Traditional defined benefit plans ended 2020 modestly in the black, after spending most of the year underwater. The story has been a significant decline in interest rates (about 75 basis points) and an increase in liabilities (11%-15%, depending on duration), offset by an increase in asset values—stocks gained 20% on the year while bonds added 10%-12%.
Which, all in all, is pretty good considering what a semi-depressing year it’s been generally. The Fed is projecting a 2.4% decline in GDP for 2020 (with robust 4.2% growth next year).
There may be more subtle things going on here, but I would read these numbers as reflecting in large part a real decline in interest rates and a correlated write-up in the value of income-producing assets.
Effect on DC Participants
If you think about DC retirement savings as directed toward the same goal as a traditional DB plan—producing retirement income—then the effect of the declines in interest rates is more significant, because DC participants are generally younger, with longer theoretical durations than a typical basket of pension liabilities. Thus, notwithstanding that typical target date funds returned double digits, most DC participants in TDFs fell behind on their retirement income goal for the year.
Interest Rates Define the Cost of the Future
What’s the connection between interest rates, asset values and retirement income? The decline in interest rates means that the cost of retirement income (and, in effect, the cost of retirement) has increased. Put simply, after a decline in interest rates, the amount you have to save today to produce a dollar of income in the future goes up as the amount you can earn on a dollar of savings (i.e., interest rates) goes down.
All income-producing assets trading in a market are subject to this effect. Thus, as a correlate, investors who hold income-producing assets (like stocks) are, when interest rates go down, compensated for the cost increase in future income by an increase in the value of their income-producing assets.
It Looks Like You’re Richer, But You’re Only (at Best) Treading Water
In this sort of economy, the risk is that DC participants will interpret their increased asset values as putting them nearer to their retirement goal. Whereas, given the decline in interest rates, they are simply treading water, or worse.
Hopefully the (much needed, if somewhat flawed) lifetime income disclosure rule will better highlight this issue for DC participants.
But for those without retirement savings assets, the increase in the cost of retirement income means either: (1) having to save more (out of what are typically highly constrained budgets); or (2) having to live on less (in retirement) and/or work longer. This is predominantly a problem for the middle class—workers in the bottom income quartile get their retirement income overwhelmingly from Social Security.
Considering this situation, two sorts of individuals who are left out of this savings dynamic come to mind: those who took CARES Act-related withdrawals and those who do not have any retirement savings.
The Effect of CARES Act Withdrawals
First—those participants who took “COVID withdrawals.” Unemployment increased significantly in 2020, from 3.5% in 2019 to (according to Fed projections) 6.7% at year-end 2020.
Notwithstanding these job losses, COVID withdrawals from DC retirement savings appear to have been relatively modest—data from Vanguard show 4.5% of participants taking CARES Act distributions, with a median of around $12,000. There have been more or less similar numbers from Fidelity as well.
There is (admittedly limited) research showing that the benefit from cash-outs—providing a financial buffer (e.g., for mortgage payments) against financial shocks (most significantly, job loss)—may outweigh, or at least offset, losses in retirement savings.[1]
We in the retirement savings industry may be concerned about this money leaving the system. But I would argue that this element of the 401(k) system (especially) is a feature, not a bug. The ability (enhanced by CARES Act tax benefits) to access savings in times of emergency encourages participants to take the risk of locking up their money in a 401(k) plan.
The Uncovered
More concerning is the second group: workers who do not have any retirement savings, typically because they are not covered by a retirement savings plan. In this regard, I think particularly of gig workers. For these workers, retirement has gotten a lot harder over the last couple of years, as interest rates have declined around 150 basis points. And they don’t have the compensating benefit of increased asset values.
That all makes the idea of a national “mandatory” retirement savings plan sound more attractive, e.g., along the lines proposed by Rep. Richie Neal (D-MA), Chairman of the House Ways & Means Committee. One of the interesting questions for 2021 is whether bipartisan support for that proposal will emerge, as blue states continue to forge ahead with their own mandatory retirement plan proposals.
No Available DC Hedge Against Declining Interest Rates
Another problem to note—with respect to an economy like the one we’ve had over the last couple of years—is that DC plans do not offer participants the financial tools to deal with interest rate risk that are routinely available to DB plan sponsors.
Critically, liability-driven investment (LDI) instruments like zero coupon bonds and credit overlays. All a DC participant can do to fend off losses from interest rate declines is to hope that (as in 2020) the equity markets keep pace and that the available bond funds reflect to some extent the participant’s individual duration (a function of the participant’s number of years to retirement), or buy an annuity, which is generally relatively expensive.
Can these DB tools be made available to DC investors? Should TDF design reflect not just an abstract notion “risk” (a.k.a. volatility) but the specific and highly relevant fact of interest rate risk. This approach is probably impractical for participants younger than around 50, because the interest rate effects are more speculative and there are no available hedges and because of the very long durations involved. But they are critical for participants 55 and older.
And Social Security Is Going to Start Crushing the Budget
Finally, let’s note something of a wild card: the fate of Social Security. That system is soon going to be making significant demands on the national budget. And we no longer have a growing population that can absorb these increased costs. At some point, someone is going to have to make some sacrifices. That will be politically ugly—although it will be less ugly to the extent that the private retirement savings system can compensate for Social Security shortfalls.
These are three issues—covering the uncovered, improving 401(k) investment options to reflect current financial challenges, and a realistic social insurance policy—that we will need to work on if future generations are going to have a shot at a decent retirement.
Footnote
[1] See “Trends in Pension Cash-Out at Job Change and the Effects on Long-Term Outcomes,” Philip Armour, Michael D. Hurd, and Susann Rohwedder, in Insights in the Economics of Aging, University of Chicago Press.
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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