Client Service August 16, 2018

Retirement Income Solutions and Strategic Withdrawals

Thomas Dodd, executive director of Pavilion Advisory Group, speaks to the importance of implementing a strategic withdrawal plan once retirees initiate distributions of DC plan assets.
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The importance of implementing a withdrawal plan once retirees initiate distributions from their defined contribution assets is well documented. Having a withdrawal plan significantly reduces or may even eliminate the risk of retirees depleting their resources.

There are two generic withdrawal plans that are effective at reducing the probability of resource depletion—systematic withdrawals and annuities. This article will examine these withdrawal plans, known popularly as retirement income solutions.

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Retirement income solutions can be examined according to three dimensions, as follows:

(1)          In-plan or out-of-plan

(2)          Managed or self-managed

(3)          Guaranteed withdrawals, non-guaranteed or a combination of the two

In-plan or out-of-plan

The decision to offer in-plan retirement income solutions is driven largely by the plan sponsor’s desire to keep retired and separated participants’ assets in the plan. Why would the plan sponsor want to keep the assets in the plan? The answer is based on the human resource objectives of the employer. Does the employer want to actively support the retirement income objectives of its employees? Perhaps this paternalistic approach is a carry-over from an era when the plan sponsor’s defined benefit plan, now terminated, was the primary retirement income vehicle. Some employers may offer in-plan retirement income solutions as a tool to provide a smooth transition to retirement and an effective method to manage its workforce. Some plan sponsors may view the decision primarily from a fee perspective.  More assets in the plan help retain scale to reduce per-unit investment and administrative fees and allow access to investment products with high minimums.

The primary reason why a plan sponsor would encourage employees to withdraw all assets at retirement is liability risk. In our litigious environment, plan sponsors may desire to reduce participants and their assets in order to reduce liability exposure. 

From a participant’s perspective, there are a different set of advantages to in-plan solutions. Participants may benefit from lower fees with institutional pricing for investment management and elimination or reduction of transaction costs. Participants will also benefit from an additional layer of oversight with the plan sponsor managing the investment options offered in the plan. On the negative side, there are usually fewer retirement income choices offered with in-plan solutions.

The in-plan/out-of-plan decision is replete with nuances. The plan sponsor may not want the retiree’s assets in the plan for liability reasons; however, the plan sponsor may support the retirement income and human resource objectives described previously. In this case, the plan sponsor may actively promote out-of-plan solutions, providing guidance to employees regarding choice and access, and assist with the asset transfer.

Managed or self-managed

Retirement income solutions can be categorized according to how the solution is delivered.

With a managed program, the retiree’s assets are invested by a professional investment adviser. The adviser typically has discretion over the assets. The adviser will discuss with the retiree his risk tolerance, tax situation and financial objectives. From this information, the adviser will determine an appropriate asset allocation and develop a withdrawal plan. The adviser will implement the investment and withdrawal plan, monitor results and alter the program as the retiree’s circumstances change. The adviser may use financial products to implement the solution. The adviser receives a fee for services, usually a percentage of the assets under management.

A self-managed program is, as the name implies, managed by the retiree. The retiree makes the decisions regarding asset allocation, investment choices and withdrawal plan. He or she will monitor results and make changes as needed. The retiree may use products as part of his investment strategy (mutual funds) or part of his withdrawal plan (annuities). A key element of a self-managed program is education and guidance. The retiree will need help in selecting investments, developing an asset allocation, and constructing a withdrawal plan. The withdrawal plan may be composed of a systematic withdrawal strategy, an annuity or a combination of the two. 

Withdrawals: Guaranteed, non-guaranteed or combination

Retirement income solutions are either guaranteed, non-guaranteed or a combination of the two. With a guaranteed solution, payments are guaranteed for a certain period, or the life or joint lives of the retiree and his or her beneficiary. This is commonly referred to as an annuity. A non-guaranteed solution is a systematic withdrawal strategy where there are no guarantees on the number of payments. Depending on investment returns and the amount of withdrawals, the retiree may or may not have adequate resources for the remainder of his life.

Guaranteed solutions (annuities)

There are many different types of annuities that would serve as a retirement income solution. The most common annuities include the following:

Immediate fixed income annuity – An annuity that commences immediately upon purchase where the payment is a fixed monthly amount. It would be payable for the life of the retiree or the joint lives of the retiree and his or her beneficiary.

