A step closer to fixing a serious 401(k) flaw

The Treasury and Labor Departments recently released regulations and guidance that at least partly address a major flaw with most 401(k) plans: Most of these plans lack methods to convert savings into reliable retirement income.

First, let's look at why this is a critical flaw, and then why the new regulations are important.

The long-running U.S. trend away from traditional pension plans to 401(k) plans imposes significant responsibilities and burdens on employees. They must be their own investment portfolio managers, deciding how to invest their savings. They must also be their own actuaries, figuring out how much to save and how to deploy these savings during retirement to make their money last.

Prominent behavioral scientist Dr. Richard Thaler sums up this challenge well: "For many people, being asked to solve their own retirement savings problems is like being asked to build their own cars."

Recent innovations, such as auto enrollment and target date funds (TDFs), have addressed some of the challenges inherent in the current design and delivery of 401(k) plans. Now, the retirement industry is turning its attention to the remaining challenge of generating income in retirement.

In theory, retiring employees could work with financial advisors to get help in deploying their savings in retirement. For many middle-income retirees, however, it's hard to find advisors who are trained in the complexities of generating retirement income and aren't biased by the way they're compensated.

A significant improvement would be if retiring employees could simply choose among retirement payment options that their employer has selected for 401(k) plan participants.

Large plan sponsors often have the resources to shop for efficient retirement income generators (RIGs) and can negotiate low-cost services that aren't available on a retail basis. A recent study by the Stanford Center on Longevity estimates that institutionally priced programs have the potential to deliver incomes that are 10 to 20 percent higher than retail programs.

The recent Treasury regulations address one possible solution: TDFs. The new rules allow for deferred annuities to be phased in as the fixed-income portion of a TDF as participants approach their retirement years. This would allow TDFs to generate a lifetime income in retirement with a portion of a retiree's savings. Presumably, the remainder of the TDF would be invested in equities, and the retiree would use systematic withdrawals to generate additional retirement income.

TDFs are often used as the default investment option of a 401(k) plan, and experience is showing that many participants allow the default investment option to become effective. The recent Treasury regulations help define how TDFs can be used in retirement. In this case, it's possible that a retiring employee may simply allow the TDF to be the default option.

The Department of Labor's guidance addresses the due diligence process that plan sponsors should follow to select insurance company products to offer in 401(k) plans. Given that large employers often have buying power in this arena, Labor's guidance is intended to make employers feel more comfortable with offering such products in their plans.

The Treasury regulation follows regulations it issued in the summer on a different type of RIG: a qualified longevity annuity contract, or QLAC. Taken together, the two Treasury regulations and Labor's guidance show progress toward addressing this major flaw of 401(k) plans. Both agencies are to be applauded for taking these steps.

Still, many other RIG types are valid methods for generating income in retirement. For example, as an alternative to annuities, retirees could invest their savings in their 401(k) plans' investment funds and use a systematic withdrawal method to generate a retirement paycheck.

The various types of RIGs each have their pros and cons, and each generate different amounts of retirement income. A very significant improvement would be if a 401(k) offered a limited menu of RIGs, some using guaranteed approaches, such as annuities, and some using investing approaches, such as systematic withdrawals. This would allow retirees to select the RIGs, or combination of them, that best fit their goals and life circumstances.

To date, regulatory and legislative support for such a robust offering has been lacking, but a number of dedicated professionals are working to make this happen. Let's hope that in five to 10 years, most 401(k) plans will be operated this way.

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    Steve Vernon helped large employers design and manage their retirement programs for more than 35 years as a consulting actuary. Now he's a research scholar for the Stanford Center on Longevity, where he helps collect, direct and disseminate research that will improve the financial security of seniors. He's also president of Rest-of-Life Communications, delivers retirement planning workshops and authored Retirement Game-Changers: Strategies for a Healthy, Financially Secure and Fulfilling Long Life and Money for Life: Turn Your IRA and 401(k) Into a Lifetime Retirement Paycheck.