Defined Contribution Plans Research Articles

Distributions to Beneficiaries of Tax-Favored Retirement Plans, before and after the Secure Act

Individual beneficiaries of tax-favored retirement plans have long enjoyed substantial tax deferral by spreading required minimum distributions (RMDs) over their lifetimes or life expectancies. Often referred to as “stretch” distributions, these extended RMDs attracted the attention of reformers who questioned whether the deferrals served the needs of retirees, or were merely estate planning tools. The result of that concern was the enactment of the SECURE Act of 2019 that significantly changed the treatment of retirement plan distributions to beneficiaries. The SECURE Act primarily targets non-annuity RMDs made to designated beneficiaries from tax-favored retirement plans that are defined contribution plans (but including IRAs). The SECURE Act eliminates life expectancy RMDs for many if not most of these beneficiaries and instead requires distribution of the entire amount of the retirement benefit before the end of the calendar year containing the tenth anniversary of the participant’s death (the ten-year rule). The SECURE Act, however, preserves life expectancy RMDs for “eligible” designated beneficiaries. Eligible designated beneficiaries (EDBs) include only (1) the surviving spouse of the participant, (2) a minor child of the participant, (3) a disabled individual, (4) a chronically ill individual, or (5) an individual who is not more than ten years younger than the participant. The determination of whether a designated beneficiary is an EDB is made as of the date of death of the participant. The SECURE Act also helpfully replaces the old five-year distribution rule with the ten-year rule, even for designated beneficiaries who are not EDBs, i.e., for those who are ineligible designated beneficiaries (IDBs). The ten-year rule also applies now to beneficiaries who succeed to plan benefits upon the death of an EDB. Unfortunately, though, beneficiaries who succeed to plan benefits upon the death of an IDB must still distribute all the remaining benefit within the same period that was applicable to the IDB. Beneficiaries that are so-called “see-through” trusts have long been afforded special RMD treatment. Now, however, the possibility of making life expectancy distributions to such a trust may be lost if any of the trust beneficiaries are IDBs. The SECURE Act partially addresses this problem by providing for “applicable multi-beneficiary trusts” that can allow a trust for a disabled or chronically ill beneficiary to still take RMDs over the beneficiary’s life expectancy. The SECURE Act also applies to commercial annuities purchased by tax-favored retirement plans that are defined contribution plans (including IRAs). These plans may now purchase lifetime and period certain annuities only for EDBs. Such annuities purchased for IDBs would normally conflict with the required application of the ten-year distribution rule. Fortunately, the SECURE Act does not apply to traditional defined benefit plans. Stretch annuities are still available under such plans even for IDBs. These annuities may provide unreduced payments for a period certain, and may allow significant increases over time in the amount of an annuity payment. It is true that joint and survivor annuity payments may be limited in amount for beneficiaries more than ten years younger than the deceased participant. Nevertheless, the payments may be as much as 52 percent of the payments to the participant for even the youngest of beneficiaries (with a higher percentage for older beneficiaries).

Implicaciones del consumo y de la flexibilidad de la oferta laboral en el bienestar de los partícipes de planes de pensiones del Sistema de Empleo

This work aims to carry out a comparative analysis of the pension plans of the employment system (both defined benefit and defined contribution plans) from the point of view of the welfare perceived by each worker. Considering flexibility in the labor supply of the promoting company of the pension scheme, we seek to maximize the utility of the time preferences of consumption and leisure for each employee. We propose a dynamic optimization problem of intertemporal choice, and we describe both the returns on the investments of the Fund and the annual wage growth rates as discrete markovian processes. For each type of pension plan, we analyse the optimal consumption and leisure values that maximize the utility (welfare) of the worker over several periods of time.

Required Minimum Distributions

Required minimum distributions (RMDs) are an important part of individual requirement accounts and defined-contribution retirement plans including 401(k), 403(b) and 457(b) plans. Such plans are intended to provide retirement income for the account owner and his or her spouse. They are not intended to pass untaxed wealth on to the next generation. RMDs do that by requiring that a portion of the balance in an account is distributed (and taxed) each year beginning by age 70½ (recently extended to age 72). This article examines the origins and extensions of RMDs, how they are calculated and how they work. It then assesses the recently enacted SECURE Act and the proposed updated Internal Revenue Service tables of the life-expectancy factors used to calculate the amount of the annual RMDs.

