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Statement of Sarah Holden Senior Director, Retirement & Investor Research
on behalf of the Investment Company Institute
ERISA Advisory Council Working Group on Spend Down of Defined Contribution Assets at Retirement
July 16, 2008
The Investment Company Institute (“ICI”)1 appreciates the opportunity to make recommendations to the ERISA Advisory Council about the spend-down of defined contribution plan assets at retirement. This statement is submitted in conjunction with testimony of ICI members and staff before the Advisory Council on July 16, 2008.
We commend the Advisory Council for examining this issue. As 401(k) and other defined contribution plans have become the most common type of employer-sponsored retirement plan, many defined contribution plan participants will have significant sums of money at the end of their careers to fund their retirements. Innovative strategies exist to manage assets in retirement, and we believe it is important to raise awareness of these options to help plan sponsors and participants evaluate their choices. There is no one particular type of distribution form that is suitable to all or most retirees. While “autopilot” plan designs and investment options are simplifying the accumulation phase for participants, there is no “autopilot” approach to the spend-down phase. Individuals have vastly different needs for retirement income and different products are designed to meet these very specific needs. Our recommendations reflect the individualized nature of the distribution decision, which involves evaluating choices with significant trade-offs.
I. Success of 401(k) System
Since their inception in 1981, 401(k) plans have grown to hold $3 trillion in assets at the end of 20072 – the largest share of employer-sponsored defined contribution plan assets. Similar plans – 403(b) plans and 457 plans3 – held another $910 billion in assets and $513 billion was held in private-sector defined contribution plans without 401(k) features. Together, this amounts to $4.5 trillion in employer-sponsored defined contribution plan assets at the end of 2007.
Because no workers have yet experienced a full career with 401(k) plans, ICI, in collaboration with the Employee Benefit Research Institute, created a model to project what a full career with a 401(k) plan might look like. The model shows that saving through a 401(k) plan throughout a full career generates significant retirement income. Even with typical participant behaviors, such as temporarily stopping contributions, cashing out when changing jobs and taking plan loans, more than 60 percent of young 401(k) plan participants today are projected to be able to replace more than half of their pre-retirement income with a 401(k) plan.4 Combined with Social Security benefits, these workers are on track to replace a significant portion of their pre-retirement gross earnings. Accounting for savings and taxes, these workers are likely to have at least as much net income to spend after retirement as they had prior to retirement.5
Median Replacement Rates for Participants Turning 65 Between 2030 and 2039 by Income Quartile at Age 65
1The 401(k) accumulation includes 401(k) balances at employer(s) and rollover IRA balances.Source: EBRI/ICI 401(k) Accumulation Projection Model
It is important to emphasize that many individuals will get the bulk of their retirement income in the form of an inflation-indexed immediate life annuity; that is, in the form of Social Security benefits. For example, looking at individuals age 65 and older in 2006 who reported they did not work, 51 percent of all income received by the group came from Social Security benefits, with 14 percent coming from private-sector pensions (both defined contribution and defined benefit) and 12 percent coming from government pensions.6 Ranked by income, the bottom half of individuals in this group get 85 percent of their income from Social Security benefits.7
II. Innovation is the Hallmark of 401(k)
Innovation in plan design and product offerings is a hallmark of 401(k) plans. 401(k) plans generally look to the employee to decide whether to participate, at what level, and how to invest his or her account. Plan sponsors and service providers have continuously innovated to assist participants in these decisions. We highlight some of these innovations below. Automatic enrollment and automatic increase get more people to participate and generally contribute more, while education, advice and target-retirement date funds help people decide how to invest.
Education and Advice
Because asset allocation is one of the most important factors in successful retirement saving, employers and providers saw the need to provide participants with education and advice on asset allocation. The Department of Labor (the “Department”) issued helpful interpretive guidance on how education programs and advice programs can be offered to participants. After the release of Interpretive Bulletin 96-1, educational tools such as newsletters (and other written material), planning calculators, and other Internet-based interactive tools, became widespread. Many plans also offer discretionary investment advice programs like the one described in Advisory Opinion 2001-09A (Dec. 14, 2001) (known as the “SunAmerica Opinion”), using a computer-based program created by an independent third-party expert to generate an appropriate asset allocation that can be automatically adjusted over time for the participant. The Pension Protection Act of 2006 (“PPA”) expands the opportunities for participants to receive advice from plan service providers. When the Department completes its work in implementing the PPA’s investment advice provisions, plan sponsors and service providers will be able to respond with more advice offerings.
