The Retirement Plan Solution: The Reinvention of Defined Contribution

The Retirement Plan Solution: The Reinvention of Defined Contribution

Volumn , Issue , 2011, Pages

  Ezra, Don ^a   Collie, Bob ^a   Smith, Matthew X ^a  

^a NONE

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EID: 84857370338     PISSN: None     EISSN: None     Source Type: Book    
DOI: 10.1002/9781118266878     Document Type: Book

References (142)

1. According to Financial Research Corporation's Lifecycle Funds Quarterly Report, First Quarter 2008, Fidelity, Vanguard, and T. Rowe Price owned the three largest market shares of target date mutual funds in the United States.
2. For the 12-month period ending December 31, 2008, the Russell Global Index showed a return of -42.79% (in U.S. dollars).
3. Bob Collie and Don Ezra, Resist the Amygdala! (Russell Investment Group, March 2007).
4. Also Jason Zweig, Your Money and Your Brain (New York: Simon & Schuster, 2007).
5. But not in a collective DC plan, as we will explain in Chapter 14.
6. See note 1.
7. This chapter is based on Bob Collie, "401(k)s: The Launch of Version 2.0." Russell Retirement Report 2008 (Russell Investments, 2007).
8. Or 401(a), 403(b), 457, and so on-but we refer to them collectively as DC or 401(k), for simplicity.
9. This chapter is based on Bob Collie, "401(k)s: The Launch of Version 2.0." Russell Retirement Report 2008 (Russell Investments, 2007).
10. Or 401(a), 403(b), 457, and so on-but we refer to them collectively as DC or 401(k), for simplicity.
11. Investment Company Institute, Investment Company Fact Book, 48th ed. (2008).
12. Alicia Munnell and Annika Sunden, Coming Up Short: The Challenge of 401(k) Plans (Washington, DC: Brookings Institution, 2004).
13. Alicia Munnell and Annika Sunden, "401(k) Plans Are Still Coming Up Short." (Center for Retirement Research at Boston College, 2006).
14. For more details of the impact of Enron's collapse on the retirement plans of its employees, see, for example, Christine Dugas, "Energy Giant's Disaster Devastates 401(k) Plans." USA Today, November 30, 2001.
15. The language we refer to is the common use of these terms. But ERISA's language has always been inclusive: "pension" accommodates both DB and DC, in ERISA.
16. Ruth Helman, Jack VanDerhei, and Craig Copeland, The 2008 Retirement Confidence Survey (Employee Benefit Research Institute: Issue Brief No. 316, 2008).
17. National Vital Statistics Reports, 51(3): Table 11. Department of Health and Human Services, December 19, 2002.
18. Further subdivisions are possible. For example, by health (those currently in good health are expected to live longer, on average, than those in poor health); by region; by race; by habit (such as smoking, as anyone knows who has purchased life insurance; insurance companies ask about habits that they know affect life expectancy); and in many other ways.
19. We have since done the same exercise with larger groups, with similar findings. People don't know how uncertain a future life span is.
20. Bryan Appleyard, How to Live Forever or Die Trying (New York: Simon & Schuster, 2007).
21. Aon Consulting. 2008 Replacement Ratio StudyTM, www.aon.com/retire.
22. As pay increases the overall required ratio rises, to 88 percent when current pay is $250,000; and Social Security replaces much less.
23. It is not only volatile investment returns that cause funding volatility, of course. The plethora of maxima and minima in U.S. funding regulations play as large a part.
24. Not all of the 12.4 percent is for retirement. A small portion is for survivor and disability benefits.
25. Moreover, for many years the trustees of the U.S. Social Security system have consistently said that the system will not be self-sustaining if it follows the path outlined in the central set of their annual projections.
26. Incidentally, this does not always work the other way around. Sometimes higher risk does not carry a higher expected return.
27. D. Don Ezra, "A Model of Pension Fund Growth," Russell Research Commentary. Russell Investments, June 1989;
28. Keith P. Ambachtsheer and D. Don Ezra, Pension Fund Excellence (New York: John Wiley & Sons, 1998).
29. Morningstar. 2008 Ibbotson® SBBI® Classic Yearbook. We are grateful to Shailesh Kshatriya for compiling the data in the form shown in Figures 4.1, 4.2, and 4.3 and Tables 4.2, 4.3, and 4.4.
30. The reason has to do with the ability to deduct a capital loss from one's taxable income. That's why, in those days, some were willing to accept a small negative return before tax.
31. As well as the slim possibility of cash as an asset class delivering a negative return, there is also the possibility of a particular cash investment delivering a negative return, even if the broader asset class does not. It is rare for money market funds to "break the buck," but it has happened on occasion.
