ERISA and Retirement Income Security: 50 Years Later
By Mark Shemtob
Retirement Section News, July 2024
2024 marks the 50th anniversary of the Employee Retirement Income Security Act of 1974 (ERISA), an opportune time to evaluate the impact of this landmark legislation. This article will focus on a single question. Has ERISA improved the delivery of Retirement Income Security (part of the name) to private-sector employees?
The traditional defined-benefit (DB) plan is a type of plan structured to provide the greatest degree of retirement income security, designed to pay out a guaranteed retirement income for the life of the retiree (and, when applicable, a beneficiary). However, over the last several decades, the number of private-sector employees covered under these traditional plans has decreased dramatically and been replaced by defined contribution (DC) plans. In contrast, public-sector retirement plans, which are exempt from ERISA, have seen a much smaller decline in DB plans. There are many differences in the private and public sector that likely contributed to this phenomenon, but ERISA and the many amendments to it has been a major factor.
Primary Reasons Leading to a Decrease in DB Plans
A. Pension Benefit Guaranty Corporation (PBGC) premiums: The annual premiums[1] required for single employer DB plans have increased dramatically over the last five decades, increasing from $31 to as much as $787[2] per plan participant. These high levels of premiums may apply even when there is virtually no risk to the PBGC that the plan will be incapable of paying promised benefits, because the premium structure does not consider the financial strength of the Plan Sponsor nor the risk inherent in a given plan design, only the current level of plan assets and liabilities.[3]
B. Constantly changing and complex plan funding rules: Over the 50 years that ERISA has existed, legislation and regulations on how much an employer must contribute annually into a DB plan has changed many times. This lack of consistency has created additional administrative expenses as well as erratic swings in funding requirements making corporate budgeting difficult especially during changing economic environments.
C. Trapped Plan Assets: If a DB plan terminates unexpectedly with more money than needed to fund all accrued benefits, the excess assets cannot revert to the employer without significant penalties. This was not the case when ERISA was initially enacted and can create a disincentive for plan sponsors to maintain DB plans.[4]
D. Lack of Tax-Deductible Employee Contributions: ERISA was amended in 1979 to allow that employee contributions to DC plans be tax deductible but not DB plans. Most public sector DB plans treat employee contributions on a tax favorable basis. This disadvantage has made private sector DB plans less attractive than DC plans.
Today’s Primary Private Sector Retirement Plans
One possible solution to this retirement income challenge would be legislation that would allow for more innovative designs that would reduce the more unattractive features of defined benefit plans that employers face.[5] These design features focus on how some of the potential liabilities shouldered by employers can be shared with plan retirees through variable benefits. This article however focuses on how DC plans can achieve this outcome.
ERISA legislation and regulation over the years has propelled the transition from DB plans to DC plans (mostly 401k plans). DC plans are not inherently designed to provide retirement-income options—monthly payments from the plan intended to last for the life of the retiree and/or beneficiary. Some retirees with sufficient assets to access expert financial advice can secure retirement income solutions outside their employer plan by rolling over their accounts to an individual retirement account (IRA). But this group is in the minority especially for retirees lacking financial literacy knowledge.
A recent study[6] found that 90 percent of plan participants would welcome in-plan retirement income options under the DC plans they participate in. A 2022 survey by the Bureau of Labor Statistics demonstrates that only 20% of private sector employees have access to DC plan annuity options with guaranteed lifetime income. However, it does not appear that regulators are concerned about this issue. It is not a priority to collect information by the Department of Labor to determine the current availability of retirement income options under DC plans.[7]
The lack of plan provided retirement income options leaves most retirees with the personal responsibility to go outside of their plans to secure access to a retirement income solution, including needed education. There is no evidence that the tens of millions of Americans that have already accumulated or will accumulate funds under their employers’ retirement plans and IRAs, including IRA rollovers from prior employer plans, are up to the challenge or have access to the right advisors. Money in IRAs is often self-managed by the individual or invested based upon the advice of a non-fiduciary advisor who lacks retirement income expertise or who may focus on only a specific solution. In addition, pricing of products and other solutions offered through IRAs are often at the retail and not institutional level, resulting in lower benefits.
Retirement Income Solutions that might be Offered by DC Plans
A retirement income solution is broadly defined as a strategy of turning a lump sum into a monthly income guaranteed or potentially designed to last a lifetime. The challenge in selecting a retirement income solution lies in the uncertainty of how long one will live as well as uncertain future financial market performance. Solutions can be based upon investments, insured products, or a combination of the two. Insured solutions are products that guarantee a lifetime income whereas investment solutions do not. The drawback to insured solutions is cost, a lack of flexibility and limited bequest amounts.[8] There are a variety of both insured and investment (non-insured) income options. Below is list of some more popular ones.
