Employers who want to provide their employees with more than nominal retirement benefits face a daunting realignment of those promises. Many of the challenges facing employee benefit programs are outside of employers' control. Longevity is increasing faster than the age of retirement, creating longer retirement durations. Interest rates are low, reducing the performance of employees' retirement investments—particularly bonds, which are a cornerstone of financing as employees approach and enter retirement. Equities have rallied since the lows of 2009, but they remain volatile and unpredictable for long-horizon investing.
All of this happens against a background of increased employee responsibility for managing retirement funds, putting complex and challenging decisions in the hands of those who may be simultaneously least prepared to make them but most affected by them. As fewer people come to count on defined benefit (DB) plans, there are open questions about whether defined contribution (DC) programs can carry the growing retirement load. These challenges are exacerbated by the cost of retiree medical coverage and long-term care insurance (LTC).
While the challenges are significant, there are several promising ideas for addressing them including DC plan optimization, increased participant education and guidance, behavioral incentives, and the possibility of layered longevity plans. None of these will solve the problems alone. Inevitable social and economic shifts will change what retirement looks like in 21st century America, particularly with regard to healthcare costs, which are an area of growing concern. Nevertheless, employers who sincerely want to help provide for the retirement of loyal workers need to be examining every possible way to make their retirement benefits work in today's complex retirement landscape.
Employees face challenges in saving enough for retirement
For a wide variety of reasons, including the decline of unions, regulatory changes, recognition on the part of employers that DB plans can be expensive and risky, and an increasingly mobile workforce, employer-managed DB retirement plans are a shrinking part of the retirement picture. Today, DC plans make up an overwhelming share of new retirement savings plans. For employers, DC plans are generally less risky, less complex, and less expensive to manage. For employees, DC plans are often less complex and usually give them more control over their investments and more freedom to switch employers but also more risk that the money may be spent elsewhere or invested in a way that doesn’t guarantee long-term security.
In today's complex retirement environment, the freedom conferred by DC plans can seem like a mixed blessing. While financially savvy employees who invest time and thought into managing their retirement accounts can do well, many employees do not fit this picture. In fact, large numbers of workers do not have the knowledge, expertise or, frankly, the degree of interest necessary to effectively manage their retirement investments. And even those employees who take an active role in managing their retirement accounts face growing complexity in adequately preparing for and navigating retirement.
The rule of thumb for retirement savings is that one can live comfortably in retirement with 80% of the income enjoyed during working years. This has one thing going for it: it's simple. But the world of retirement is not simple, and it’s getting less so.
- People are living longer, requiring them to have more capital going into retirement.
- Longer lives mean a greater likelihood of needing long-term care.
- Medical costs continue to rise far faster than inflation.
- Medicare and Social Security both face significant challenges in coming years.
- Low interest rates, economic weakness, and volatile equities markets make it hard to plan how much to save and where to invest savings.
- Potentially high inflation can deteriorate the value of retirement assets.
In the face of these many challenges, it is almost inevitable that employees will begin to retire later. Rather than retire as soon as possible, many workers will choose to do the opposite—to keep generating income and keep their employer-sponsored health insurance, even if it means working longer. There is serious discussion afoot about raising the ages at which people can begin drawing partial and full Social Security benefits.
Whether or not that happens, we can expect older workers to compete with younger workers for jobs even more intensely than they do today. Even if employers continue to show a preference for younger, less costly workers over more experienced but more expensive older workers, the workforce is likely to become increasingly multigenerational as the stakes for retirement get higher.
Most employers who offer retirement benefits want those benefits to be adequate and effective. That means employers need to look deeply at their offerings and find ways to optimize retirement savings and investment to help employees save enough and invest it well.
What employers can do—and where barriers remain
Optimization of plan design is a key part of achieving an effective retirement program. One of the simplest optimizations is automatic enrollment. The Pension Protection Act of 2006 made it easier for employers to enroll employees in 401(k) plans, allocate predetermined levels of salary to those plans, and even invest those funds in preselected investments determined to be appropriate for retirement savings.
