In the early 1980s, I worked at a very big company that introduced one of the first 401(k) plans. To give the plan an appealing “brand,” the company called it The Capital Accumulation Plan.
I think that is a pretty accurate (and effective) way of describing how a lot of employees, especially the younger ones, perceive their 401(k): as a vehicle for building capital. And 401(k) account balances do, to some extent, function as generic savings—subject to certain limits, they can be borrowed out or withdrawn, e.g., for a financial hardship, including the purchase of a home.
But in the long run, 401(k) savings are supposed to function as a retirement benefit. And that means that the accumulated capital in a 401(k) plan account must, at some point, be turned into income.
The Importance of Income
Why is that? I got a vivid and personal lesson on the importance of retirement income last year when a good friend was deciding whether to retire and wanted to talk his decision through with me. Most of the factors he was considering, and the decisions he made (he did ultimately retire), turned on two things—his anticipated retirement income and retirement expenses.
Now, there’s one key variable in my friend’s situation that was critical to his decision, and indeed is critical to retirement income policy issues generally: my friend did not intend (and would soon be unable) to work “in retirement.”
This variable is important because, if an individual is able to continue working, and is retiring “because he wants to do other things,” the possible failure of his retirement income to match or exceed his retirement expenses is not catastrophic. He always has a Plan B, going back to work. And that alternative retirement income solution (as it were) puts him (nearly) in the position of that younger 401(k) plan participant—he can (to some meaningful extent) continue to think of his 401(k) account as capital, rather than income.
The Challenge of Turning Assets into Income
But if an individual can’t go back to work after retirement (and, of course, this will happen to most individuals at some point), then if expenses exceed income sometime in the future, it is a catastrophe. And the prospect of that possible catastrophe focuses the mind on future income.
This challenge of turning a pile of assets into a stream of income forces the prospective retiree to reckon with the three risk factors that every DB sponsor must also consider: asset returns, interest rates and mortality.
Unpacking that a little, I would say that for the individual, “mortality” stands for a more complicated set of risks than just outliving your assets: whether you will need long-term care and whether you may face some unforeseen and costly emergency in the future also must be considered.
The relationship of interest rates and asset returns is interesting. In effect, these two risks trade off against each other, with interest rates standing (more or less) for “certainty” and asset returns standing (more or less) for “speculative risk” (hopefully on the upside). And it is the case that, as you age, and the alternatives to living on the income your asset pile can produce dwindle, your appetite for speculative risk (e.g., investments in equities) disappears, to be replaced by an appetite for certainty (e.g., investments in bonds or an annuity).
SECURE Act’s Mandatory Lifetime Income Disclosure
It is in this context that the SECURE Act’s lifetime income disclosure requirement becomes important. Right now, sponsors generally focus their 401(k) disclosure on the account balance (a.k.a. asset pile). But if, like my friend, a participant’s primary concern is income, the amount of income (within some reasonable certainty) her account can produce is the key factor—not just in the decision to retire or keep working, but also in decisions about how much to save. And it’s my guess that a lot of participants will start to focus on this issue (of income) beginning around age 50.
In August 2020, the Department of Labor released an “interim final rule with request for comments” on SECURE-mandated lifetime income illustration requirements. Very briefly, that rule—which will affect quarterly/annual statements in 2022—calculates DC plan lifetime income based on the participant’s current account balance, assuming the participant is age 67 (and therefore may retire immediately) and calculating post-retirement interest based on the 10-year constant maturity Treasury securities yield rate.
Thus, under the DOL’s approach, participants’ accounts would not be credited with anticipated earnings before age 67—a factor that would be especially significant for younger participants. This feature has attracted considerable criticism, including from the SECURE Act’s main sponsor, House Ways and Means Committee Chairman Richard Neal (D-MA). The DOL is currently considering these criticisms and may (some would say “is likely to”) change this rule to allow some sort of credit for pre-retirement interest/account earnings.
I’m not going to weigh in on this controversy, other than to say I agree with those critics.
Refocusing on Retirement Income
The point I want to make is that this project has the possibility of (finally) focusing participants (and sponsors and policymakers) on the issue of the production of retirement income out of 401(k) account balances. Which will highlight a number of important issues. To name three big ones:
1. The impact of declining interest rates on retirement income. As I discussed in my January column, “The Future Has Gotten Way More Expensive,” much of the 401(k) asset gains in recent years have been offset by declines in the amount of income those assets can buy. Both trends are a consequence of declining interest rates.
2. The problems with annuities as a solution to the 401(k)/retirement income challenge. In the abstract, annuities look like the perfect retirement income solution. But 401(k) plan participants have been very “annuity-hesitant,” as they say. And the issues with the individual annuity market—the complexity of annuity products, their cost, the high commissions, and the idea that they have to be “sold not bought”—have proved to be daunting.
3. The need for innovation in lifetime income solutions. These issues do not exist in the traditional DB world, for the obvious reason that traditional DB plans are focused on producing income for the participant. The problem has been, of course, that in the DB world the plan sponsor has taken on all the risks discussed above. Also, declining interest rates (and the losses associated with them) drove a lot of employers out of the DB business. Nonetheless many of us believe that there are features of the DB system that add value. We should be looking at DB designs as a possible employer-based solution that produces a net gain to the system (rather than just moving risk around).
To do all of this, the comprehensive disclosure created by the SECURE Act and being implemented by the DOL must be realistic and credible. If it can pull that off, it just may change our current system for the better—and not just a little bit.
Michael P. Barry is a senior consultant at October Three and President of O3 Plan Advisory Services LLC, which provides retirement plan regulatory analysis targeted at plan sponsors and those who provide services to them.
Opinions expressed are those of the author, and do not necessarily reflect the views of ASPPA or its members.
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