approach used for decades by defined benefit plans. Finally, Nestegg must indicate whether he would like to begin taking guaranteed withdrawals within the next 10 years. Since Nestegg is 15 years from retirement, he selects a guarantee with withdrawals beginning anytime after a 10-year waiting period. That's it. The online interactive modeling tool tells him the price of his guarantee.

Nestegg pays an annual fee for his guarantee, typically between 50 and 90 basis points (0.50% - 0.90%) of his account balance. Annual fees from account holders are used by the guarantee provider to cover the cost of hedging the market risk, and to pay required administrative expenses. Once Nestegg elects a 401(k) guarantee, his guaranteed withdrawal balance helps him maintain peace of mind during market downturns. In addition, he will see his guaranteed withdrawal balance side-by-side with his current account value on his 401(k) statements.

Nestegg has $200,000 in his 401(k), which means he starts with a guaranteed withdrawal balance of $200,000. As he makes contributions, the guaranteed withdrawal balance grows alongside his account balance. Each year, if his account experiences positive earnings, that increase ratchets the guaranteed balance upward. In Nestegg's first year, he deposits $6,000 and he earns $10,000 in investment returns. With his annual ratchet, his guaranteed withdrawal balance increases to $216,000. In his second year, he deposits $6,000 and he loses $5,000 due to a market downturn. His account value is now $217,000. However, his guaranteed withdrawal balance is $222,000. The guaranteed withdrawal balance increases with his deposits, and is unaffected by the market downturn (see table on page 6 and graph on page 7 for an example of how this works).

It is important to note that the guaranteed withdrawal balance can only be used for a stream of withdrawals—typically upon retirement. It cannot be taken as a lump sum. In Nestegg's case, at age 65 he can take annual guaranteed withdrawals up to 8% of the guaranteed withdrawal balance. He can take these withdrawals regardless of the actual performance of the account. The guaranteed withdrawal balance is reduced, dollar-for-dollar, upon each withdrawal. Withdrawals continue until the guaranteed withdrawal balance is exhausted. Once the guaranteed withdrawal balance is exhausted, any remaining account value (due to positive earnings) is Nestegg's to use as he pleases.

As an alternative, Nestegg can elect to receive lifetime withdrawals. The lifetime withdrawal amount is calculated based on his personal circumstances upon retirement. The lifetime withdrawal amount can be based on a single life or a joint-and-survivor calculation.

The annual withdrawal that is available will be defined as one of the key components of the 401(k) guarantee. (If the participant needed to take a lump distribution, he could do so with his current account balance—not his guaranteed withdrawal balance.)

At the end of 15 years, Nestegg has accumulated almost $400,000 in his guaranteed withdrawal balance, but a downturn in the market has driven his account balance down to $296,000. While he can continue to work if he wants to, he has security in knowing that, at a minimum, he will be able to withdraw $400,000 from his 401(k) over time.

With a guaranteed withdrawal balance, Nestegg can retire on schedule. His plans are not disrupted by the market decline. He decides to do just that, effectively ending the accumulation period and entering the payout period.

The payout is similar to an annuity, but it is markedly different in two important ways. First, Nestegg retains control over how he invests his assets; second, he benefits from any positive market performance.

Given these choices, Nestegg elects to receive a 6% lifetime guarantee. With this structure, Nestegg can withdraw at least $24,000 per year for the rest of his life. Also, he can still benefit from strong market performance, where positive earnings can increase his withdrawable amount. The annual ratchet continues to lock in new gains throughout the payout period. Meanwhile, the guarantee protects his ability to take withdrawals even during market downturns, and it protects him from running out of money due to longevity risk.

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The guarantee changes the way James Nestegg thinks about his retirement. In an environment marked by deep uncertainty, there is comfort to be found in significantly reduced market risk. In time, this type of guarantee may become the standard for how people protect their retirement investments.

 

The benefits of 401(k) guarantees extend throughout an organization. Plan administrators like Sally Sponsor will see increased employee interest in their company's 401(k) plan. With a 401(k) guarantee in place, confused investors can find the confidence to get more involved in their retirement savings. Human Resources earns a feather in its cap for installing an affordable solution that can benefit employees from the mailroom to the boardroom.

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And it's not just private enterprise that stands to gain. Just as Fiona Fiducia recognizes the value of guarantees for her organization, so too will government and other finance officers who oversee 457s, 403(b)s, and other defined contribution plans, a savings pool that totals over $3.7 trillion4. The benefit guarantee concept could also apply to the additional $3.7 trillion IRA market5.

Guaranteeing a withdrawal balance within a retirement savings plan is a way to learn from yesterday's market volatility. As an aging workforce contemplates a changing retirement paradigm—one that pundits seem to agree provides less of a safety net—guarantees offer a new, economically feasible way to deliver the retirement security that employers and employees all hope for.

1. "National Compensation Survey: Employee Benefits in Private Industry in the United States, March 2005," Summary 05-01, U.S. Department of Labor, U.S. Bureau of Labor Statistics, August 2005.

2. "Research Fundamentals The U.S. Retirement Market, 2005," Investment Company Institute, July 2006, Vol. 15. No. 5, www.ici.org.

3. Ibid.

4. Ibid.

5. Ibid.

Dan Campbell is the head of operations for Milliman’s Retirement Guarantee Network (RGN). He works with 401(k) plan sponsors and plan administrators to analyze, implement, and manage 401(k) guarantees. Dan has more than 20 years of experience in 401(k) plan consulting and administration.

Ken Mungan heads Milliman's Financial Risk Management Practice (FRM), which includes offices in Chicago, London, Amsterdam, Sydney, and Tokyo. FRM offers strategic consulting and a risk management tool, MG-Hedge, which hedges more than $500 billion in assets.