Deferred fixed income annuity – This is the same as an immediate fixed income annuity except that payments are deferred to a certain date, usually the retirement date.

Immediate variable income annuity – This annuity is similar to the fixed income annuity except that the payment amount is adjusted periodically to reflect the performance of an investment portfolio that the retiree has selected. One variation of this type of annuity is where there is a minimum income guarantee.

Deferred variable income annuity – This is identical to the immediate variable income annuity except that payment commencement is deferred to a certain date.

Inflation-adjusted annuity – This is an annuity where the payment amounts are adjusted periodically to reflect inflation.

Qualified Longevity Annuity Contract – This type of annuity allows retirees to transfer 25% of qualified plan assets (up to $125,000) into an annuity that commences payment no later than age 85.

The advantages of annuities are the guarantee of payments for the retiree’s lifetime and the elimination of investment risk or, in the case of variable annuities, the reduction of investment risk. The primary negatives are their illiquidity and the loss of funds should the retiree die shortly after payments commence.

Non-guaranteed solutions (systematic withdrawals)

Systematic withdrawals are rules-based approaches to determining retirement income, but, unlike annuities, the periodic payments are not guaranteed for the life of the retiree. The risks with systematic withdrawal strategies are asset depletion and investment risk.

Commonly used systematic withdrawal strategies include the following:

Constant dollar method – A dollar amount is determined at retirement based on a percentage of the retiree’s assets committed to the strategy. This dollar amount may be adjusted annually for inflation or other rules-based measures.

Endowment method – Each year a constant percentage of assets is withdrawn.

Life expectancy method – Annual withdrawals are based on the remaining life expectancy of the retiree (or joint life expectancies of the retiree and partner).

These withdrawal strategies can be managed in many different ways. The withdrawal strategy can be packaged in a product, known as a managed payout fund. This is a mutual fund with a built-in systematic withdrawal strategy. The investment approaches in these managed payout funds run the gamut. It could be a retirement tier in a target-date fund series. It could be a multi-asset investment approach, a balanced (equity and fixed income) approach or a fixed income approach. Plan sponsors should confirm if these types of products are available on their recordkeeper’s platform and are also operationally feasible due to required investor disclosures. 

The withdrawal strategy could be managed by a professional investment adviser or self-managed.

Combination

The third approach is to combine guaranteed withdrawals with non-guaranteed withdrawals. One method to accomplish this is a product known as a guaranteed minimum withdrawal benefit (GMWB).  This is an insurance product that combines systematic withdrawals with an annuity. A minimum monthly payout is guaranteed for the life of the retiree or joint lives of the retiree and beneficiary. There is usually a feature for an increase in the monthly payment if investment performance is favorable. There is some liquidity as retirees may withdraw a portion of their account balance although that may reduce the guaranteed amount. Investment management and insurance fees are assessed against the account balance. 

Another method is to buy an annuity with a portion of the retirement assets and run a systematic withdrawal strategy with the remainder of the assets. This could be done in either a managed program or a self-managed program.

There is a clear need for more innovative retirement income solutions along with enhanced communication and education as more retirees come to depend on defined contribution assets.

Note from the editor:

Thomas H. Dodd, executive director, Pavilion Advisory Group Inc., in Chicago, oversees relationship management, guides investment strategy and leads business development at Pavilion Advisory Group. He has 43 years of investment and actuarial experience and is a CFA charter holder and a member of the CFA Institute, the CFA Society of Chicago and a Fellow of the Society of Actuaries. 

This feature is intended to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of Asset International, Strategic Insight or its affiliates.

The Markets August 15, 2018

Different Flavors of Fee Levelization

As one of the first steps of pursuing fee levelization, plan sponsors and advisers should consider whether participants will be charged on a “pro rata” or “per capita” model.
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The concept of fee levelization is garnering attention from defined contribution (DC) plan sponsors and advisers, commencing from such sources as the increased volume of litigation over plan costs and the Department of Labor’s Employee Benefit Security Administration’s (EBSA’s) focus on fee disclosures.