Target-Retirement Date Funds
Target-retirement date funds (also known as lifecycle funds) are an innovation that automates the asset allocation process for participants. These funds change their investment mix over time to become more conservative, based on the date on which the targeted investors expect to retire. Developed by mutual fund companies in the early 1990s, target-date funds are essentially one-stop asset allocation. The Department recognized the value of the target-date concept when it included target-date funds or portfolios as a qualified default investment alternative for participants who are automatically enrolled in a plan or otherwise fail to provide investment instructions.8
Automatic Enrollment and Automatic Increase
Perhaps the most important 401(k) plan innovations have been the use of automatic enrollment and automatic increase, which automate for participants the decisions to enroll in a plan and increase contribution levels over time. The number of plans with automatic enrollment, estimated to be around 36 percent in 2007,9 is expected to rise further as a result of the PPA. Among plans with automatic enrollment, the PSCA found that in 2004, 9 percent had automatic increase; by 2007, this had grown to nearly 33 percent of plans with automatic enrollment.10 Today, automatic enrollment is widely accepted as one of the most important innovations in the retirement savings space.
The popularity of defined contribution plans with employers and employees and the innovations we have described, which benefited from actions by employers, service providers, Congress and regulators, have made these plans highly successful in accumulating assets for retirement. There is every reason to expect that the defined contribution plan market will be equally successful in assisting participants in managing their assets in retirement.
III. Innovation for the Distribution Phase
The spirit of innovation that defines the 401(k) system already is addressing the distribution, or “decumulation,” phase with products and services that speak to a wide range of income needs. Some combine the features of annuities with mutual fund investments. Others rely on mutual fund payout options to provide regular income. In addition, insurers are offering innovations in annuities, such as guaranteed minimum withdrawal benefits, inflation protection, and death benefits.
One new retirement income product combines mutual fund withdrawals with annuity payments in one check. An advisor helps the individual determine how much to invest in mutual funds while gradually using those assets to purchase annuity credits until a certain level of annuity income is attained. Other products are pure mutual funds with sophisticated payout designs meant to provide a predictable monthly check. Some of these managed payout funds are designed to preserve principal throughout the life of the investment, and others are designed to distribute the entire account, including principal, over a set number of years. In testimony before the Advisory Council today, two ICI members will describe the managed payout funds offered by their respective companies.
In addition, systematic withdrawal plans from mutual funds, in which the investor typically receives a specified percentage of his or her account regularly on a schedule established in advance with the fund company, have existed for many years. Systematic withdrawals also can be calculated each year based on remaining life expectancy, similar to a required minimum distribution calculation in an IRA or qualified plan. Systematic distribution plans are a simple and straightforward way to spend down assets while minimizing the risk of running out of money and also keeping an account balance available for unexpected expenses.
All of these various distribution forms – from pure annuities to mutual fund systematic withdrawals, and everything in-between – have advantages and disadvantages. Annuities allow individuals to receive a regular stream of income without worrying about market volatility and outliving one’s assets. On the other hand, buying an annuity usually means not having access to savings in case of emergency and, depending on the type of annuity, increased risk of falling behind inflation. The combinations of additional protections are not without cost. Mutual fund products like managed payout funds typically have lower fees than annuities and enable individuals to access money in an emergency and pass on remaining assets to heirs, but do not come with the guaranteed income of an annuity.11 The optimal distribution choice for a participant could be a single product or combination of products and will depend on individual circumstances, including health status and other income sources, such as Social Security, defined benefit plans, or inheritances of the employee or employee’s spouse.
IV. Distribution Decisions
When a 401(k) participant retires, he or she typically can choose to either leave his or her account balance in the plan or take a lump-sum distribution. Some plans offer annuity or installment payment options as well.12 When annuities are offered within a plan, participant take-up rate is low13 and lump-sum distributions are elected more often. A common misconception, however, is that when a lump-sum distribution is selected, the distribution is used for consumption purposes right away. Research shows that this is not typically the case. In fact, most people roll over their lump-sum distributions into an IRA, with many of those forgoing any cash payments until mandated under the required minimum distribution rules. As described below, research shows that, by and large, people act responsibly with their defined contribution plan account balances at retirement.