32. The authors greatly appreciate the efforts of their Russell Investment colleagues Yuan-An Fan, Richard Fullmer, and Grant Gardner for their work in simulating these results.
33. See note 1.
34. At the time of writing, the authors only know of one company offering this type of product, which is Vanguard.
35. The actual calculation is a little more complicated, but this is close enough for a first approximation, which is all that this appendix tries to achieve.
36. See, for example, Jeffrey R. Brown, Olivia S. Mitchell, and James M. Poterba, "The Role of Real Annuities and Indexed Bonds in an Individual Accounts Retirement Program," Working Paper 99-18. The Wharton Financial Institutions Center, 1999.
37. Government Accountability Office. "Private Pensions: Low Defined Contribution Plan Savings May Pose Challenges to Retirement Security, Especially for Many Low-Income Workers," 2008.
38. And that is only the tip of the iceberg. The American Benefits Council on June 26, 2008, made available to its members a chart created by Davis & Harman LLP comparing features of ten different proposals to expand retirement savings coverage via DC-type arrangements.
39. This is the brainchild of J. Mark Ivry and David C. John, "Pursuing Universal Retirement Security through Automatic IRAs." The Retirement Security Project, www.retirementsecurityproject.org.
40. But, as we shall also see, Australia mandates coverage.
41. James J. Choi, David Laibson, Brigitte C. Madrian, and Andrew Metrick, "Defined Contribution Pensions: Plan Rules, Participant Decisions, and the Path of Least Resistance." Tax Policy and the Economy 16. MIT Press, 2001. Revised in 2004 to include additional data and analysis.
42. Sarah Holden and Jack VanDerhei, "The Influence of Automatic Enrollment, Catch-up and IRA Contributions on 401(k) Accumulations at Retirement," EBRI Issue Brief No. 283. Employee Benefit Research Institute and Investment Company Institute, July 2005.
43. Franco Modigliani and Richard Brumberg, "Utility Analysis and the Consumption Function," in K. K. Kurihara (Ed.), Post-Keynesian Economics (London: George Allen and Unwin, 1955);
44. Milton Friedman, A Theory of the Consumption Function (Princeton, NJ: Princeton University Press, 1957).
45. "MetLife Retirement Income IQ Study: A Survey of Pre-retirement Knowledge of Financial Retirement Issues," June 2008, www.MatureMarketInstitute.com.
46. But public-sector workers frequently contribute to their DB plans.
47. Government Accountability Office. "Private Pensions: Low Defined Contribution Plan Savings May Pose Challenges to Retirement Security, Especially for Many Low-Income Workers," 2008.
48. See "Lump Sum Distributions," EBRI Notes 26(12) (December 2005).
49. Hewitt Associates, "Trends and Experience in 401(k) Plans (Hewitt Associates, 2007), p. 16. Fifty-six percent of surveyed plans used a money market or stable value fund as their default investment option. By 2007 this had declined to 17%.
50. John Hancock Financial Services (2002). "Insight into Participant Investment Knowledge and Behavior." Eighth defined contribution plan survey.
51. Greenwich Associates, "United States Investment Management Market Dynamics Report 2006," 2007.
52. Or, at any rate, if they are not experts, they typically seek input from experts. The American pension law, the Employee Retirement Income Security Act of 1974 (ERISA), requires investment fiduciaries not only to be procedurally prudent but also to bring expertise to their decisions.
53. Munnell, A., Soto, M., Libby, J., & Prinzavalli, J. "Investment Returns: Defined Benefit vs. 401(k) Plans": Issue Brief #52. Center for Retirement Studies at Boston College, September 2006.
54. Watson Wyatt Insider, "Defined Benefit vs 401(k) Plans: Investment Returns for 2003-2006," June 2008, www.watsonwyatt.com/us/pubs/insider.
55. Burgess and Associates, study performed for John Hancock, covering 2001-2005, www.johnhancock.com/about/news/newsaug1406.jsp.
56. See, for example, Vanguard, "How America Saves 2008: A Report on Vanguard 2007 Defined Contribution Plan Data," (The Vanguard Group, Inc., 2008), 35.
57. Actually, there is, and many of us use it. We borrow against our human capital to obtain a mortgage, which we then invest in real estate. That's one way to convert bondlike human capital to equity-like financial capital. But we do this outside the 401(k) plan-indeed, it would be illegal to do it within the plan.
58. That, at any rate, is the principle. In the United States, the qualified default investment alternative (QDIA) regulations require all default options to be diversified, with the result that one does not see 100 percent equity exposure at the highest point of the glide path.
