Needs Versus Wants: What do Collective Defined Contribution Plans Address?
By Esther Peterson, Mark Shemtob and Lee Gold
Retirement Section News, April 2024
Financial security in retirement hinges on fundamental risks that can be managed through retirement plan design, including investment risk, longevity risk, inflation risk, and withdrawal timing risk. Retirement experience data points to increasing risks of a person depleting financial resources before the end of their life (longevity risk) and a need to improve peoples’ access to retirement security. How can a collective defined contribution (CDC) plan meet these issues? How do the features of CDC plans align with what employees want? To address these questions, this article highlights two reports, each with expert insights from a retirement professional. I thank Mark Shemtob and Lee Gold for engaging in a dialogue about employee needs and wants.
Commentary by Mark Shemtob on “Securing a Reliable Income in Retirement, An Examination of the Benefits and Challenges of Pooled Funding and Risk-Sharing in Collective Defined Contribution (CDC) Plans.”
In a post-defined benefit (DB) plan world should we settle for traditional defined contribution (DC) plans? This paper asserts that the answer to this question is “no” and does an excellent job of introducing CDC plans. In CDCs, annual contributions stay fixed by allowing benefits to vary based on the investment and mortality experience of the covered participants. Other features can vary from plan to plan.
CDC plans have been around for a while and are used in many countries outside of the United States.[1] These plans are distinct from both DB and DC plans, which allow benefits to vary based upon investment experience but not mortality experience. An amendment to ERISA[2] permitting benefits to fluctuate due to mortality experience would open the door to CDCs and other innovative plan designs.
The paper on securing a reliable income outlines the general structure and features of a traditional CDC pension plan. The features include intergenerational wealth transfer, mandatory annuitization, and a single investment option. These three elements may make it difficult for CDCs to be embraced in the United States. Over the years, U.S. workers may have developed a false sense of security in managing their own retirement account balances, even if they lack expertise to do it well. Work would need to be done in communicating CDC concepts effectively with participants.
As described in the paper, a key to providing successful retirement income lies in the pooling of both longevity and investments. Pooling of investments can provide the following benefits:
- Greater investment opportunities,
- lower fees, and
- the ability to counteract the impact of depressed markets when a person is on the threshold of retirement.
The first two benefits may be achieved through the use of well-managed investment portfolios. Thus, a traditional CDC plan is not needed.
However, the third benefit generally requires a movement of resources among different age cohorts. This is a key feature under a traditional CDC plan, which reduces volatility in benefit payments, although it may be less than desirable to a population that is accustomed to owning their retirement balances. An alternative way to reduce investment volatility is through the use of more conservative investments, though with potentially lower returns and benefits. For those willing to assume the volatility, an option for more aggressive portfolios could be permitted.
CDC plans that are more traditional pool longevity risk among both active and retired participants. A more palatable approach might be to provide that the longevity pooling only occurs (partially or fully) voluntarily starting at a participant’s retirement age.
Finally, the paper addresses other important considerations regarding our retirement system. These include the encouragement of in-plan retirement income solutions as well as the potential for expanded use of pension equity plans (PEPs), which allow smaller plans to band together and enjoy the efficiencies and benefits that larger plans have.
Interview with Lee Gold about What Retirement Plan Features do Employees Really Want?
Esther Peterson (EP): Do you believe that CDCs address needs in retirement better than traditional DC plans, and why? Based on the recent SOA research, do the preferences of employees align with what you think they need in retirement?
Lee Gold (LG): My answer to this question is a bit more nuanced than “yes” or “no.” Employees want both security and flexibility. DC plans offer lots of flexibility and very little, if any, security. CDC plans offer more security but less flexibility. Consequently, there is a place for both of these plans in the retirement strategies for an individual.
EP: Assuming you can’t have both, would people generally rather have a secure income for life (as in a CDC plan) or the potential to bequeath money to their spouse or other beneficiaries (as in a traditional DC plan)? Why do you think this is so?
LG: The ability to provide retirement benefits for a spouse and the ability to leave a bequest are in the top five of important features for almost every demographic cut: Age, gender, educational level, income level. They are very important. That desire reveals itself in the data in that there is a stronger preference for a 20-year certain payout than for a single life annuity payout. The most preferred payment option is a 20-year certain and life. In summary, preferences indicate a desire for lifetime income, but only if the retiree has some protection against losing all their lifetime savings because of an early death.
EP: What do you think is the biggest challenge with aligning employee needs with what they want?