Optimal dynamic asset allocation for DC plan accumulation/decumulation: Ambition-CVAR

We consider the late accumulation stage, followed by the full decumulation stage, of an investor in a defined contribution (DC) pension plan. The investor’s portfolio consists of a stock index and a bond index. As a measure of risk, we use conditional value at risk (CVAR) at the end of the decumulation stage. This is a measure of the risk of depleting the DC plan, which is primarily driven by sequence of return risk and asset allocation during the decumulation stage. As a measure of reward, we use Ambition, which we define to be the probability that the terminal wealth exceeds a specified level. We develop a method for computing the optimal dynamic asset allocation strategy which generates points on the efficient Ambition-CVAR frontier. By examining the Ambition-CVAR efficient frontier, we can determine points that are Median-CVAR optimal. We carry out numerical tests comparing the Median-CVAR optimal strategy to a benchmark constant proportion strategy. For a fixed median value (from the benchmark strategy) we find that the optimal Median-CVAR control significantly improves the CVAR. In addition, the median allocation to stocks at retirement is considerably smaller than the benchmark allocation to stocks.

The Shifting Ground of Pension Design: Reflections on Risks and Reporting

Debates about the relative merits of defined-benefit (DB) and defined-contribution (DC) pension plans have been a prominent part of pension discourse over the past forty years. The intensity of the debate has ebbed and flowed over the years but has been more intense in recent years as there has been a shift from DB to DC plans in Canada. This shift has left the remaining members of DB plans feeling threatened and, for many, the sense of threat has been compounded by the emergence of target-benefit (TB) plans. Discussions of DB, TB and DC in the abstract tend to obscure basic issues related to the similarities and differences among these plans that should be taken into account. My hope is to provoke an examination of some of these issues free from the hyperbole that is widely invoked in partisan debates about DB and DC. In both the private and public sectors, I hope this would lead to the exploration of ways to limit the financial risks of a workplace pension plan (WPP) without going to pure DC. I will also note some measures that will help make DB plans more transparent. Basically, I will argue that: 1) There is so much diversity in the design of DB and DC plans that generalizing about the merits of DB versus DC has little precise meaning. 2) While DB plans generally go further than DC plans in achieving a predictable gross replacement rate (the ratio of retirement income to pre-retirement earnings), they will give rise to a variety of net replacement rates (taking into account factors like taxes and mortgage payments) and may push pre-retirement living standards below post-retirement levels. Net replacement rates come closer to defining living standards than do gross rates. 3) The financial and economic circumstances of the early 21st century have been difficult for all types of pension and retirement savings plans and I will focus on the impacts on DB plans that explain the changes noted above. 4) The relative advantage of DB plans in providing predictable benefits stems from cross-subsidies among the members. These are not inherently problematic but transparency problems may arise because cross-subsidies are not identified and measured. 5) There are measures that plan governors can adopt that can help reconcile the (un)predictability of contributions and benefits and make DB plans more transparent. Finally, I argue that regulatory and tax policy can be adapted to facilitate more flexibility in plan designs.

Tax incentive and household saving strategy: A regression discontinuity approach to catch-up contributions

ABSTRACT This study examined how the catch-up provision—a tax-deferral incentive—impacts total retirement saving and household saving strategies. Using the Survey of Consumer Finance from 2004 to 2016, this study found that the catch-up provision does not have a positive impact on total retirement saving in the majority of cases; however, this provision was found to positively impact contributions to defined contribution plans among middle-class households whose income ranges were between $50,00 and $100,000. The study also found that household saving and consumption habits, which include self-control factors, as well as employer-match programs, play an important role in increasing savings for retirement. The results of this study have implications for future work on a broad spectrum of social policies and programs that promote financial security in retirement.

Redistributive effects of different pension systems when longevity varies by socioeconomic status.

