From the September 2008 issue of Treasury & Risk magazine

Defined Contribution Plans: Version 2.0

Pioneers overhaul their 401 (k) plans to net employees more money for retirement and perhaps guaranteed lifetime income like pensions.

When Verizon Communications created a defined contribution (DC) plan for non-union employees, it followed conventional wisdom and offered an optional, do-it-yourself 401(k) replete with a wide choice of retail mutual funds. After all, since their inception in the 1980s, DC plans have been considered a convenient, tax-free savings vehicle that shifted risk from the employer to the employee. They were not meant to be the primary replacement for defined benefit plans (DB) payouts and other retirement income. That was then.

Now, in the face of regulatory changes, diminishing personal savings rates, soaring credit card debt, massive foreclosures, Social Security concerns and soaring healthcare costs, most traditional DC offerings are showing their age. "They outgrew their old skin," says Robert Collie, investment strategy director for Russell Investments. The first step, he says, is to determine the best features of DB, or pensions, that are missing from 401(k)s and then figure out ways to reinterpret and repackage DC plans. "It's important to start thinking of all retirement plans as pension plans, not just for the wealthy but for the masses," explains Collie.

Rare is the corporation that won't at least consider changes in DC plans that will net participants more money for retirement and, eventually, guaranteed lifetime income. Call the new and improved plans, DC Version 2.0, as Russell dubs it. The transformation began quietly a few years ago with automatic enrollment, which got a big boost when the Pension Protection Act of 2006 identified allowable default investments.

Since then, pioneers have been overhauling their 401(k) offerings. Consultants label it the DBization of DC plans. What started with auto-enrollment designed to mimic the automated enlistment of pension offerings, has turned into innovative companies adding automatic yearly escalation of employer contributions and managed, institutional fund choices.

It's not something that can be accomplished overnight, and it's not for the faint of heart. It's mostly an evolutionary process, says Chip Castille, head of DC product development for Barclays Global Investors (BGI). But enlightened companies are stepping up to the plate, redesigning retirement savings plans in one fell swoop. Expect some pain at first, but cool relief comes over time as corporate retirement savings plans better protect employees after they stop working. "It's a lot like ripping off a Band-Aid," Castille explains. "It hurts a lot, but then it's over."

Verizon suffered some pangs early on. "Transforming a mammoth retirement savings plan for 250,000 eligible workers is not easy," says Michael Riak, savings plan director of Verizon Investment Management Co. (VIMCO), the company's asset management arm with $61.6 billion under management. "But it was well worth it." Indeed, some consultants call Verizon's glidepath to DBification, developed with Russell, a template for Version 2.0.

Last year, Verizon shook up its investment strategy by replacing retail mutual funds with institutional funds managed by professionals to reduce expenses and add control over investment mandates. This shift led to lower fees, because of the economies of scale, and gave participants the benefits of managed investments not open to most individuals. What's more, and this is a key factor many DBization pioneers cite for overhauling plans, is that, historically, DB plans yielded higher rates of return than DC investments configured by participants with little investment expertise.

From 1995 through 2006, for example, DB plans outperformed DC plans by 1 percentage point a year on average, according to consulting company Watson Wyatt. That figure may seem small, but it adds up to a cumulative dollar difference of nearly 14% for money invested from the start of the period. It's best to leave it to the experts, says Collie. "Employees can sometimes be too conservative, and they need to mix-up asset allocations," he says. "But you don't want to turn every employee into a chief investment officer," Collie continues. "So you hire managers to build DB portfolios into DC plans."

Mixing it up to include new investment choices for employees and to change the risk equation is just what Verizon had in mind when it added alternative investments including private real estate and absolute return funds to the lineup. This breaks new ground, according to Martha Spano, senior consultant for Watson Wyatt Worldwide in Washington. For most DC plans, it's a trend that's years off, she said when the new program was introduced in 2007.

Verizon also added 10 target date funds--the fastest growing category of DC investment options because they are geared to specific demographics and an emerging markets strategy--and removed four lifecycle funds. What's next on the agenda? Riak says Verizon is mulling over other fund choices.

But what do retirees do with their, hopefully, abundant disbursements when they are finally read to stop working? That's the $2.5 trillion-dollar (estimated total DC investments) question. The answer, consultants say, is offer investments that provide guaranteed minimum withdrawal benefits (GMWB), or lifetime income.