59. Shlomo Benartzi and Richard H. Thaler, "How Much Is Investor Autonomy Worth?," March 2001. AFA 2002 Atlanta Meetings. Available at SSRN: http://ssrn.com/abstract=394857.
60. This is an example of what is referred to by some as the agency dilemma and by others as the agent-principal problem: That the incentives of those making the decisions are not necessarily exactly the same as those whom the decisions most affect.
61. Government Accountability Office, "Private Pensions: Changes Needed to Provide 401(k) Plan Participants and the Department of Labor Better Information on Fees," GAO-07-21.
62. This analysis depends on the assumption that the market return-or something very close to it-can be achieved by passive managers. This is not necessarily true in all markets.
63. Daniel Kahneman, Eugene Higgins, and Mark W. Riepe, "Aspects of Investor Psychology," Journal of Portfolio Management 24(4) (1998).
64. Dennis Dittrich, Werner Guth, and Boris Maciejovsky, "Overconfidence in Investment Decisions: An Experimental Approach," CESifo Working Paper Series No. 626, 2001. Available at SSRN: http://ssrn.com/abstract=296246.
65. J. Edward Russo and Paul J. H. Schoemaker, Decision Traps: Ten Barriers to Brilliant Decision Making and How to Overcome Them (New York: Simon & Schuster, 1989).
66. Ruth Helman, Jack VanDerhei, and Craig Copeland, The 2008 Retirement Confidence Survey (Employee Benefit Research Institute: Issue Brief No. 316, 2008).
67. Theodore S. Geisel, Oh, the Places You'll Go! (New York: Random House, 1990).
68. www.nobelprize.org.
69. David Laibson, "Golden Eggs and Hyperbolic Discounting," Quarterly Journal of Economics, May 1997.
70. Samuel M. McLure, David I. Laibson, George Leowenstein, and Jonathan D. Cohen, "Separate Neural Systems Value Immediate and Delayed Monetary Rewards," Science 306 (October 15, 2004).
71. Cass R. Sunstein and Richard H. Thaler, "Libertarian Paternalism Is Not an Oxymoron," University of Chicago Law Review 70(4) (2003).
72. Cerulli Associates, "Quantitative Update, Retirement Markets 2006," Exhibit 1.61.
73. Sheena S. Iyengar and Mark R. Lepper, "When Choice Is Demotivating: Can One Desire Too Much of a Good Thing?" Journal of Personality and Social Psychology 79 (2000).
74. Sheena S. Iyengar, Wei Jinag, and Gur Huberman, "How Much Choice Is Too Much? Contributions to 401(k) Retirement Plans." Pension Research Council Working Paper: 2003-10. The Wharton School, University of Pennsylvania, 2003.
75. Now, DB plan decision making is also frequently heuristic driven rather than entirely rational, but that is a different story altogether.
76. Terry Odean, "Do Investors Trade Too Much?" The American Economic Review, December 1999.
77. Terry Odean and Brad Barber, "The Courage of Misguided Convictions: The Trading Behavior of Individual Investors," Financial Analysts Journal, November/ December 1999, pp. 41-55.
78. See, for example, Travis Sapp and Ashish Tiwari, "Stock Return Momentum and Investor Fund Choices," Journal of Investment Management 4(3) (3rd quarter 2006); or Morningstar Investor Return Methodology (March 2008).
79. Steven L. Beach and Clarence C. Rose, "Does Portfolio Rebalancing Help Investors Avoid Common Mistakes?" Journal of Financial Planning, May 2005.
80. Jeffrey R. Brown, Marcus D. Casey, and Olivia S. Mitchell, "Who Values the Social Security Annuity? New Evidence on the Annuity Puzzle," NBER Working Paper No. 13800, February 2008. Available at SSRN: http://ssrn.com/abstract=1092850.
81. The correct answer to the Lottery Split question is $400,000. Either $240 or $242 would be considered acceptable as the correct response to the Interest question.
82. Organized by AARP and the Securities Industry and Financial Markets Association, New York, NY, on April 4, 2008.
83. Financial Literacy Foundation, "Financial Literacy: Australians Understanding Money," 2007, p. xii.
84. Presentation at the CITI-FT Financial Education Summit, New Delhi, December 2007.
85. The Economist, April 5, 2008.
86. These simple examples are taken from Jump$tart's "2007 12 Principles Calendar: 12 Principles that Every Young Person Should Know." 8. Copyright©by The Curators of the University of Missouri. Sponsored by Citi Office of Financial Education, Department of the Treasury, Jump$tart Coalition for Personal Financial Literacy, and University of Missouri-St Louis. Used here with permission.