We propose a general analytical framework to model the redistributive features of alternative pension systems when individuals face ex ante differences in mortality. Differences in life expectancy between high and low socioeconomic groups are often large and have widened recently in many countries. Such longevity gaps affect the actuarial fairness and progressivity of public pension systems. However, behavioral responses to longevity and policy complicate analysis of possible reforms. Here we consider how various pension systems would perform in an OLG setting with heterogeneous longevity and ability. We evaluate redistributive effects of three Notional Defined Contribution plans and three Defined Benefit plans, calibrated on the US case. Compared to a benchmark non-redistributive plan that accounts for differences in mortality, US Social Security reduces regressivity from longevity differences, but would require group-specific life tables to achieve progressivity. Moreover, without separate life tables, despite apparent accounting gains, lower income groups would suffer welfare losses and higher income groups would enjoy welfare gains through indirect effects of pension systems on labor supply.

Thoughts on the Looming Pension Problems Facing Chicago, Cook County and Illinois

Recent increases in Cook County’s property taxes have reignited longstanding political controversies about public-sector expenditures of the City of Chicago, Cook County and the State of Illinois. These fiscal problems leave Illinois with among the worst fiscal health of any of the fifty states. Much of the state’s poor fiscal condition is attributable to the unfunded pension liabilities of its various governmental entities. These liabilities have an adverse impact on property values (due to increased property taxes, uncertainty about how these unfunded pension liabilities are to be ultimately resolved, and the crowding out of public-sector services). Partly as a result of these harmful forces, the Chicago area has seen the lowest home appreciation rate of any major metropolitan area in the country. Importantly, these fiscal problems are expected to worsen, as the gap between the pension plans’ assets and liabilities is expected to widen considerably over the coming decades. Moreover, it is challenging to raise taxes in an environment where Illinois’ overall taxes are the third-highest in the country (and, specifically, its property taxes are the second-highest in the country and its sales taxes are the seventh-highest in the country). Without a comprehensive plan to arrest these runaway pension liabilities, the economic engine that is the Chicago metropolitan area will slowly falter. Now that the Democrats control the governorship as well as both legislative bodies, it would seem an appropriate time to consider a “grand bargain.” I propose three bold items: a) all new public-sector employees are to be enrolled in defined-contribution pension plans, b) all new significant sources of revenue, cost-cutting mechanisms and the monetization of the state’s assets are to be dedicated to the pay-down of unfunded pension benefits, and c) a constitutional amendment is needed to moderately reduce the future benefits (of the current defined-benefit pension plans) of the existing public-sector employees (and their beneficiaries).

Retirement concerns and financial literacy in Brunei

PurposeDespite the inclusion of financial literacy in retirement studies, there are limited studies that look into retirement concerns and how financial literacy plays a role in managing retirement concerns. Understanding retirement concerns prior to retirement is important given how it affects retirement satisfaction. Therefore, this paper aims at assessing the retirement concerns in Brunei and the role of financial literacy in managing those concerns.Design/methodology/approach700 government employees, divided into three groups, were interviewed: Defined Contribution Plan (DCP) employees retiring in the next 10–15 years, DCP employees retiring in 20–30 years' time and Defined Benefit Plan (DBP) employees retiring in the next 10 years. Pearson's chi-square tests and logistic regressions were used to ascertain significant relationships.FindingsThe results indicate the relatively younger DCP group is more likely to be financially literate compared to senior groups however, these respondents are more inclined to focus on private home ownership at this juncture. The findings also indicate the importance of knowing how much to save for retirement towards determining those with an additional retirement plan, and consequently reducing their retirement concerns. The value of financial advice is also significant in determining the amount to save for retirement and in possessing an additional retirement plan.Research limitations/implicationsResults cannot be generalised to the population, as purposive sampling was utilised due to the absence of a population frame.Practical implicationsThe implications of the paper may provide value to policymakers to consider approaches to enhance the quality of financial advice and provide sound knowledge in computing the amount needed for retirement. Understanding the role of financial literacy vis-à-vis retirement concerns may also be useful for neighbouring countries with similar socio-cultural aspects such as Malaysia.Originality/valueGiven the limited research on retirement concerns and financial literacy, this paper is one of the few to emphasise on the importance of knowing how much is needed to save for retirement, in relation to retirement concerns. This may also be useful in other countries/communities with similar retirement context such as those with relatively low retirement planning or with similar retirement schemes. Further, with the 1993 pension reform, there is no known publication on retirement concerns and expectations in Brunei. Left unchecked, it may lead to poverty in old age and/or dependency on welfare institutions and family support.

