Last month the Department of Labor published advance notice of a proposed regulation that could significantly change the attitudes of retirement plan sponsors and participants by showing them important information not typically considered at present. In particular, new illustrations could lead to higher retirement savings rates and greater use of immediate life annuities as a distribution mechanism from retirement accounts.
The department is tentatively stating that it will require every sponsor of a defined contribution plan to illustrate to each participant, on a regular basis, a projection of the lifetime stream of payments, though a life annuity, that could be produced from the participant’s current and projected future account balances in the DC plan. So, in the department’s example and under its suggested assumptions, if a married participant aged 45 has $125,000 in her 401(k) account and the plan has a normal retirement age of 65, the projected balance would be $557,534 at retirement. Two monthly lifetime non-inflation-indexed annuity streams of payments would be shown, as if the participant were now 65 — $564, based on the current balance and estimated current annuity rates, and $2,514, based on the projected balance.
This transformation of values is really quite significant because it will change the perspective about what 401(k) and other DC plans are intended for and what they are able to do. Currently, disclosures in DC plans focus on the accumulated account value, built up over time, which will be taken at retirement, if not before, typically as a lump sum rolled over to an IRA. This approach leaves the participant at a loss as to how to handle her account during retirement. In the future, the proposed regulation would cause a focus on the lifetime income that the retirement account can produce through a life annuity. This focus is akin to how most defined benefit (DB) pension plans have long illustrated their promised benefits to plan participants.
On the one hand, these may be unsettling numbers for many workers in DC plans because, especially under current low interest rates, even seemingly large account values will actually produce modest lifetime income streams. This realization could very well lead participants and sponsors to increase their contributions to the retirement plan — a good result, desired by the government, in light of the impending retirement shortfall of the baby boom generation predicted by many studies and the universally acknowledged need to adjust Social Security.
On the other hand, and particularly for those approaching retirement, this income illustration could be a comforting number because it will lead to the increased use of immediate life annuities to settle retirement accounts, which will produce a surer, and likely higher, stream of guaranteed lifetime payments than many other non-annuity distribution methods of broadly similar characteristics. This realization is also a desire of the government, which is concerned about the increasing number of workers without access to life annuities, as employers have turned from DB pensions to DC plans. Several experts are also concerned about the possible destitution of even middle-class Americans, as many will decline into extreme and fragile old age and spend down their assets and rely on welfare programs such as Medicaid. The consequence could be that plan sponsors will offer life annuities in their plans (relatively few do now) because participants will demand them, or else participants will seek them out from third-party vendors. Indeed, the department may be setting a benchmark for the development by the financial services industry of innovative retirement income products and strategies already underway.
There are many assumptions underlying the department’s proposed illustrations, including potentially controversial calls on expected investment returns, inflation, interest rates, wage growth and mortality probabilities. In particular, many experts would disagree with the department’s view on whether the estimated annual lifetime payment at retirement should be of an inflation-indexed or nominal fixed annuity. The question of whether the illustrations should be required or just strongly encouraged, quarterly or annual, will also be debated. The department can be sure to get an avalanche of comments and suggestions by the July 8 deadline from the many parties in the private sector interested in this issue. Then a further stage of revised proposal and comment will occur. This deliberative process is appropriate for such an important change. Within the government itself, there should also be coordination between the Department of Labor and the Social Security Administration, which produces an annual statement for all workers containing projections of expected Social Security retirement benefits.
The Department of Labor, along with the Department of Treasury working on other related tax regulations affecting distributions from retirement plans, is to be commended by all, independent of political views, for taking the lead on this important issue in such a careful manner. The illustrations represent a good opportunity to impart a new-old, and essential, way of thinking about saving for retirement, and to assist workers to plan for and achieve retirement security without falling into dependence on government social insurance and welfare programs though inattention and lack of information.
Mark Warshawsky is a Washington, DC-based economist. He was formerly Assistant Secretary for Economic Policy at the Treasury Department and a member of the Social Security Advisory Board. He is currently Vice Chairman of the federal commission on long-term care, and author of Retirement Income: Risks and Strategies. These opinions are his own and not necessarily those of his affiliated organizations.