87. Elizabeth Johnson, "From Financial Literacy to Financial Capability among Youth." Journal of Sociology and Social Welfare, September 2007.
88. This paragraph is based on Clive R. Belfield and Henry M. Levin, "Should High School Economics Course Be Compulsory?" Economics of Education Review, 2004.
89. Quoted in The Economist, see note 6. For an elaboration of these views see Richard H. Thaler and Cass R. Sunstein, Nudge: Improving Decisions about Health, Wealth and Happiness (New Haven, CT: Yale University Press, 2008).
90. But the social security safety net isn't available until age 65.
91. See note 4.
92. In another change, money can now be left in super indefinitely. But in that case, investment earnings continue to be taxed at 15 percent.
93. And, of course, who should pay for any increase.
94. Roughly half of Australian DC accounts are in retail funds, but those participants typically have an investment adviser, so they have access to expertise.
95. We have been told that the main reason is probably that, having achieved the benefit of moving from stable value to target risk, the benefit of a further move to target date is not as substantial or obvious to Australians.
96. Most Canadian DC plans follow the traditional route of using individual accounts for each participant. Collective DC is used only in multiemployer plans; some commentators call them "target benefit" plans.
97. Incidentally, the Dutch seem very keen on longevity protection. Even their individual DC plans typically result in an annuity purchased at retirement.
98. But they do need to understand the nature of the "promise" underlying the benefit level in their collective DC plan, and how it is different from the promise in a DB plan. That requires a different form of education.
99. Justin Fox, "Where Retirement Works," June 14, 2007. Available at www.time.com/printout/0,8816,1633069,00.html.
100. Thao Hua, "DC Conversions Have a Dutch Flavor," April 3, 2006. Available at www.pionline.com/apps/pbcs.dll/article?AID=/20060403/PRINTSUB/604030713/1031/TOC.
101. "Collective DC: Arcadis Pension Fund," published September 26, 2006. Available at www/epn-magazine.com/news/printpage.php/aid/1737/CollectiveDCArcadispensionfund.html.
102. www.pensionrights.org/policy/internationalpensions/netherlandsdcplan.html.
103. Keith P. Ambachtsheer and D. Don Ezra, Pension Fund Excellence (New York: John Wiley & Sons, 1998).
104. Reported April 1, 2008, by CBC News. Available at www/cbc.ca/canada/toronto/story/2008/04/01/teachers-plan.html?ref=rss&loomiasi=t0:a3:g4:r5:c0.
105. Bureau of Labor Statistics, Consumer Expediture Survey, 2006.
106. George Kinder, The Seven Stages of Money Maturity (New York: Dell Publishing, 2000).
107. Paul Fronstin, Dallas L. Sallisbury, and Jack VanDerhei, "Savings Needed to Fund Health Insurance and Health Care Expenses in Retirement: Findings from a Simulation Model," Employee Benefit Research Institute, Issue Brief No. 317, May 2008.
108. Donald R. Hoover, Stephen Crystal, Rizie Kumar, Usha Sambamoorthi, and Joel Cantor, "Medical Expenditures during the Last Year of Life: Findings from the 1992-1996 Medicare Current Beneficiary Survey," Health Services Research 37(6) (2002), 1625-1642.
109. Jane Li, Robert Del Col, Lisa Burns, and Jim Graves, "A Process-Centered Approach to Retirement Income," FundQuest Incorporated, 2007.
110. Ruth Helman, Jack VanDerhei, and Craig Copeland, The 2007 Retirement Confidence Survey. Employee Benefit Research Institute: Issue Brief No. 304, 2007.
111. Ruth Helman, Jack VanDerhei, and Craig Copeland, The 2008 Retirement Confidence Survey. Employee Benefit Research Institute: Issue Brief No. 316, 2008.
112. See note 10. No doubt some had multiple reasons, accounting for the total exceeding 100 percent.
113. All 50 states, the District of Columbia, and Puerto Rico have life and health guaranty associations that provide some protection against insurer insolvency. For more information on this topic, we suggest visiting www.nolhga.comorwww.naic.org.
114. Jeffrey R. Brown, Olivia S. Mitchell, James M. Poterba, and Mark J. Warshawsky, The Role of Annuity Markets in Financing Retirement (Cambridge, MA: MIT Press, 2001).
115. Meir Statman, What Do Investors Think? Risk-Aversion, Loss-Aversion and the Annuities Puzzle. Presentation to the Retirement Income Industry Association, February 2007.