ICI Defined Contribution Distribution Decision Survey
In late 2007, ICI surveyed recent retirees who had actively participated in defined contribution plans (including 401(k), 403(b), and governmental defined contribution plans) about how they used plan proceeds at retirement. Seventy-one percent of respondents report having more than one option for how their plan assets are distributed at retirement, including the options to take a lump-sum, to take installment payments from the plan, to purchase an annuity, or to leave the assets in the plan and delay taking any distribution. One-fifth of participants who reported having more than one distribution option chose to delay taking some or all of their balance; about one-fifth annuitized some or all of their balance; 11 percent chose to take installment payments from the plan; and 57 percent took some or all of their balance as a lump-sum distribution.
Given the Option, More than Half of Retirees Choose Lump-Sum Distribution1,2
1Based upon respondents' recall. Seventy-one percent of respondents indicated they had multiple distribution options at retirement. Responses are from a survey of employees retiring between 2002 and 2007 who were interviewed in the fall of 2007.
Of those that chose a lump-sum distribution, only 14 percent spent all the proceeds of the distribution. Notably, for those that spent all the proceeds, the median value of the lump-sum distribution was only $25,000. The remaining participants rolled over some or all of the balance to an IRA or otherwise reinvested the assets.
Bulk of Lump-Sum Distributions at Retirement Is Rolled Over
Note: Individuals retired from a defined contribution plan between 2002 and 2007. Data as of Fall 2007.
In making their distribution decision, retirees with a choice of options often consulted multiple sources of information. Forty-three percent indicated they sought advice from a professional financial adviser that they found on their own. About one-third indicated they attended a seminar or workshop offered by their employer; 30 percent reviewed written materials provided by their employer; and 14 percent used a professional financial adviser provided by their employer. Sixteen percent sought advice from a publication and 11 percent considered information provided in mutual fund company materials.
ICI IRA Owners Survey
In a separate survey of IRA owners, ICI found that households that own IRAs tend to be responsible stewards of their IRA assets.14 In May 2007, ICI surveyed households that owned IRAs and asked a series of questions about withdrawals. Of households with traditional IRAs in 2007, 19 percent reported taking a withdrawal in tax-year 2006. Withdrawals were typically modest: the median withdrawal is $7,500 and nearly 20 percent of withdrawals totaled less than $2,500. The median ratio of withdrawals to account balance was 6 percent. The most common reason for taking a withdrawal, cited by over 60 percent of individuals who took withdrawals, was to meet minimum distribution requirements under the Internal Revenue Code.
Because current withdrawal activity may not be a good indicator of future withdrawal activity, ICI also asked about future plans. Among traditional IRA-owning households in 2007 that did not take a withdrawal in tax-year 2006, 70 percent said that they were unlikely to take a withdrawal before age 70½. Among all traditional IRA-owning households, 80 percent said they had a strategy for managing income and assets in retirement, and 71 percent of these households said the plan involved preserving traditional IRA assets as long as possible.
Likelihood of Withdrawing from Traditional IRA Before Age 70½
Source: Investment Company Institute
Traditional IRA owners typically seek advice when building their retirement income strategy.15 About two-thirds of traditional IRA households with a strategy consulted a professional financial adviser when creating the strategy. About one-third of households with a strategy consulted written materials (e.g., book, article, newsletter) and 30 percent consulted with friends or family. Seventeen percent used an Internet website to help create their retirement income and asset management strategy. Fewer than 10 percent create their investment strategy without consulting outside sources.
Most IRA Owners Consult Professional Financial Adviser When Creating Strategy
Note: Multiple responses are included.Source: Investment Company Institute
To summarize, our research illustrates rational decision-making by defined contribution plan participants at retirement. Retirees often consulted multiple sources of information in making their distribution decision. Only a very small portion of defined contribution plan retirees took a lump sum at retirement and spent the entire distribution. Those that did so tended to have small balances that could not be annuitized on a reasonable basis. IRA owners tend to leave assets in the IRA for as long as legally possible, as part of an overall strategy for managing assets in retirement. In formulating this strategy, it is common for IRA owners to consult a financial adviser. The behavior of IRA owners suggests that 401(k) plan participants would benefit from greater access to education and advice as they retire. Our recommendations below reflect these findings.
V. Recommendations for Spend-Down Phase
The trend of automation works well in the accumulation phase of employer-sponsored retirement savings. Today’s automated plan features are simple, easy to understand and easy to apply to a whole participant population. During accumulation, the needs of individuals are relatively similar. If one can afford to save for retirement, it is generally a good idea to do so. The basic principles of investing (i.e., modern portfolio theory) can generally apply to most retirement savers. For a participant who does not feel that the automatic choices are right for him or her, undoing the automatic election is easy and does not involve significant permanent damage.