Putting the pension back in 401(k) retirement plans: Optimal versus default deferred longevity income annuities

Abstract The US Treasury recently permitted deferred longevity income annuities to be included in pension plan menus as a default payout solution, yet little research has investigated whether more people should convert some of the $18 trillion they hold in employer-based defined contribution plans into lifelong income streams. We investigate this innovation using a calibrated lifecycle consumption and portfolio choice model embodying realistic institutional considerations. Our welfare analysis shows that defaulting a modest portion of retirees’ 401(k) assets (over a threshold) is an attractive way to enhance retirement security, enhancing welfare by up to 20% of retiree plan accruals.

Retirement incentives and behavior of private and public sector workers

AbstractOver the past several decades, private sector workers in the USA with employed-sponsored pensions have experienced a dramatic shift from defined benefit (DB) to defined contribution plans, while this trend has been less pronounced for public sector workers. In this paper, we use data from the Health and Retirement Study to explore changes in the retirement incentives and retirement behavior of public and private sector workers over the past quarter-century. We find that both groups have become less likely to report having a DB pension or any pension. Compared to their private sector counterparts, public sector workers have a higher level of retirement wealth and a larger financial gain from continued work at older ages, and these differences by sector are growing across cohorts. Both groups respond to financial incentives in making retirement decisions. However, growing differences by sector in the gain to continued work do not appear to have translated into diverging retirement behavior, as we observe similar trends in the two groups.

Active Management in Defined Contribution Plans

We analyze the problem that fiduciaries face when monitoring and selecting from a universe of active mutual funds within a defined contribution (DC) plan. In a DC plan, a fiduciary must recognize that there are two levels of decision makers, namely, the fiduciary, who decides which funds will compose the DC plan, and the individual plan participants, who must decide which funds to invest in and the timing of their investment. Moreover, plan participants, and to some degree the fiduciary, need to be able to make investment decisions without being investment professionals. We find that due to the general lack of consistency in performance of mutual funds, fiduciaries and plan participants would be better served by selecting passive rather than active funds across the US equity mutual fund space. Moreover, the most consistently outperforming funds tend to have meaningfully higher tracking errors relative to their stated benchmarks, which makes effective asset allocation in a DC plan more difficult. TOPICS:Wealth management, retirement, mutual fund performance, passive strategies Key Findings • There are two levels of decision makers in defined contribution (DC) plans—fiduciaries and plan participants—and this complicates active fund selection. • Most DC fiduciaries would be better served by replacing active US equity mutual funds with low-cost passive alternatives for both wealth aggregation and performance consistency reasons. • Consistently outperforming active funds are rare and tend to have higher tracking error, which makes asset allocation more complicated.

Practical Applications of Liabilities Matter: Improving Target Date Glidepath Construction through Liability Adaptive Asset Allocation

Practical Applications Summary In Liabilities Matter: Improving Target Date Glidepath Construction through Liability Adaptive Asset Allocation, from the Summer 2019 issue of The Journal of Retirement, author Michael W. Crook (of UBS Global Wealth Management in New York, NY) calls into question the rationale behind the most popular investment funds in today’s employee defined-contribution (DC) plans. Target date funds (TDFs)—which, for example, are held by 75% of participants in DC plans managed by Vanguard—use a preset schedule called a glidepath to reallocate assets from equities to fixed-income securities as a participant’s retirement date approaches. The author finds that this approach does not work as well as the liability-driven investment (LDI) strategy used by pension plans. LDI is more responsive to the needs of participants because it focuses not on participants’ retirement dates, but on how close they are to having enough money on which to retire. It reallocates assets to fixed-income securities as a participant’s plan balance approaches the amount needed to fund all retirement expenses. The author finds that LDI produces better outcomes, is easier to explain to clients, and makes it easier for financial advisors to provide customized financial planning and total wealth management for their clients.

Current Developments in German Pension Schemes: What Are the Benefits of the New Target Pension?