Common Insured Solutions
A. Fixed income annuities: These are what we generally consider as pensions. The retiree pays a one-time premium to an insurer and in exchange receives an insurance company guaranteed fixed income for his or her life. For an additional premium or reduced income, a provision can be added that pays a death benefit to a beneficiary.[9]
B. Variable annuities with guaranteed benefit payments: These products are held in underlying investments and are coupled with an insurance feature (rider). The insurance product provides, for an additional fee, a guaranteed income is payable for the life of the annuitant(s) regardless of how long he or she lives or how well the underlying investments perform. There may, however, be limitations on the permitted underlying investments as well as the amount that can be distributed in any single year to maintain the income guarantee. At death, a benefit is payable to the extent there is still a positive account balance.
C. Fixed indexed annuities with guaranteed benefit payments: These are similar to variable annuities with guaranteed benefit payments with the exception that the underlying annuity value is generally based on a market index with both downside and upside limits on the loss or gain of the applicable index.
D. Qualifying Longevity Annuity Contracts (QLAC): These are a special type of fixed income annuity. The benefit is not paid for many years in the future; often 15 or 20 years after premium payment. They are often referred to as longevity insurance. They are used as a supplement to a non-insured solution to cover the risk of outliving funds.
Common Noninsured Solutions
A. Structured payout programs: A monthly benefit amount is typically determined based upon the account balance, a fixed payout term, and an expected rate of return. This amount can stay steady or be periodically modified (increased or decreased) to reflect investment experience and updated future life expectancy. Once the account is exhausted, no more funds can be paid. Thus, this approach requires careful monitoring if it is to last a lifetime.
B. Distributions Based on Required Minimum Distributions: This approach pays out an annual amount based upon the table used to determine the minimum amount that must be withdrawn each year to avoid excise taxes. It can be modified by incorporating an annual payout amount greater than the minimum. Without modification, the annual payouts will likely increase from year to year.
C. The 4% or other percentage rule: This approach pays an initial benefit equal to 4%[10] of the account balance with an annual increase based upon inflation. Payments cease when the account runs out of money.
There are many other strategies available, both insured and noninsured. And multiple strategies can be combined as a diversification tool that may provide other advantages. Such a combination is illustrated in this article. https://contingencies.org/retiree-income-a-combo-approach/
Expanding on Availability of In-plan Retirement Income
In 2019 legislative and regulatory action was taken intended to encourage more DC plans to provide retirement-income options.[11] Employer DC plans are a good venue to serve the retiree income needs due to the relationship and trust (plan sponsors must serve as fiduciaries) that already exists between employers and plan participants. In addition, there is the potential to provide a smoother transition from work to retirement. DC plans can also accept rollovers from plans that covered employees when working for previous employers. In addition, employer plans have access to lower cost institutional investments and products as well as expertise that the average retiree may not have access to. Some large employer retirement plans do offer income options. Though others do not. Many that do, may not provide the education and tools needed for retirees to make informed choices. In addition, they may not offer a variety of options. A 2024 Alight study (“2024 Hot Topics in Retirement and Financial Wellbeing”)[12] indicates growing interest by employers in noninsured in-plan retirement income options.
Many employers may choose not to offer retirement income options directly from the plan for fiduciary reasons. There are liability concerns associated with continuing to maintain accounts within the plan after an individual has retired. There may also be resistance to the additional administration and expenses associated with providing monthly benefit payouts. To the extent that employers are reluctant to offer retirement income alternatives due to fiduciary concerns, an expansion in Safe Harbor approaches to include non-insured investment income options is an idea that should be considered. However, it is unlikely that smaller plans will adopt retirement income solutions even with safe harbors. Thus, an alternative approach may need to be considered. How either safe harbors or small plan alternatives might work is beyond the scope of this article.
It should be apparent that because of the wide variety of income options available, it is impractical to offer them all. However, the vast majority of plan participants preferred to have both insured and investment-based options to select from in retirement.[13] Finding a good balance is a challenge. Education is a critical element when offering choice. Education should include a general description of retiree income risks as well as a description of the available options (short video explanations may be helpful). The description covering each option should include:
- The risks of the option (e.g., running out of funds, inflation, etc.);
- the cost of the option (e.g., fees and commissions); and
- restrictions on the option (e.g., liquidity and legacy).
Specific numerical illustrations on options offered might help many retirees to make more informed decisions.
Conclusion
The private finance and insurance industry keeps looking to create new ways of paying out retirement income (insured and non-insured). However, employers have not been sufficiently encouraged to provide retirees access to retirement income solutions designed to last a lifetime within their retirement plans. We require solutions that are cost effective, offer adequate yet limited choice, are well understood, and easy to implement. For those retirees covered by retirement plans that provide robust income support or retirees that have trusted IRA advisors, this critical component of retirement security is already available. However, most retirees are not so fortunate. For them, we require more. The solution might lie in enhancements to ERISA that would help to bridge the transition from DC account balances to retirement income.
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.
Mark Shemtob, FSA, MAAA, is a director of the Institutional Retirement Income Council. Mark can be contacted at markeaasa@yahoo.com.