In the distribution phase, however, the needs of individuals can vary widely. Automation of the retirement income decision is less advantageous. There is no universally accepted or generally applicable way of spending down retirement assets. Outliving one’s assets is not the only risk faced in retirement. How an individual chooses to use these assets depends on a number of factors, including age, health, the costs of a given product relative to the value of assets, liquidity needs, and the desire to leave assets to heirs. Other income sources, such as Social Security, defined benefit plans, or inheritances, will play a large role in determining how individuals use their 401(k) plan assets. For smaller account balances, annuitization or a systematic withdrawal plan may not be feasible. These factors make the choice of a spend-down product or approach an individual decision. For these reasons, a plan sponsor that determines to designate a default distribution option should select one that participants can undo easily and without great expense.
The ICI makes the following recommendations to the Advisory Council on how the Department can help improve decision-making by individuals in the distribution phase:
Recommendation 1: The Department should adopt regulatory policies to facilitate greater use of advice programs and further development of educational materials. Interpretive Bulletin 96-1 should be extended to cover education for the spend-down phase and the Department should complete its work on the PPA’s investment advice rules.
Because there is no one-size-fits-all solution, education and advice are of great importance in the distribution phase. It is imperative for individuals to consider their particular needs in retirement. Before making a selection, participants should understand the objectives of the various distribution options available and how those options address their needs, appreciate the limitations of each option, and understand product fees and expenses. Annuities and other products that produce a regular income stream can be complex, and certain features such as flexibility and inflation protection may mean more cost to the consumer. Like IRA owners, who commonly turn to financial advisers when deciding on their retirement income strategy, 401(k) plan participants would benefit from and likely would seek out education and advice programs made available to them.
The Department should tailor its policies to encourage education and advice programs in the distribution phase. One step the Department can take would be to extend Interpretive Bulletin 96-1 or provide other guidance that makes clear that sponsors and service providers may convey the general advantages and disadvantages of various distribution forms without triggering fiduciary liability. Another is to complete the projects underway to implement the PPA’s investment advice provisions to provide additional guidance on advice within 401(k) plans and IRAs. IRA rules are particularly important considering that many people roll over lump-sum distributions from employer-sponsored defined contribution and defined benefit plans into IRAs at retirement or other termination of employment.
Recommendation 2: The Department should develop additional educational information and tools and make them widely available on the Department’s website. Other regulators may provide the Department with valuable insights in this endeavor.
Much of the educational material relating to retirement savings on the Department’s website is geared toward the accumulation phase. EBSA should develop additional educational materials to help participants with distribution decisions at retirement and make these materials prominent and easily accessible on the Internet. In developing these materials, the Department should work with other regulatory agencies with an interest in assisting and protecting retirement savers. For example, in an effort to improve services to older investors, the Securities and Exchange Commission, the North American Securities Administrators Association, and the Financial Industry Regulatory Authority recently announced that they will seek to identify effective practices used by financial services firms in dealing with senior investors.16
The forgoing recommendations are based on the fundamental tenet that the decision of how to take a distribution of defined contribution plan assets at retirement is highly individualized. Under ERISA, defined contribution plan sponsors have the freedom to determine the distribution options for their plans. Plan participants must consider their own personal circumstances and the objectives, limitations and costs of the distribution options available. To help participants in this process, we believe employers should be encouraged through Department guidance to offer education and advice. The Department itself should build on its efforts to educate individuals about saving and investing, to include materials on making retirement income decisions.
We thank the Advisory Council for allowing us this opportunity to submit our views.
1The Investment Company Institute is the national association of U.S. investment companies, including mutual funds, closed-end funds, exchange-traded funds (ETFs), and unit investment trusts (UITs). ICI seeks to encourage adherence to high ethical standards, promote public understanding, and otherwise advance the interests of funds, their shareholders, directors, and advisers. Members of ICI manage total assets of $12.90 trillion and serve almost 90 million shareholders. ICI’s mutual fund members manage about half of 401(k) assets and advocate policies to make retirement savings more effective and secure.