Growing numbers of DC plans are using automatic enrollment to increase employee participation. For employees who are not interested in managing their retirement savings themselves, such arrangements can greatly increase plan participation. It frees those employees from having to make decisions about how much to contribute and what to do with those savings. There are requirements for informed consent and restrictions around where funds can be invested, which adds a measure of protection for employees who take a "hands-off" approach.
Plans can also be designed with automatic deferral increases as salaries increase, helping to ensure that employees are putting away an appropriate proportion of their wages. And these kind of behavioral incentives can and should be supplemented with increased participant education and guidance, so that employees can make smart planning decisions, understand risks, and better manage their financial future both during their working and retirement years.
One way to help employees save enough is for employers to increase their contribution match rates and for employees to continue contributing at a consistent rate. Yet few employers can afford extravagant matching plans. During the recent economic downturn, a large number of employers reduced their matching rates or eliminated matching altogether, at least temporarily. Additionally, while many see matching as an incentive for increased employee participation in retirement plans and increased savings, research is inconclusive in this regard. At least one paper1 concluded that match rates have little to no effect on employee savings rates under automatic enrollment. Employer matching provisions should be carefully designed so that it is sustainable for the employer over the long term yet effective at helping employees reach their goals. Increased employee education may help accomplish this goal.
One problem with using an employer-matched 401(k) plan as the only form of retirement benefit is that there are always some employees who cannot or will not contribute. Some may start too late, or they may stop later in their careers because of high personal expenses such as dependents’ college tuition. When they are not contributing to their plans, these individuals get no matching contributions and thus no employer-provided benefit. In addition to optimizing the match rate, an employer could add a profit-sharing contribution, or shift some of the match to a profit-sharing contribution, so that all employees have at least some retirement benefits.
Employers are also looking to provide employees more enhancements and more benefit options with their 401(k) accounts. Some are beginning to offer managed funds and target-date funds that help relieve some of the management burden and longevity risk faced by employees today. Even better, a custom model portfolio can be designed with an appropriate "glide path" toward retirement, automatically increasing the proportion of low-risk mutual funds and bonds as the employee approaches retirement. Others are choosing to add annuities as part of the range of investment options, giving employees an alternative income stream in retirement. Offering a Roth feature in a 401(k) plan is another option, providing tax-free distributions. For certain employees, particularly those who have high incomes as they approach retirement, Roth accounts can be a valuable option.
Retiree medical and LTC benefits
The history of retiree medical benefits mirrors that of pensions. Social and regulatory changes have caused significant shifts in how employers and retirees fund medical coverage. But unlike DC plans, which are a relatively viable means of funding retirement costs, retiree medical coverage is in crisis. With healthcare costs representing a mounting portion of retirement spending, this crisis threatens the retirement landscape as a whole. Many employers eliminated retiree medical coverage when the Financial Accounting Standards Board (FASB) changed the accounting requirements for retiree medical plans in 1993. Many government employers still fund retiree health costs, but that, too, may cease due a 2007 Government Accounting Standards Board (GASB) accounting requirement similar to the 1993 FASB rules. Some employers continue to pay for or subsidize medical insurance for retired employees. However, the rising cost of healthcare—particularly for older individuals—has resulted in huge rises in insurance premiums, which has in turn caused many employers to shift costs to workers or cut retiree medical insurance coverage altogether.
Workers are faced with less-than-ideal choices. Once their term of employment ends, their employer-provided health insurance will typically end, as well. If they are under 65, they must rely on funds from health savings accounts, purchase expensive insurance in the private market (difficult even with the subsidies provided by some employers), or go uninsured—a very risky proposition for an aging population. Once they reach 65, they have access to Medicare, but out-of-pocket costs for those insured solely by Medicare continue to grow. And recent legislative changes have greatly diminished the prospects of once-popular Medicare Advantage plans.