116. Moshe A. Milevsky and Virginia R. Young, "The Real Option to Delay Annuitization: It's Not Now-or-Never." York-Schulich-Finance Working Paper No. MM11-1, 2001.
117. In clarifying the ideas expressed in this section, we found a very useful discussion in Peng Chen and Moshe A. Milevsky, "Merging Asset Allocation and Longevity Protection: An Optimal Perspective on Payout Annuities," Journal of Financial Planning, June 2003.
118. As always, we ignore credit risk here: the risk that the insurer might not survive as long as the purchaser.
119. One example is a variable immediate annuity sold by the Teachers Insurance and Annuity Association-College Retirement Equities Fund (TIAA-CREF).
120. Ruth Helman, Jack VanDerhei, and Craig Copeland, The 2007 Retirement Confidence Survey. Employee Benefit Research Institute: Issue Brief No. 304, 2007.
121. Wei Sun, Robert K. Triest, and Anthony Webb, "Optimal Retirement Decumulation Strategies: The Impact of Housing Wealth." Federal Reserve Bank of Boston Public Policy Discussion Paper No. 07-2, 2007.
122. Greenwald Strategy Service 2007 Financial Advisor Survey, Mathew Greenwald & Associates, Inc., October 31, 2007 (a presentation to Russell Investment Group).
123. While Social Security payments are indexed to the cost of living, most DB pensions (at least in the private sector) are fixed dollar.
124. In the United States, this might take the form of Supplemental Security Income, paid to those over 65 and with low incomes. See www.sa.gov/pubs/11000html.
125. But see Chapter 18, where we describe new products that can guarantee you an income for life as well as potentially provide a death benefit if you die early.
126. See, for example, Richard K. Fullmer, "Modern Portfolio Decumulation: A New Strategy for Managing Retirement Income," Journal of Financial Planning, August 2007.
127. See note 6 in Chapter 16.
128. Quoted in Richard I. Kirkland, Jr., "Should You Leave It All to the Children?" Fortune, September 29, 1986.
129. Charles W. Collier, Wealth in Families (Cambridge, MA: Harvard University, 2006).
130. New design features are common not only because the features themselves are of interest, but also because they help the products to resist commoditization.
131. At the time of writing, we have not seen this product on the market. But its features have been discussed in investment literature.
132. The observation that governance is about process is consistent with ERISA's fiduciary principles, which are also about process. For a more detailed analysis, see Bevis Longstreth, Modern Investment Management and the Prudent Man Rule (New York: Oxford University Press US, 1986), chap. 44.
133. "Responsible parties" are those who, by education or experience, have the abilities to fulfill their duties competently, or who can fulfill those duties through the selection and monitoring of consultants and experts.
134. 2007 Annual Social Security Statement, "Unless action is taken soon to strengthen Social Security, in just 10 years we will begin paying more in benefits than we collect in taxes. Without changes, by 2040 the Social Security Trust Fund will be exhausted." 4. Nor, for that matter, should the interests of the employer affect the fiduciary's decision. But we do not discuss that aspect in our example.
135. The Vanguard Group, How America Saves, 2007.
136. "Default Investment Alternatives under Participant Directed Individual Account Plans; Final Rule," Department of Labor, Employee Benefits Security Administration, 29 CFR Parts 2550, Federal Register, October 24, 2007.
137. John Beshears, James Choi, David Laibson, Brigitte Madrian, and Brian Weller. "Public Policy and Saving for Retirement: The 'Autosave' Features of the Pension Protection Act of 2006," in Better Living through Economics, 2007, p. 8.
138. Unless, of course, you believe, as we discussed in Chapter 6, that low-paid employees have valid reasons for not participating.
139. 2006 Hewitt Universe Benchmarks. "How Well Are Employees Saving and Investing in 401(k) Plans?" 5. William E. Nessmith and Stephen P. Utkus, "Hardship Withdrawals and the Mortgage Crisis," Vanguard Research Note, Vanguard Institutional Investor Group, April 2008.
140. Jennifer Levitz, "Investors Pull Money Out of their 401(k)s," September 23, 2008, http://wsj.com/article/SB122212664298765183.html#.
141. Federal Thrift Investment Board, Board Member Meeting Minutes, www.frtib.gov/FOIA/minutes.html. June 2008 Minutes, see page one of Attachment 1. Thrift Savings Fund Statistics.
142. Sue Asci, "Consumers Increasingly Take Loans from Retirement Plans," Investment News, April 14, 2008, www.investmentnews.com/apps/pbcs.dll/article?AID=/20080414/REG/702355424/-1/Topic&template=printart.