2See Investment Company Institute, 2008 Investment Company Fact Book, 48th Edition. www.icifactbook.org/
3403(b) plans allow employees of educational institutions and certain nonprofit organizations to make salary deferrals much like in 401(k) plans. 457 plans fill this role for employees of state and local governments and certain other tax-exempt organizations.
4See Sarah Holden and Jack VanDerhei, The Influence of Automatic Enrollment, Catch-up, and IRA Contributions on 401(k) Accumulations at Retirement, Investment Company Institute Perspective, Vol. 11, No. 2, and Employee Benefit Research Institute Issue Brief, No. 283 (July 2005). www.ici.org/perspective/per11-/pdf//pdf/02.pdf. In the first year of retirement, the median individual in the lowest income quartile is projected to replace 51 percent of pre-retirement income from 401(k) savings (for this group, the median replacement rate from Social Security would be 52 percent); the median individual in the lower middle income quartile would replace 54 percent of pre-retirement income from 401(k) savings (31 percent median replacement rate from Social Security); the median individual in the higher middle income quartile would replace 59 percent of pre-retirement income from 401(k) savings (23 percent median replacement rate from Social Security); and the median individual in the highest income quartile would replace 67 percent of pre-retirement income from 401(k) savings (16 percent median replacement rate from Social Security). Results stated herein reflect the model’s baseline case, which assumes continuous employment and 401(k) plan coverage and historical market returns. The model uses participants born between 1965 and 1974, who would turn 65 between 2030 and 2039. The model converts the 401(k) accumulations into an income stream—an annuity or set of installment payments—using current life expectancies at age 65 and projected discount rates.
5See Peter J. Brady, “Measuring Retirement Resource Adequacy,” Journal of Pension Economics and Finance (forthcoming).
6Statistics reported are ICI tabulations of Bureau of Labor Statistics, Current Population Survey (CPS) data.
7The importance of Social Security has not changed much over time, as the story was much the same three decades ago (based on ICI tabulations of CPS data). Whatever changes may be made to Social Security in the future, we assume it will continue to provide significant income to lower-wage workers in retirement.
8See 29 C.F.R. Part 2550, Default Investment Alternatives Under Participant Directed Individual Account Plans; Final Rule, 72 Fed. Reg. 60451 (Oct. 24, 2007).
9See Profit Sharing/401k Council of America (PSCA), 51st Annual Survey of Profit Sharing and 401(k) Plans, 2008 (forthcoming).
11It is important for participants to understand that the guaranteed income of an annuity depends on the insurance company’s ability to pay.
12For example, among the plans surveyed by the PSCA in 2006, about one-fifth indicated they provided an annuity option and more than half offered an installment payment option from the plan. See Profit Sharing/401k Council of America (PSCA), 50th Annual Survey of Profit Sharing and 401(k) Plans, 2007. The Department has proposed rules on what a plan fiduciary should evaluate in offering an annuity in the plan. See Proposed Regulation on Selection of Annuity Providers for Individual Account Plans, 72. Fed Reg. 52021, proposing amendments to 29 C.F.R. Part 2550.404a-4. Of course, a participant may use a lump-sum distribution to purchase an annuity on the retail market.
13Anecdotal evidence suggests that the rate of annuitization is low even in defined benefit plans where a choice exists, despite the default status of the annuity option and spousal consent requirements. See “Immediate Income Annuities and Defined Contribution Plans,” Vanguard Center for Retirement Research, Vol. 32, May 2008.
14See Sarah Holden and Michael Bogdan, The Role of IRAs in U.S. Households’ Saving for Retirement, Investment Company Institute Research Fundamentals, Vol. 17, No. 1, January 2008. www.ici.org/fundamentals/pdf/fm-v17n1.pdf. See also, Sarah Holden and Michael Bogdan, Appendix: Additional Data on IRA Ownership in 2007, Investment Company Institute Research Fundamentals, Vol. 17, No. 1A, January 2008. www.ici.org/stats/res/fm-/pdf/v17n1_appendix.pdf.
15See Holden and Bogdan, The Role of IRAs in U.S. Households’ Saving for Retirement.
16See SEC, NASAA and FINRA Announce New Steps to Help Protect Senior Investors (press release issued Feb. 8, 2008), available on the SEC’s website at www.sec.gov/news/press/2008/2008-16.htm. The initiative will seek input in the following areas: marketing and advertising to seniors; account opening; product and account review; ongoing review of the relationship and appropriateness of products; discerning and meeting the changing needs of customers as they age; surveillance and compliance reviews; and training for firm employees.