Data & Research March 3, 2015

Plan Design Is One Way to Stanch Outflows

Retirement readiness is the loser when participants take distributions before retirement, says BMO Retirement Services in a white paper.
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In its nine-part educational series for plan sponsors, BMO shines a light on retirement plan issues including plan design and operational efficiency. The series is designed to assist plan sponsors cost-effectively help participants gain the most from their 401(k) plans.

The third paper in the last section, just released, deals with participant utilization, addresses plan leakage and ways plan sponsors can stanch outflows. Other topics in the section were participation, contributions and investing behavior.

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Auto features—enrollment, escalation and easily implemented investment options—can help guide participants along their way to a successful retirement, the paper notes. But addressing plan leakage from loans, in-plan distributions and cash-outs also plays a part.

Plan participants contribute about $175 billion to their retirement accounts each year, which is matched by an additional $118 billion in employer contributions, according to a HelloWallet study. Unfortunately, BMO notes in its paper, participants take an estimated $70 billion in non-retirement withdrawals each year—an offset of nearly 26% against current contributions.

Even though loans taken from a 401(k) plan are generally repaid by the participant, BMO believes they should still be viewed as plan outflows. Loans are issued to participants in pre-tax dollars but are repaid with after-tax dollars, the paper points out. And after the participant retires, those dollars are taxed again when distributed from the plan.

As a result, the Employee Benefits Research Institute (EBRI) projects an erosion of retirement income of 10% to 13% for those participants who stop contributing during the loan deferral period. Despite this threat to retirement readiness, nearly 20% of participants have an outstanding balance at any point, and about 40% of participants initiate at least one loan over any five-year period, according to research cited by BMO.

“While the causes of the outflows from 401(k) plans are important, the actions plan sponsors can take to prevent them are critical,” says Todd Perala, director of strategic initiatives in retirement and trust services of BMO Global Asset Management and the paper’s author. “The steps we recommend to clients include restricting participants to single loans for serious hardships only. After hardship withdrawals, sponsors should consider automatically restarting participant contributions.”

Perala also recommends that plan sponsors be frank in their communications about the negative impacts of plan loans, hardship withdrawals and cash-outs. “If possible, sponsors should amend their plans to allow for partial distributions by participants at retirement and permit new employees to roll over existing loans from prior providers,” he says.

BMO clearly outlines the three main types of plan leakage or outflows:

  • Loans: The leading cause of loan-related outflows are employees separating from plans; and more than two-thirds of participants with outstanding loan balances opt to take cash distributions rather than repay the loan. Even if repaid, these researchers believe 401(k) loans should be considered outflows as they are issued pre-tax, but repaid in post-tax dollars.
  • In-plan distributions: While plans allow hardship withdrawals, such outflows are often accompanied by a suspension of contributions for six months. This suspension, coupled with the opportunity cost of the initial hardship withdrawal, can result in participants losing a large portion of their retirement security.
  • Cash-outs: These are perhaps the most common outflow source and typically occur when participants leave their employer. Rather than rolling their retirement savings into an IRA or their new employer’s defined contribution plan, they opt for a cash distribution. This option typically subjects participants to taxation and a possible 10% IRS penalty.

 

BMO offers simple steps to limit leakage that could benefit participant outcomes:

  • Restrict loans: Allow one loan at a time, for serious financial hardships only.
  • Negotiate with the service provider: Allow participants to make loan repayments after they separate from service.
  • Automatically restart participant contributions six months after issuing a hardship distribution.
  • Develop targeted communications: Address the negative impacts of in-plan loans, taking hardship distributions and cashing out of the plan.
  • Amend the plan: Allow partial distributions by plan participants and permit new employees to roll over existing loans from prior providers.

 

“BMO Defined Contribution IQ: Outflows” can be downloaded from BMO’s website, where links and information about the other papers in the series are available.

Data & Research March 3, 2015

Largest Pensions Troubled By Longer Lifespans

The United States’ 19 largest pension funds hold roughly 40% of the nation’s pension obligations, according to Russell Investments, so it’s no big surprise they are struggling with longevity trends.
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An assessment of Russell Investments’ “$20 Billion Club,” an index tracking the largest private U.S. pension funds, finds “actuarial losses” had the most significant impact on pension performance during the last year.

Russell defines actuarial losses as those pinned to interest rates and mortality assumptions, among other factors. Since early 2014, both interest rate declines and updated mortality assumptions have seriously dampened mega-plan funded status, Russell says.

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Russell’s $20 Billion Club comprises the 19 largest corporate defined benefit (DB) plans that together represent roughly 40% of the pension assets and liabilities of all U.S. publicly listed corporations. New Russell data shows these corporate DB plans have seen a ballooning projected benefit obligation hit their balance sheets in the past year, largely underpinned by the adoption of updated mortality assumptions for accounting/actuarial purposes.

These lackluster results come after a resurgent 2013 for large pensions. At the start of financial year 2014, Russell says, these mega-pensions faced a combined deficit of $114 billion, the lowest it had been since 2007.

“However, by the end of 2014, that figure had risen to $183 billion, hit by a double blow of an unexpected decline in interest rates and updated assumptions about how long retirees are expected to live,” Russell’s analysis explains. 

Russell says the impact of investment returns has actually been neutral or positive in every year for the past decade or so, discounting 2008’s meltdown. “Plan sponsor contributions outpaced new benefit accruals and hence had a steady positive impact over this period,” Russell adds. “The big headwind has come in the shape of ‘actuarial losses.’”

As explained by Russell’s Bob Collie, chief research strategist, Americas Institutional, yearly actuarial gains and losses can be traced largely to changes in interest rates. Falling rates lead to higher values being put on the liabilities, while rising rates lead to lower liability values. 

In 2014, the median discount rate used for U.S. plans fell by 0.83%, to 4.02%, pushing liabilities up and hurting funded status. In an added twist, this fairly sizable and largely unpredicted drop in interest rates came during the same year as significant changes in commonly used mortality tables that help plans make assumptions about life expectancy.

“The widespread adoption of newly published mortality tables added some $29 billion to the combined liabilities [of the $20 Billion Club], turning an already negative year into a significant setback,” Russell says.

Industry experts have noted that pension plans should expect more frequent mortality assumption updates—likely leading to additional funding stress. However, the Russell analysis goes on to suggest liabilities are about as high today as they will ever be, though knowing exactly when liability values may peak is tough.

“When interest rates rose in 2013, we concluded that liabilities most likely had indeed peaked and that they would never regain the high of 2012,” Collie says. “But that conclusion reckoned without the combined impact of a fairly sharp fall in interest rates and the speedy adoption of the new mortality tables. Together, those effects have led to a 2014 liability value that is even higher than 2012: against the odds, pension liabilities have re-peaked.”

Given this turn of events, Collie says Russell currently “offers no predictions as to whether 2014 now represents peak pension liabilities or whether liability values will go higher still.” The main source of uncertainty is actuarial gains/losses: the combined effect of the other variables (service cost, benefits, interest cost, and others) is relatively stable and can be expected to tamp down the combined liability value by perhaps $5 billion to $10 billion, or more if there is substantial pension risk transfer activity in 2015.

The $20 Billion Club was launched in 2011 and at the time represented 16 U.S. pensions meeting the minimum asset hurdle. Additional information and analysis is here. 

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