"The subject of retirement income is probably the hottest topic in the industry for DC plans," says Castille. Riak agrees: "We are helping employees out so much on the accumulation phase, it's time to turn our attention to the decumulation phase." If feasible, says Phil Stormas, director of Verizon's wealth accumulation process, the country's second-largest telecommunications company would like to make it happen in 2009.

While still not a must-have benefit, GMWBs are much discussed at boardrooms across the country. These annuity and annuity-like options are calculated to make sure retirees' have enough income to assure that their golden years are golden. Most popular in this, the early stage of implementation, are opportunities to roll over lump sum disbursements into products promising life-long income.

In fact, the Retirement Security Project (RSP) suggests that all employers let participants test-drive lifetime income alternatives through an automated default into GMWBs. "We're working on a proposal that would make it easier and more palatable for workers to annuitize their savings," says Lina Walker, RSP research director.

RSP, a nonprofit organization, suggests that a substantial portion of assets be defaulted into two years of disbursements, payable as 24 consecutive monthly payments. At the end of the trial, participants could decide to formalize the program or opt out. Indecisive participants' disbursements will default into the annuitization program. "Forced participation would help retirees overcome existing biases and reframe their view of lifetime income products."

Whatever products employees choose, fears prevail that savings rates in corporate retirement plans and personal investments don't guarantee that retirees' savings won't expire before they do. "In fact, income from private annuities accounts for 2% of current retirees," notes Walker.

Employers are looking forward to a new class of savings options that will guarantee lifetime payouts, filling a void that has existed since the inception of DC plans. These products, which haven't had much take-up yet, wrap annuity-like investments into 401(k)s while employees are still on the job. That way, their allocations for life-long income will grow as they grow older.

Some consultants, however, reckon that most retirees don't want their savings dolloped out in small portions at regular intervals. "We know for sure that if people have the choice of getting a pile of money or a stream of income, they are going the take the pile of money," says Alicia Munnell, a professor at Boston College's Carroll School of Management and the director of its Center for Retirement Research. "How to make this work for retirees is a critical problem that must be solved if DC plans are to do a better job."

One potential solution, which many consultants and plan sponsors aren't particularly keen on, is development of a new class of annuity-like products that can be packaged into other DC investment options, such as target date funds. That way, participants can invest all, or a portion, of their savings into a product that promises lifetime income, and watch that investment grow as employees work their way through the ranks.

One soon-to-be released product would do just that. BGI's SponsorMatch bundles three portfolios, including an annuity, into a single asset-management strategy. The two other portfolios are a beta portfolio to capture market returns and an institutional alpha portfolio for enhanced return potential. "It is a variation of a traditional defined contribution (DC) target maturity date fund in that it matches the participant's retirement year, but because it incorporates an annuity, it behaves more like a defined benefit (DB) plan," according to Kristi Mitchem, head of BGI's defined contribution group.

Another soon-to-be-unveiled GMWB product developed by UBS Global Asset Management and insurer Genworth Financial Inc., promises a life-long disbursement of a minimum 5% of an investor's portfolio, even if the total distribution exceeds the portfolio's value. "It offers the advantages of annuities, but with the flexibility, simplicity and institutional pricing of a collective fund," says Cindy Vogl, senior product manager for UBS global asset management. "Participants retain control over the assets, which can continue to grow after retirement."

SponsorMatch is designed for employer contributions; the UBS product is employee funded.

Castille, for one, questions the feasibility of these annuity-like products. "While I applaud the industry for being innovative, I've got big doubts about building annuities of time," Castille says. For one, thing, it's unclear exactly at what age participants should start allocating money to these products. "What point at which do you put the solution into place?" he asks. "It doesn't make sense to worry about something that won't be a problem when you're 85, when you re 25." For another, annuities can be complicated and costly.

Once those problems are solved, retirement plan developers will move on to the next big retiree worry: skyrocketing health care costs. Many pension plans still provide medical insurance for their members, but this benefit is sorely lacking from DC plans. "There is certainly a lot of concern in this area," says BGI's Castille. "But I don't think the marketplace has the capability of delivering that right now."

Verizon's Stormas agrees that health care costs for retirees must be addressed, and also that there is no existing framework for turning this objective into a bona fide benefit. "We have talked about it, but solutions are a long ways off," he says.

The truth is that even many DB plans are jettisoning provisions for retiree health care that were once guaranteed by the plans. So, clearly, Version 2.0 won't be your father's pension plan. In fact, as corporations cut back on union benefits, your father's pension plan is no longer his pension plan.


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