When many people hear 401(k) they don’t associate it with a retirement pension plan. In fact they’re likely to say I have a 401(k) but I don’t have a pension. Curiously, the 401(k)s is an unintended consequence of pension law. I believe the majority of people seek lifetime income no matter what it is called. That lifetime income may potentially be found by taking a holistic approach to your 401(k) plan.
Defined-benefit pension plans
Most people never say defined-benefit pension plan. It is a mouthful. It has been shortened to pension. It promises to pay a worker a certain dollar amount for life. Sometimes that comes with a cost-of-living increase and sometimes not. Typically a company hires an actuary to develop a plan for savings and investments who considers things such as expected mortality rates. Based on these calculations they tell the employer how much they need to fund (save) given an assumed rate of investment return. The actuary’s original forecast is monitored against actual savings and rates of return to determine if changes are warranted.
Pension plans typically have a committee that determines the mix of investment to be invested in (asset allocation) and hires institutional investment managers to do the actual investing. Theoretically, one would expect a sophisticated approach unavailable to the average investor. Because the plan is buying in bulk, you may expect a lower fee as a percentage of the investments being managed. If one follows the request for proposals on Pension & Investments magazine you’d find that these sophisticated managers don’t always provide the superior investment returns that the pension funds expect.
When pensions go unfunded bad things happen to the promise to pay. Sometimes that comes from overconfidence in the investment returns. Sometimes that comes from underfunding. The State of Illinois and the City of Chicago are wrestling with answers when the pension payout bills come due and your coffers are underfunded.
Defined contribution pension plans aka 401(k) and 403(b)
The Employee Retirement Income Security Act (ERISA) which governs pension plans helped to create what we now refer to as the 401(k) and 403(b) plan. It gives employees the ability to save while they work and employers the ability to provide matching contributions. The defined contribution term is still somewhat of a misnomer. No one tells the employee how much have they have to save. The “defined” contribution refers to the maximum an employee and/or employer can contribute. Today the employee can contribute $18,000 or $23,000 if over 50 years old. Those limits are significantly higher than an IRA which is only $6000.An employer can provide a matching contribution or a profit sharing contribution that has its own limits. Many employees aren’t aware of the differences. I feel this is one of the biggest misses in employee education.
Rather than sophisticated investment managers and asset allocation managers employees are often provided with the same investments they would be able to invest in if they had an IRA. These investments may be more expensive on a per unit basis. The costs have been bundled into the investment purchase. To the uninitiated it appears that things are free whereas they can be very expensive.
Employees may find that they are saving and investing in the dark. Employees still need a little guidance on how to develop their own asset allocation. The investment menu or the choices of investments are pre-selected for them. Even when the employer provides a qualified default investment alternative, employees need to understand how much they should save. If the returns of the qualified default investment are poor, should they save more? If so, how much more?
Putting a DB plan into your 401(k) plan
How can you help your employees receive the benefits of a defined-benefit plan without you taking on the funding risk of the defined-benefit plan? I believe the first step is to offer one-on-one financial advice by a fiduciary advisor to each and every employee. This is not education nor is it the casual meeting that some employees have signed up for to talk to your plan’s adviser.
The employee sits down with the equivalent to an actuary, a CERTIFIED FINANCIAL PLANNER™ professional, Chartered Retirement Planning Counselor or other advanced designation in retirement planning. That person will help them develop a tailored plan to determine how much they need to save, for how long and at what rate of return. Research from the Employee Benefits Research Institute1 highlights that women need to save more than a man with the same salary and beginning balance. That difference is due to longevity expectations. Might some of your male employees have family history that suggests the same? The sooner they save more the less drastic behavior they will be subjected to later. Research from Vanguard2 highlights differences in savings and investing behavior based upon race as well. It is easier to address these issues one-on-one rather than trying to figure out a plan feature answer.
Depending upon how the advice service is delivered, this could include advice on what investments to select. I recommend at least annually advice but preferably every six months, the employee meets with the fiduciary adviser to monitor progress. Vanguard2 recently showed that the right adviser could add an additional 3 percentage point increase. It is Interesting that half of that gain was based on counseling employees on their behaviors.
This fiduciary adviser would also discuss whether or not the employee wanted to provide a spousal benefit and if they had any desires to pass on a portion of their retirement wealth to future generations. I believe the majority of employees want what they believe is a pension: to be guaranteed lifetime paychecks that keep up with inflation. The answer could possibly be a single premium fixed annuity. This annuity could be either for the employee or the employee and spouse (potentially partner). Income guarantees are based on the claims paying ability of the issuing company.
Intrigued? Let us schedule a consultation to show you how easy this implementation can be on a one-on-one basis. We’ll start with you. Contact us by form, email (james.brewer@lpl.com) or phone (773-699-4756).
1How Much Needs to be Saved for Retirement after Factoring in Post-Retirement Risks: Evidence from the EBRI Retirement Security Projection Model, Employee Benefits Research Institute, March 2015
2 Putting a Value on your Value, Vanguard, March 2014
For Plan Sponsor Use Only – Not for Use with Participants or the General Public. This information was developed as a general guide to educate plan sponsors, but is not intended as authoritative guidance or tax or legal advice. Each plan has unique requirements, and you should consult your attorney or tax advisor for guidance on your specific situation. In no way does advisor assure that, by using the information provided, plan sponsor will be in compliance with ERISA regulations.
