Defined Contribution Plans
Scott Matheson, CFA, CPA
Senior Director | CAPTRUST Defined Contribution Practice Leader
Earlier this year, drivers across America’s highways—from the 405 in Los Angeles to New York City’s West Side Highway—began noticing some thought-provoking billboards popping up from Prudential, the insurance company. One that stuck with me read, “The first (person) to live to age 150 is alive today.” Given my role at CAPTRUST, the tagline “Let’s get ready for a longer retirement” obviously grabbed my attention. I acknowledge that life insurance and annuity companies stand to profit from engaging Americans in planning for an 85-year retirement, and I certainly approach all advertisements with a healthy dose of skepticism. But longevity is top of mind for the retirement industry and, as such, around the halls of CAPTRUST.
My colleague John Curry’s article in this quarter’s Strategic Research Report highlights a number of the social and public policy issues associated with a society where life expectancy increases year after year, as well as the accompanying impact on the retirement industry. Evaluating the issues through the lens of a defined contribution plan participant, the defined benefit retirement plans of yesteryear are increasingly less common in the private sector, placing a greater onus on the participant to save and invest. Further, the increasing popularity of defined contribution plan design transfers the risk of participants outliving their money squarely onto the participant at a time when people are living longer.
Longevity trends impact the retirement industry in a number of meaningful ways. With growing life expectancies, we could see the normal retirement age creep higher than the commonly used age 65 threshold. The conventional game plan for migrating participant portfolios away from equities and toward fixed income assets followed within target date funds, managed accounts, and participant advice offerings will need to evolve as people live and potentially work longer. If people live in retirement for longer periods of time than the duration of their working careers, the challenges to defined contribution plans are immense—from savings to investing, to “decumulating” those savings sustainably.
Defined Benefit Plans
Senior Director | CAPTRUST Defined Benefit Practice Leader
Contrary to most topics regarding pension plans, the impact of longevity trends is a bit more straightforward. In 2012, the Society of Actuaries (SOA) issued a study exploring the impact of increased life expectancy—also referred to as mortality improvement—on pension liabilities.1 When actuaries extrapolate the value of an employer’s future promises in today’s dollars they have to make assumptions about participant life expectancy. As life expectancy has increased, the time horizon that pension plans will have to pay benefits to participants has also increased, which ultimately increases
pension liabilities. The SOA study indicates that current mortality tables underestimate life expectancy and ultimately pension liabilities by a margin of 2 to 4 percent.2 Regulation will ultimately force adoption of more effective mortality tables and plan-specific demographics will determine the magnitude of the impact. It is interesting to note that younger, active female workforces will experience the largest mortality gain.3
Longevity implications based on plan sponsor liability settlement decisions will vary. Insurance companies are far better at estimating the true costs of mortality improvement, and thus include a markup as part of single premium group annuity prices as plans terminate. Additionally, the timing of a lump sum payout window will impact cost. Choosing to use a lump sum window under new mortality assumptions will result in a higher lump sum settlement amount than the current tables in a similar rate environment.
For employers who choose to maintain plans or self-insure, there is a high probability that funding levels will decline when actuaries adopt the new mortality improvement scales. At a minimum, plan sponsors may be writing a check to participants for longer than assumed.
The notion of an actuarial table assuming how long a given individual will live and collect benefits is a rather futile concept. While slightly more effective than visiting the average palm reader, mortality tables do not control the amount of bacon the average Pearl Cantrell eats (see cover story on longevity). With improvements in healthcare and wellness initiatives, employers should be actively planning for mortality improvement and the commensurate added expense.
The practical answer is that employers will have to consider a multitude of factors when planning for longevity. These factors include a look at plan design as it relates to normal retirement age and workforce management, future contribution strategies, asset allocation strategies that may have to work harder, and pension risk transfer strategies. Creative solutions such as longevity insurance can also be part of the mix. Regardless of how these factors impact your organization, careful planning for increased longevity will be an integral part of running a successful retirement program.
Senior Manager | Nonqualified Executive Benefits
Since nonqualified plans are designed for key executives, longevity impacts their lives in several ways, especially given low annual qualified plan deferral limits relative to their compensation. The potential accumulation versus spending “gap” resulting from a longer life and fewer ways to save for retirement needs will likely make nonqualified plans more popular for plan sponsors as a retention tool, particularly in cases where defined benefit plans are frozen or simply do not
exist. We continue to have discussions with plan sponsors about nonqualified plan features and benefits, and if we can help you assess their viability in your plan offerings, please let us know.
For plan sponsors with an existing nonqualified plan or for those in the latter stages of starting one, longevity carries a more immediate need for attention, particularly for those plans financed with life insurance. Permanent life insurance is a popular choice when selecting a financing solution for a nonqualified deferred compensation plan. Using life insurance can offer attractive advantages compared to alternatives (see CAPTRUST Position Paper: A Three-Step Approach to Nonqualified Plan Financing for more details). One frequently emphasized advantage is the opportunity for cost recovery upon the payment of death claims. However, quantifying this advantage is difficult and dependent on the timing of death among the population of individuals insured.
Human longevity assumptions have a significant impact on the present value projection of these death claims. A death claim of $1 million 30 years in the future has a significantly higher present value than the same death claim 50 years in the future. Death from natural causes might happen as early as age 70 or perhaps as late as 90, and this 20-year difference can be meaningful from a cost standpoint. Averages taken from mortality tables are more dependable when the pool of lives is extremely large but have less correlation when a small number of policies are issued. Another danger exists if the mortality assumptions taken into account are based on the life expectancy of a blue-collar population as opposed to an executive or white-collar population.
The simplest way to guard against these potential risks is to apply less weight to cost recovery when considering the use of life insurance. Additional advantages of using life insurance continue to include the potential for attractive annual corporate cash flow and positive impact to the income statement. Another way to address the issue of longevity, while still factoring in the cost recovery impact of life insurance, is to perform a sensitivity analysis and inflate the average age assumption beyond current mortality projections. This allows the company to gauge the economic significance of a group of insureds living longer than expected.
Finally, when determining the number of policies to issue inside a portfolio, using a larger number of smaller policies will help reduce longevity risk by increasing the pool of insureds and protecting against outliers.
1 Exposure Draft, Report of the Society of Actuaries, Mortality Improvement Scale BB, March 2012