Question

Explain the importance of understanding investment decisions and their consequences in retirement planning.

please write at least 275 words. please type your answer. NO handwrite please.

Answer 1

We know that all asset classes do not have the same historical returns or risks. When planning for retirement, it is important to have historical perspective of returns and risks involved.

Over the past 30 years we have borne witness to the collapse of the private pension system with for-profit employers, tax-exempt entities and now the governmental sector replacing defined benefit pension programs (DB) with defined contribution plans (DC). This evolution has represented one well-documented transfer of risk: the transfer of investment risk and its related funding risk from employers to employees. However, this risk transfer did not come without a cost to employers.

Defined contribution plans make the participant the sole decision maker for the four factors that determine an employee’s ability to retire successfully: contribution rate, investment strategy/return, time horizon, and spending needs in retirement.

Retirement Preparation in a Defined Contribution World

	Contribution Rate	Investment Return	Time Horizon	Retirement Income Needs
Participant Approach	Employers determine the contributions they make into participant accounts, but for the vast majority of defined contribution plans, those contributions need to be augmented by employee deferrals and supplemental savings. A participant’s supplemental contribution rate is a critical element in the rate of success in retirement savings.	Participants in defined contribution plans select investments that ultimately determine the rate of return achieved on their savings and any contributions made by their employer.	DC plans have very little control over when a participant elects to retire. Plans are structured to permit participants to continue saving on a tax-deferred basis until they elect to retire or are terminated by their employer. Some participants may be incented to continue working past age 70½ to avoid IRS Minimum Required Distributions.	The degree to which savers have managed expenses well in their accumulation phase will impact their ability and willingness to retire. Eligibility for health benefits and fixed mortgage costs are significant variables in determining a participants income needs.

In the transition from DB to DC, these critical elements were transitioned from sophisticated pension committees and diligent plan sponsors, to participants that in many cases lack the expertise, tools, or time to manage them effectively.

While the transition from DB to DC has fulfilled the promise of offloading the funding risk from plan sponsors to participants, it has created a number of unintended consequences that create challenges in trying to meet the objective of retirement security for employees. In particular, the DB pension model is particularly successful in pooling longevity risk to ensure that participants do not run out of income in retirement. In the DB model, some participants would die at younger ages and therefore receive fewer payments from the plan, while some participants would live longer and receive greater benefits than "average."

DC plans are fundamentally different in so much as each participant has to account for their own longevity risk. Because each participant is on their own, there is no ability to average out the risk of outliving your income and each participant needs to plan for the likelihood they might exceed the average. In 2010, the Social Security Administration reported US life expectancy at 78. However, a male who reaches normal retirement age as measured by Social Security lives on average until age 84. Average life expectancy is just that, average; plan participants must plan and save to live well into their 90s. As a result, while transferring the risk to participants, DC plans push the goal line farther away for participants. Each participant is faced with the daunting task of managing a pension plan for one and the results are startling:

• Employees whose primary retirement plan is a defined contribution plan tend to retire one to two years later than employees covered by a pension plan2
• Individuals covered only by a defined benefit plan are 87% more likely to retire in any given year than individuals only covered by a defined contribution plan3
• A 1% increase in the S&P 500 Index in any given year increases the probability that the pre-retiree will retire by 2.5%4
• Delayed retirements may also increase employers’ healthcare costs. Healthcare costs for a 65-year-old worker are twice those of a worker between 45 and 545
• The ability to retain young talent is impacted by the prospect of career and professional advancement

At the same time when participants are adjusting to managing their own retirement, research has shown that people are hard-wired with behavioral biases that make them ill-equipped to make the prudent, rationale choices everyone assumes.

Behavioral Challenges to the DC Model

	Contribution Rate	Investment Return	Time Horizon	Retirement Income Needs
Participant Approach	Humans suffer from the Current Moment Bias. We cannot imagine the future and prefer pleasure today over certainty or pleasure in the future. When participants would benefit most greatly from savings (early in their working career) they opt to use their money elsewhere and defer saving for their retirement.	Humans are so ill-suited to the task of investing, that it is difficult to isolate only a few of the obstacles that befall them. Certainly one of the most damaging is the Gambler’s Fallacy wherein participants try to reveal patterns in a random set of data (market returns). This will cause participants to chase returns by buying high and selling low.	Without the certainty of income that defined benefit plans provide, participants fall more readily into behavioral traps. For pre-retirees it is the Status Quo Bias, wherein participants make no changes. By remaining employed they continue to receive income, health benefits, and income by deferring the uncertainty of retirement.	People pay far more attention to bad news than good news, and culturally there is an infinite amount of bad news to digest. Will inflation return to 1970s levels? Will Social Security be available for me in retirement? How much will long-term care cost? This Negativity Bias causes participants who do evaluate their income needs to routinely overstate the amount of income required.

Retirement Readiness

For the DC plan system to survive, employers must revisit the purpose of the plan. While the DC model began as a supplementary tool for participants with pension benefits, they have transitioned into the primary retirement savings vehicles for millions of participants. Along the way, the ancillary benefits of giving employees flexibility, choice, and access have become the tail wagging the dog of the retirement plan with little thought given to the end goal of a successful retirement.

Returning to the primary purpose of providing retirement benefits will require sponsors, and the vendors they hire, to communicate with participants in a manner that allows a participant to reasonably estimate how the factors within their control – contribution rate, investment choices, time horizon, and spending needs – impact their retirement success. This transition in communication model we broadly refer to as "retirement readiness."

The concept of retirement readiness is predicated on the practice of taking current assets and assumptions about future behavior to make estimates as to the level of income a participant could reasonably expect to receive in retirement. The big change that comes with the retirement readiness concept is in changing the focus to income rather than assets. The best retirement programs focus communications with participants on income rather than assets. While assets will change with the rise and fall of markets, retirement income expectations are substantially less market dependent. With this shift, participants are left to focus on the things within their control to improve their retirement savings program.

Calculating and reporting retirement income estimates is the participant-equivalent of the funding levels that pension plans calculate and report. As we transition the responsibility for managing retirement success to participants the only reasonable way to approach the challenge is to provide participants with the tools to understand their own "funding status."

Unfortunately, merely reporting replacement income for participants will not magically fix the DC system overnight. Sponsors who wish to drive the best outcomes for participants may need to reexamine historical decisions that continue to impact the design of their plan.

LIFECYCLE OF A DEFINED CONTRIBUTION PLAN

With the wealth of data availability about participants, there is a tendency to use data to obscure what is otherwise a simple math problem. What is the rate of savings by wage, age, and sex? Does the sales staff save more or less than the IT staff? While these data points are interesting, they continue the fallacy that a magic education session focused on 35 year old men earning between $30,000 and $40,000 a year will change the way they have made, and will continue to make, decisions on how to best utilize the retirement plan.

Within the DC plan we think it is wise to look at participants in three groups:

1. Young Savers – This group is in the early stages of their retirement savings process; they generally have lower incomes and more competing priorities for income that can be allocated to savings.
2. Accumulators – This group is generally mid-career and is highly productive within the organization. In many cases they have progressed to a level of financial security and as a result are more able to think about retirement
3. Pre-Retirees – Most pre-retirees have concluded the costs of developing and supporting a family and have tremendous experience within the organization. Saving for retirement may be their primary financial "goal."

Plan sponsors should increasingly be looking at the four factors within their control: plan design, plan services, investment structures, and employee education, to maximize the efficacy of their retirement plan, thereby improving the health and satisfaction of their employee population.