We analyze the newly introduced German occupational pension scheme called target pension (Zielrente), which links the beneficiaries' benefits during the retirement phase to the mortality experienced among the pension beneficiaries and the performance of the financial market, from a pension beneficiary's perspective. We model the contract payoffs related to the target pension according to the new enhancement law on German occupational law. Specifically, we include two parameters in the plan design, one to control the surplus participation and one to control the loss participation. These parameters are chosen in such a way that the initial wealth of the retiree equals the initial value of the target pension. With the help of expected lifetime utility and wealth equivalent, we find that the target pension provides a meaningful supplement to the first and third pillar. Further, we find some comparative advantages of the target pension over the traditional pure defined benefit and some defined contribution plans from a policyholder's point of view. Our analysis shows that target pension plans can be outperformed by defined contribution plans with variable annuities, while the latter are accompanied by a considerably higher ruin probability.

Size and Investment Performance: Defined Benefit vs. Defined Contribution Pension Plans

Using a comprehensive sample of over 160 thousand U.S. private pension plans, we find significant economies of scale in investment performance and administrative expenses that are more prominent for defined benefit (DB) than for defined contribution (DC) plans. Small DB plans underperform size-matched DC plans and face the highest termination probability, and the majority of both types underperform passive benchmarks. Small plans and small sponsors prefer the DC structure more strongly than large ones do. Our results highlight the inefficiency of small DB plans, which is consistent with the secular shift toward DC plans and the recent trend of consolidation.

A Stochastic Control Approach to Defined Contribution Plan Decumulation: 'The Nastiest, Hardest Problem in Finance'

We pose the decumulation strategy for a Defined Contribution (DC) pension plan as a problem in optimal stochastic control. The controls are the withdrawal amounts and the asset allocation strategy. We impose maximum and minimum constraints on the withdrawal amounts, and impose no-shorting no-leverage constraints on the asset allocation strategy. Our objective function measures reward as the expected total withdrawals over the decumulation horizon, and risk is measured by Expected Shortfall (ES) at the end of the decumulation period. We solve the stochastic control problem numerically, based on a parametric model of market stochastic processes. We find that, compared to a fixed constant withdrawal strategy, with minimum withdrawal set to the constant withdrawal amount, the optimal strategy has a significantly higher expected average withdrawal, at the cost of a very small increase in ES risk. Tests on bootstrapped resampled historical market data indicate that this strategy is robust to parametric model mis-specification.

Investors’ Risk Preference and Age in Korean Defined Contribution Plans

Our study investigates the relationship between investors’ age and investment risk preference. We use a unique dataset—defined contribution plan account data (observations = 18,781), provided by a Korean financial institute (a recording-keeping service provider). Investment risk preference is measured by three variables: share of equity, five-year volatility of selected funds, and share of principal guaranteed products. While controlling for individual characteristics such as gender, employee status, plan duration, wage, accumulated assets, and number of employees, we test the relationship between individuals’ age and investment risk preference in asset allocation. Echoing the results of previous studies, we find that age is significantly related to investment risk preference. Both equity share and volatility have an inverted-U-shaped relationship with age, and the share of principal guaranteed products has a U-shaped curve coinciding with age. Our results indicate that age is associated with increased risk preference due to learning effects and greater financial understanding. However, after reaching a certain point, risk preference decreases because of the need for a secure retirement income. Finally, the estimated coefficients of the interaction effect variables show that some individual groups—executives, high earners, and large asset holders—are more risk-taking than are other same-age groups. Key words: Retirement Pension Fund; Pension Service Provider; Defined Contribution Participants; Investment Risk Preference; Age JEL Classification: G10, G20

What if OregonSaves Went National: A Look at the Impact on Retirement Income Adequacy