LG: It’s my belief that most workers need additional lifetime income beyond what they receive from social insurance programs like Social Security. The biggest challenge is communicating an approach that will feel good to them and not make them feel like they are losing out on something. Communication is key, perhaps something like this:
“With 50% of your money, you can do whatever you want. Have fun, but not too much fun too fast. With 40% of your money, we are going to structure a payment program that is guaranteed to pay a benefit for the next 20 years to you, or your beneficiaries should you pass away before the 20 years is complete. Lastly, we need to protect you in case you live a long life. Therefore, the final 10% of your nest egg will be used to purchase lifetime income protection that will continue to provide a payment beyond these 20 years, should you or your spouse still be alive.”
I believe this type of message would sit much better than just telling someone they need to buy an annuity. We need to avoid having the retiree feel like they are losing in this process, and a single life annuity is not the preferred option (too much to lose). So, let’s provide lifetime security and payment guarantees as the starting point, and then allow the employee to opt out of those guarantees if they so choose.
EP: Traditionally, employees have contributed much more to employer sponsored DC plans with payroll deduction than to personal Individual Retirement Accounts (IRAs). Does your research provide additional insight on this topic or helpful information to increase savings?
LG: While not the focus of this research, there is perhaps one finding that is helpful in this area. The personal utility of a retirement plan is weakened the more an employee has to pay for that plan. This is not a shocking result by any means. Employees will be more satisfied with a plan where the employer is contributing to the cost than one where the employee must fund it all themselves. Again, not shocking. The satisfaction level drops significantly if employees have to pay more than 50% of the cost, so employers should keep that in mind when designing their plans.
In my experience and readings over the years, what is clear is that we as humans are inherently lazy. I don’t mean that in a negative sense. What I mean is that we like it when things are easy for us. Technology has made so many mundane tasks easier; who still writes a check these days? The ability of an employer to facilitate automatic enrollment with payroll deduction is a leap ahead of asking an individual to research various IRA providers, open an account, and create the necessary process to contribute funds to that IRA every month. It’s less a matter of preferences than it is ease of use.
EP: Does the research offer any insights helpful to meeting the needs of employees who do not currently save in employer plans?
LG: Since the cost-sharing issue is so important (#2 out of 15), employers who are unable to help fund a retirement plan are at a distinct disadvantage. Employee-funded plans will not be as appreciated as much as plans where employers are helping to fund the benefits. Our research was focused on employer-provided plans, so there are limited insights into situations where no employer plan exists.
EP: What can employers do to better prepare employees for a financially secure retirement?
LG: I think all the automatic enrollment/escalation features and default investment options (target-date funds) in DC plans are working well for many participants. However, it is my belief that the money could be better allocated, particularly employer contributions. A CDC plan may be a good option, but it would need a few tweaks. Most participants would benefit from having a professional manage their funds rather than doing it themselves. A pooled investment option, managed by a professional, is likely to do better in aggregate than a group of individual investors making their own choices. That said, participants do not prefer to have someone manage their money … unless the participant has the ability to override and make a different decision. It’s my belief that most participants would accept the help of a professional and are unlikely to make changes to what the professional decides. However, having that ability to override the professional is key to acceptability. In the US, we would need enabling legislation to allow pooled investments, managed by professionals, to include some form of individual choice.
CDC plans also offer the ability to pool (share) mortality risk among the retirees in the pool. Modeling shows that the majority of retirees will benefit from mortality pooling rather than trying to self-insure their own income stream if investments are the same between the two approaches. Do-it-yourself retirement only wins for the majority of participants if extra investment risks are taken, and those increased risks actually result in higher rewards. Employers should keep in mind that employees don’t want to risk losing a large part of their nest egg in the event of an early death. Lifetime income options with longer guarantee periods (15–20 years) will be more in-line with employee preferences.
CDC plans with fixed employer contributions, lifetime payments to retirees with fixed-period guarantees would be a more efficient approach to providing retirement income than the traditional DC plan offers today. While insurance companies can be brought in to help with the payout phase, their products are often too complex for the average retiree, who ends up doing nothing due to choice paralysis. Insurance companies also must be paid for the risks they carry and the services they provide. An employer CDC plan does not have the need to generate profits, just to break even. While CDC plans provide a valuable tool in the retirement toolbox, we need enabling legislation to make them a reality.
Statements of fact and opinions expressed herein are those of the individual authors and are not necessarily those of the Society of Actuaries, the newsletter editors, or the respective authors’ employers.
Esther Peterson, ASA, EA, MAAA, is a consulting actuary for Milliman and can be reached at esther.peterson@milliman.com.
Mark Shemtob, FSA, MAAA, is the owner of MS Advisory LLC and can be reached at mshemtob@abarllc.com.
Lee D. Gold, ASA, EA, MAAA, is a principal and financial wellness consultant with Mercer in Denver, Colorado. He can be reached at Lee.Gold@mercer.com.