LTC insurance faces challenges, as well. Like all things healthcare-related, the need for and cost of LTC are growing with a longer-lived population. Just as awareness of the need for LTC insurance is growing and more and more people are signing on, insurers are increasing premiums, reducing benefits, and even leaving the LTC market altogether. Before insurers realized that their solvency projections for LTC products were not in line with reality, attractive premiums led many employers to offer subsidized LTC insurance as part of their retirement benefits. As premiums grow and bottom lines contract, fewer employers can afford to fund LTC insurance. Workers bear the costs, and more of them may choose to put off funding potential LTC needs in favor of more immediate items.
What can employers do in the face of the looming retiree medical and LTC crises? In some ways, their hands are tied. They have little control over longevity, health costs, insurance premiums, and similar underlying factors. Some employers have chosen to implement wellness programs that could help people reduce medical costs in retirement by staying healthier—losing weight, quitting smoking, and so on. However, few studies have shown that these frequently expensive programs provide hard-dollar returns. Insurance subsidies can help, but they need to be undertaken with a clear understanding that costs are not likely to go down in the future and that providing a substantial subsidy will be expensive.
The federal government is providing a measure of relief. Assuming all goes as planned, state health insurance pools resulting from the 2010 healthcare reform bill may provide a measure of relief by making less expensive health insurance available in the private market. To “tide over” retirees in the gap between retirement and Medicare eligibility, that same bill authorized a one-time reimbursement of healthcare costs for retirees not yet eligible for Medicare but still covered by employers' health insurance. Future solutions to the retiree health care challenge will likely have to be similarly broad in scope to be effective.
Looking ahead
Some aspects of retirement funding can be influenced by employers; others cannot. Whether it comes down to new products, new policies, or increased employee education, there are many options for optimizing retirement benefits even in today's challenging climate. What all employers can and should do is conduct a serious analysis of their benefit offerings.
With all the complex questions involved, this is not an area in which instinct will suffice. What should the default automatic contribution levels be given a company’s industry, demographics, and types of employees? What matching rates will help employees save enough without breaking the employer's budget? What additional products and plan features could put employees on an appropriate glide path to retirement? It is critical to answer these questions based on evidence rather than intuition.
Given that the main purpose of offering retirement benefits is to attract and retain workers, it is critical to provide benefits in a way that is sustainable. A layered longevity plan is one potential way to ensure that people do not outlive their retirement balances for an uncertain duration—due to the fact that no one knows their precise longevity. In the layered longevity plan scenario, employers would fund a DB plan that is specifically designed for longevity protection. The longevity plan would come into effect later than today's retirement plans (e.g., age 80) and would provide lifetime income throughout the duration of an uncertain longevity horizon. Because fewer employees would live long enough to claim benefits compared to traditional DB plans, longevity plans would be less expensive to fund. Longevity plans are not allowed today because employer-provided retirement benefits are required to come into effect no later than age 65.2 If the regulations change, the combination of an optimized DC plan for the bulk of retirement with the security of a longevity plan could provide a very attractive retirement solution.
Interestingly, such a scenario would represent a reversal of the historical pattern. DC plans began as a supplement to DB plans and later became the rule rather than the exception. This solution would have DC plans as the main retirement funding model with limited DB plans for longevity protection. The retirement funding challenges facing the aging U.S. population cannot be solved by employers alone, but they cannot be solved without them, either. Creative thinking and an analytical approach are both required if employers are to play a leadership role in the retirement landscape of tomorrow.
1 The Impact of Employer Matching on Savings Plan Participation under Automatic Enrollment, Beshears et al., 2007, http://www.som.yale.edu/faculty/jjc83/aematch.pdf
2 Of course there remains the possibility of deferring these benefits until age 70, something that may not be permitted by all plans.