The OregonSaves program began in July 2017 to provide defined contribution (DC) plan coverage for those workers in the state of Oregon who are not currently eligible for an employer-sponsored DC plan. The program requires employers to automatically enroll workers into a post-tax individual retirement account (IRA). The program’s default contribution rate is 5 percent; contributions automatically increase by 1 percent each year until they reach 10 percent (unless the employee opts out of automatic increases). Employees can opt out of the program or choose a savings rate of as little as 1 percent and as much as 100 percent of gross pay, up to annual Roth IRA contribution limits. With more than a year of experience with the OregonSaves plan, the Employee Benefit Research Institute (EBRI) asked the question: What if OregonSaves were a national program? How would that impact the retirement security of American workers? We further asked how a national version of OregonSaves would compare with nationwide implementation of 401(k) safe harbor plans among employers who do not currently offer a defined benefit (DB) or DC plan. We examined both using EBRI’s Retirement Security Projection Model® (RSPM). The incremental benefit of including a full auto portability system in addition to these changes was also simulated. We found that the “national” OregonSaves plan would provide a 16.3 percent reduction in retirement deficits (as measured by the average retirement savings shortfalls (RSS)) for the youngest age cohort simulated (those currently ages 35–39). The reduction would be smaller for those closer to age 65, with the reduction being only 3.1 percent for those currently ages 60–64. Overall, this would reduce the simulated retirement deficits by $456 billion, or 12 percent of the $3.83 trillion under the baseline assumptions. In contrast, the 401(k) safe harbor plan expansion would reduce the retirement deficits for the youngest cohort by an additional 8.8 percentage points (for an overall reduction of 25.2 percent). The additional reduction for those ages 40–44 would be slightly higher (9.2 percentage points), but by ages 60–64 the additional reduction would only be 2.5 percentage points. Overall, this scenario would reduce the simulated retirement deficits by $645 billion, or 17 percent of the $3.83 trillion under the baseline assumptions. Finally, we added a full auto portability scenario to both of the access expansion scenarios. Under the “national” OregonSaves plan with a full auto portability scenario, simulated retirement deficits would be reduced by $759 billion, or 20 percent of the $3.83 trillion under the baseline assumptions. Under the 401(k) safe harbor plan expansion with a full auto portability scenario, simulated retirement deficits would be reduced by $1,031 billion, or 27 percent of the $3.83 trillion under the baseline assumptions.

Equity in the Distribution of Tax Preferences for Pensions: Capping the Amount Allowable in Tax-Preferenced Retirement Plans

Tax-preferenced retirement plans are designed to be vehicles for saving for retirement, not massive tax shelters for wealthy individuals. Because tax preferences for retirement savings cause a loss in federal tax revenue, and are one of the largest sources of tax expenditures, it has long been a principle in pension policy and tax law in the United States and in other countries to limit the amount of retirement tax preferences an individual can receive. Specifically, U.S. tax law sets limits on the maximum benefit provided by a tax-preferenced defined benefit plan and the maximum contribution to either a tax-preferenced defined contribution plan or individual retirement account (“IRA”). It was never the intent of Congress, the tax policy, or pension policy communities that tax-preferenced plans should provide a tax preference for wealthy individuals to accumulate massive savings in retirement plans. Indeed, the conventional understanding of providing tax subsidies for the affluent to save for retirement is not to incentivize them to save, since the affluent will save adequately without such incentives, but to induce them to establish plans to capture tax benefits for themselves and then require them to include rank-and-file employees in the plans thus established. The purpose of the section 415 limits is to control the tax subsidies for the wealthy so that the tax incentives for them to establish plans do not impose excessive revenue loss to the government treasury.

Optimal Dynamic Asset Allocation for DC Plan Accumulation/Decumulation: Ambition-CVAR

We consider the late accumulation stage, followed by the full decumulation stage, of an investor in a defined contribution (DC) pension plan. The investor's portfolio consists of a stock index and a bond index. As a measure of risk, we use conditional value at risk (CVAR) at the end of the decumulation stage. This is a measure of the risk of depleting the DC plan, which is primarily driven by sequence of return risk and asset allocation during the decumulation stage. As a measure of reward, we use Ambition, which we define to be the probability that the terminal wealth exceeds a specified level. We develop a method for computing the optimal dynamic asset allocation strategy which generates points on the efficient Ambition-CVAR frontier. By examining the Ambition-CVAR efficient frontier, we can determine points that are Median-CVAR optimal. We carry out numerical tests comparing the Median-CVAR optimal strategy to a benchmark constant proportion strategy. For a fixed median value (from the benchmark strategy) we find that the optimal Median-CVAR control significantly improves the CVAR. In addition, the median allocation to stocks at retirement is considerably smaller than the benchmark allocation to stocks.