Michael Volo, senior partner at Cammack Retirement, explains, “With fee levelization the recordkeeper applies their recordkeeping fee as a percentage of assets, to each individual investment option. If revenue sharing in the investment option exceeds the recordkeeper’s required revenue, the recordkeeper credits each participant who has assets in the fund with the amount of the excess. If the investment provides less than the required revenue amount, the recordkeeper adds an additional fee, in the amount of the shortfall, to the accounts of each participant using the investment. A participant with several different investments might experience multiple credits and debits based on the revenue sharing in each investment, relative to the required revenue.”

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Some plan sponsors and retirement plan providers remain perplexed by fee levelization. A 2017 Plan Sponsor Council of America (PSCA) report on non-profit employers found almost half of survey respondents were unaware of fee levelization, while only one in four plan sponsors could verify if their plan employed revenue-sharing to pay costs. 

Still, 33% of sponsors say they have already taken steps to ensure that fees are assessed to participants in a more equitable manner, according to Aon Hewitt’s “2016 Hot Topics in Retirement and Financial Well-Being.”

Michael Sasso, partner and co-founder of Portfolio Evaluation, stressed that it is a plan sponsor’s duty to consider fee levelization, even more now as firms face an upsurge in lawsuits. As companies are sued left and right over fees, plan sponsors must consider not if, but when, potential litigation can occur should certain plan costs be deemed too high or inconsistent, he says.

“In order to better protect yourself and get ahead of it, it would be wise for companies to really look at this, study it, and do what’s best for them. Have a process in place and make sure it’s well-documented,” he says.

Plan sponsors need to question how revenue sharing payments are applied towards each participant, Sasso says. The practice of revenue-sharing occurs when an investment company or manager pays a portion of funds to the recordkeeper, to decrease administrative service costs instead of paying a brokerage cash expense. Because revenue sharing differs with certain investments, participants invested in certain funds could end up subsidizing costs for participants in other funds, Sasso points out. The unparticipating workers, he says, end up “riding on the coattails of participants in funds generating revenue sharing.”

Volo believes the trend in fee levelization tackles this revenue sharing gap, and improves the situation participants, plan sponsors and recordkeepers are put in when remunerating these costs.

“It addresses that disparity and allows for revenue sharing to go back to participants, allows the plan sponsor to select the funds with the lowest net investment fees, and again, it’s a progressive fee, consistent with how investment fees are charged,” he says.

How participants are charged for these fees, from fee levelization to revenue sharing, can depend on the recordkeeper as well. Recordkeepers levelize fees differently from one another, and since it is a complicated process, not all recordkeepers offer the service.  

Other fees

Other fees can be levelized as well. Plan sponsors and advisers should consider whether participants should be charged at a “pro rata” or “per capita” model, Sasso says. “Pro rata means participants will pay a percent on their account balance, while with ‘per capita’ expenses, participants are charged equal dollar amounts. For example, if a sponsor were to charge each participant an annual per capita fee, say $75, a participant with a $5,000 account balance would be paying 1.5% of their assets, whereas a person with a $500,000 account balance would be paying a mere 0.02%. A ‘pro rata’ 10 basis-point fee for a participant with a $500,000 balance would result in $500 in plan fees, whereas a participant with a $5,000 balance would only pay $5. According to Volo, most advisers would suggest a per capita approach, or apply pro rata fees along with revenue sharing fee leveling.

“When that fee methodology is adopted, it lifts constraints off of selecting funds to provide certain revenue sharing to pay for the recordkeeping expenses, because there’s an explicit fee for recordkeeping,” he says. “So, often it allows plan sponsors and advisers to choose low or no revenue sharing funds, to reduce investment expenses to participants.”

Volo say plan advisers can help plan sponsors with fee decisions by requesting both pro rata and per capita prices from recordkeepers.

Participant reaction to fee levelization

For those DC plan sponsors worrisome over participant reaction—and education—concerning fee levelization, Volo explains how incorporating a questions and answers (Q&A) forum or a frequently asked questions (FAQ) portal could mitigate confusion. Some participants may not give the subject any attention, but most, he says, will address the resource should distresses arise. It’s the plan sponsors making an emphasis on fee levelization, he says, that typically generates the need for educational materials.

“Those who are interested have strong communication material provided during the rollout of fee leveling, including FAQs to address any concerns that participants have,” he says.

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