How to Optimize a 401(k) Plan for Employer, Employees

Lately the benefits press has written an awful lot about the latest trend in employer-provided retirement benefits: making defined contribution (DC) plans look more like defined benefit (DB) plans.

  • Communicating an estimate of how big an annuity a participant’s account balance can buy
  • Providing the option to take a distribution from the plan as either a series of installments or as an annuity.

Let’s consider what’s going on here.

Annuity Estimate

Yes, there is a huge push from the government and from some employers to communicate the annual benefit that can be “bought” with a participant’s account balance. Most commonly, this is framed as a single life annuity that begins at age 65 — and uses a dream-world set of actuarial assumptions.

For example, it might assume a discount rate in the range of 5% to 7%, because that’s the rate of return that the plan recordkeeper or other decision maker thinks, or wants the participant to think, is available to the participant.

I have a challenge for people who are pushing that. Go to the open annuity market. Find me some annuities from safe providers that have an underlying discount rate of 5% to 7%. I’m taking a wild (perhaps not so wild) guess that in late 2016, you won’t find any. An insurer in business to make money (that is why they’re in business, isn’t it?) would be crazy today to offer annuities with an implicit discount rate in that range.

But annuity estimates continue to frequently use discount rates like that.

Distribution Options

Many DC plans offer distribution in a series of installments. Participants rarely take this option, however. For most, the default behaviors are either (1) taking a lump-sum distribution and rolling it over into another retirement account, or (2) taking a lump-sum distribution and buying the proverbial (or not) bass boat.

Why is that? I think it’s partly a behavioral question. But when retiring participants look at how much they will be able to draw down from their account balances, it’s just not as much as they’d hoped. In fact, there is a tendency to suddenly wonder how they can possibly live on such a small amount. So, they might take a lump sum and spend it as needed, all the while hoping something good will eventually happen.

Similarly, if they have the option of getting an annuity from the plan, they are typically amazed at how small the annuity payout is. And even with an uptick in the number of DC plans offering annuity options, the take-up rate remains inconsequentially small.

Isn’t There a Better Way?

In part the switch from DB plans to DC plans was predicated on the concept of “employees get it.” They understand an account balance, but they can’t get their arms around a deferred annuity. So, let’s give them an account balance.

The switch from DB to DC plans was also partly aimed at allowing participants to capture potentially better investment returns. Of course, with that upside potential comes downside risk. So, let’s give them most of that upside potential and take away the worst of that downside risk. That sounds great, doesn’t it?

How do we do all that? See below for more detail, but the solution lies in a DB plan that looks to participants like a DC plan. And, in the design of that plan, we’re going to guarantee their principal while giving them reasonable, positive returns.

Before going into that, however, let’s return to the genesis of the existing problem. Once participants got into their DC plans, they wanted investment options. Yet I recall that back in the late 1980s and early 1990s, a plan with as many as 8 investment options was viewed as having too many. Now, many plans have 25 or more such options.

But, what for? The average participant isn’t a knowledgeable investor. And even the miraculous invention commonly known as robo-advice isn’t going to change that.

Suppose we give them the upside potential with professionally managed assets that they don’t have to choose. Well, that’s available in many DC plans. They’re called managed accounts. But they commonly have management fees — typically in a range of 15 to 70 basis points, according to a Forbes article — on top of the fund fees. Depending on a participant’s individual circumstances, that can be a lot of expense.

But, suppose your account was part of a managed account with hundreds of millions or billions of dollars in it, therefore making it eligible for deeply discounted pricing. You’d have more safety, without losing upside potential, and you’d get that at a lower cost.

Yes, There Is a Better Way

You can give the best of all of that to your participants by leveraging a concept that has been around for about 10 years.

It seems hard to believe that it was that long ago that Congress passed and President George W. Bush signed the Pension Protection Act (PPA) of 2006. The PPA was lauded for various changes it made to 401(k) structures. These changes were supposedly going to make retirement plans great again. But for most, they didn’t.

However, buried in that bill was a not-new, but previously legally uncertain concept now known as a market-return cash balance plan (MRCB).

Remember all those pluses that I asked for above? Lower fees. Guarantee of principal. Upside potential. Professionally managed assets. The MRCB has them all.

Remember the annuity option that participants thought they wanted, but found out they didn’t because insurance companies’ profit needs made the benefits too low? Well, the MRCB doesn’t need to turn a profit. And for participants who prefer a lump sum, it would be an exceptionally rare MRCB that doesn’t have a lump-sum option; in fact, I’m not aware of any that don’t.

Plan-Sponsor Financial Implications

Plan sponsors wanted out of the DB business largely because their costs were unpredictable. But with a properly designed MRCB, costs should be easy to budget for and within very tight margins.

In fact, I might expect an MRCB to stay closer to budget than a 401(k) with a match (remember, the amount of the match depends on participant behavior).

And, in a DB world, if a company happens to be cash-rich and in need of a tax deduction, there will almost always be the opportunity to advance fund, thereby accelerating those deductions.

For more information about Cash Balance plans, click here.


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