Following their scramble to address the near-term implications of the stock-market meltdown and its effects on retirement funds, organizations are soon going to have to deal with the longer-term effects. Moreover, the basic questions will be: What have we learned and what should we do differently?
Given what has happened, recognizing the increased importance of controlling risk should be very high on the list of lessons learned. Plan-design approaches that better balance surety and risk for both employers and employees will be a key component of future plan-design considerations.
For defined-contribution plans such as 401(k)s, the application of progressive investment alternatives, including annuity options, will transform their focus from cash-accumulation vehicles into secure retirement plans.
For defined-benefit plans, this will likely entail the consideration of variable benefit formulas inclusive of the next generation of cash-balance programs and other "hybrid" approaches. (For more information on DB plans, see the sidebar.) For employees, education and communication will be critical to achieving these objectives.
Rethinking the 401(k)
Until now, both employers and employees have viewed 401(k) plans primarily as vehicles for capital accumulation. Because 401(k) plans were initially designed to augment an employer's traditional DB plan, little attention was paid to risk or to whether employees were accumulating enough money on which to retire comfortably or how those funds were invested. All that has since changed.
First, although recent surveys indicate that a majority of employers within the Fortune 1,000 that sponsor DB plans continue to maintain open DB plans, a growing number of employers have frozen or closed their plans, leaving employees to depend on their 401(k) as the primary source of retirement income.
Then came the crash of 2008, in which most 401(k) plan participants saw their account values decline by 30 percent or more (including participants utilizing target-date funds), with little hope for a quick recovery. As a result, many current retirees have experienced significant reductions in prospective retirement income and employees who were hoping to retire in the next 10 or so years have been left wondering when or whether they will ever be able to do so.
Moreover, younger generations of workers have had their faith in their 401(k) plans shaken significantly.
What's needed now is a new form of 401(k) plan that preserves the best aspects of today's plans but performs more like a DB plan in that it significantly reduces risk and lets employees know (rather than guess) what kind of income they can expect in retirement. In short, 401(k) plans need to be transformed from capital-accumulation vehicles into bona fide retirement programs.
One way to do this is by introducing progressive investment alternatives, including annuity options, which would work as follows: An employee would establish his or her retirement- income objective and, in conjunction with an investment adviser, determine the required contribution and optimum (least risky) investment allocation necessary for meeting that objective.
This strategy would be continuously re-evaluated, recognizing investment performance to date, and adjusted to rebalance contributions and the optimum investment allocation supportive of the retirement income objective. For example: If emerging market performance exceeds expectations, perhaps some risk can be "taken off the table," but if emerging market performance falls short of expectations, perhaps additional risk (or a higher rate of employee contributions) is required.
This strategy should result in progressive reductions in risk as the retirement goal is achieved. During the employee's working years, a portion of his or her 401(k) would be transferred into a guaranteed income vehicle on a periodic basis. For the purpose of this discussion, we'll refer to these as annuities.
This so-called periodic annuitization would avoid the risks of annuitization at retirement, which may not be the optimum market timing due to prevailing interest rates at the time of retirement, and is similar in concept to dollar-cost averaging in making stock investments.
Security would be the primary benefit of periodic annuitization. Once the money is annuitized, there is no investment risk. Sixty-year-old employees who already have the bulk of their 401(k) plan assets in annuities would know exactly what they would receive if they were to retire today, and they would have a good idea of what they would have to live on if they retired in five or 10 years.
By the time a person retires, his or her retirement plan would be free of investment risk and even longevity risk -- although, depending on the annuities, inflation risk may still be a concern. This new generation of annuity products, which is only just beginning to emerge, will be created and offered by the same financial institutions that are now managing employees' 401(k) plans.
How it Works
The key to making a progressive investment alternative work is to make it as automatic as possible. Ideally, employees should not have to make any investment or annuitization decisions. What they would have to do is set a goal by specifying how much income they'll want or need in retirement. Based on that, the plan will determine the amount of assets each employee must accumulate by the time he or she retires in order to support that income.
Further, ongoing analysis will determine how much money the employee needs to contribute (factoring in employer matching funds) and where that money needs to be invested with the optimal amount of risk the employee needs to accept to meet his or her goal.
As an employee's 401(k) plan assets accumulate (and are periodically annuitized), it will become evident whether the plan is on track to meet the employee's goals. Is he or she saving enough and taking enough risk to generate the needed savings? Adjustments will be made automatically, both to the amount being saved and to the risk being taken -- the object being to meet the goal with the least possible amount of risk.
Switching to a progressive investment alternative is going to require a great deal of employee education and ongoing communication. Despite what has happened to the markets, employees will need to:
* Be convinced that this is the right alternative,
* Be taught to think of their 401(k) plan as a retirement plan rather than a capital-accumulation vehicle,
* Be educated about risk and the importance of reducing it, particularly as they approach retirement,
* Learn to think more conservatively about their 401(k) investments,
* Be willing and committed to making the additional contributions necessary to support retirement-income objectives, given more conservative investment allocations and annuitization, and
* Take a fresh look at annuities, which have long been the backbone of the DB business but are going to become more important in DC plans as well.
Employers that offer progressive investment alternatives will gain a true retirement program for their employees as opposed to a capital-accumulation vehicle. Employees will gain a secure retirement fund and peace of mind.
Moreover, the re-emergence of retirement as a realistic and attainable goal will benefit both employees and employers. Employees will be able to retire when they want to and when they should, which will help employers with workforce planning. A workplace that is full of employees who want to and should retire, but cannot, will be avoided.
Stewart D. Lawrence is a senior vice president and national retirement practice leader in the New York office of Sibson Consulting. Robert McAree is a senior vice president and retirement practice leader in the New York office of Sibson Consulting.