In many countries with developed defined contribution retirement plans, like the US, UK and Australia, the debate around the decumulation phase of retirement saving is taking centre stage, as an ever growing number of plan members are entering retirement and looking to convert their savings into an income stream.
End of the day, that was always the initial reason most people joined retirement plans, not only to amass savings, but to generate some form of income in retirement and to be able to live (ideally) as comfortably as possible. To be able to take that trip to Europe you always wanted (we Europeans probably wrongly envision that taking a trip to Europe is a dream for any american retiree), buy that red Corvette or take a long cruise to sunny Aruba. If the retirement industry in previously mentioned countries has been reasonably successful in auto-enrolling large numbers of employees in retirement plans and with the help of target date funds invest their savings quite well until the point of retirement, what happens next is still quite up in the air.
You enter retirement and have half a million dollars in your 401(k) and then what? What kind of income will that provide for me, will it be guaranteed, where and in what way will it be invested, will it provide me with lifetime income, if not how do I know how many years I will live, what about my spouse, … and many similar questions go thru the mind of most newly retirees that are fortunate enough to amass some savings. Coming from Slovenia, where you can only draw down savings from collective retirement plans in the form of a life annuity, I was quite surprised years ago when I started to study retirement industries in the leading markets and found out the situation is quite different. In the US for example, annuities are not the main way of decumulating retirement assets. Many follow a well known rule of thumb called the 4% rule under which you just leave your savings invested and if you retire at 65 you withdraw 4% of your assets in the first year, and then increase this amount by the rate of inflation every year after that. The rule has some supporters and even more critics. Blanchett, Kowara, and Chen wrote a nice review of it and also other withdrawal strategies way back in 2012 [1].
What the 4% rule and other similar strategies don`t cover is longevity risk, which basically means the risk that you will outlive your savings. None of us know (luckily) how long we will live, so it’s impossible to calculate in advance how much money I can draw down from my savings every year and it’s no wonder Nobel prize winner William F. Sharpe called this the single nastiest, hardest problem in finance. One of the main challenges of the retirement industry is also, that we focused for too many years or decades on the amount of saved assets and not on the income those assets can generate. If I have half a million saved for my retirement, that does not tell me much about what kind of life I will be able to live, will I be able to pay my bills together with my social security, will I be able to take that cruise to Aruba? At the end of the day, this is exactly what interests retirees.
So to help combat this and reframe retirement saving and individual savers to start looking at what kind of income their savings will provide for them in retirement, legislators all around the globe started passing laws that would mandate the retirement industry to provide to members of pension plans some kind of projections of lifetime income. In the US, the SECURE act and the later more specific rules from the Department of Labor, make it mandatory for 401(k) plan sponsors to annually disclose to plan participants estimates on how much income their account balance would produce, if used to purchase an annuity. First estimates will be already included on statements this year, so I thought it might be of interest to some, how we did this in Slovenia and what was the feedback from members, as pension funds in Slovenia had to send to all members projections of their lifetime income for the first time this January.
Mandatory lifetime income projections in Slovenia
In Slovenia the story of income projections started more seriously in 2020, when the Ministry of labour prepared the draft rules for projections and started consultations with the retirement industry, which we all welcomed (disclaimer: I work for one of the pension funds in Slovenia and was involved in the proceedings on behalf of our fund). The initial idea was, all members would receive the projections along with their annual balance statement which all members receive at the end of january. Projections would have to be made for all members assuming they keep saving until age 65 with their current saving rates. For their existing savings three scenarios of future investment returns would have to be calculated (target, pessimistic and optimistic). From the three scenarios of accumulated assets at age 65, each member should receive a calculation of the basic life annuity that his or her pension plan provides under current rules using current interest rates and mortality tables. The annuity amount should be rounded up and given in monthly gross amount (in Slovenia 50% of the annuity is calculated in the income tax base due to special tax treatment).
In the later consultations the future investment returns scenarios were much discussed and at first there was an idea the ministry would, along with the Insurance supervisory agency and the Securities market agency, calculate each year what yields should be used in the projections and that they would be the same for all providers. In Slovenia pension funds manage so-called life cycle funds with three funds, more dynamic equity funds, balanced funds with medium equity exposure and the most conservative guaranteed funds with minimum equity exposure and principal guarantee. Members are switched automatically between funds as they reach certain age limits, from more dynamic funds to more conservative, the closer they get to retirement. So future assumptions of investment returns would be made for the three funds for three scenarios each year. Similarly, it was predicted for the fees used to calculate future assets (management fee and entry fee) that they should be in accordance with the rules of each pension plan.
How we did it
After a long exchange of ideas and some delays the ministry published the final version of the rules for projections in November 2021 – meaning we (the funds) had only 2 months to bring to life the projections and make them work. The final version of the rules mandated projections to be made under the following conditions:
- Predicted retirement age of the member is 65 years (the member has the right to reduce this number but not lower than 60 and the pension plan has to make a new calculation if the member expresses this desire).
- The amount of future payments is calculated by taking into account the average monthly payments of the last 12 months.
- When calculating the entry fee, the actual entry fee according to the policy of each member is taken into account.
- For the existing assets two scenarios of future investment returns have to be made – the target and the pessimistic scenario (the optimistic scenario was left out unfortunately).
- Each fund has to calculate projections of future investment returns for all funds for the two scenarios every year under the set out conditions. The projections of returns are based on historical average returns of benchmarks that best represent each fund and their structure. For the pessimistic scenario the average annual return of the benchmarks for a period of the worst 10 years within the last 30 calendar years is used and for the target scenario the average annual return of the benchmarks is calculated for a period within the last 30 calendar years (also taking into account the average annual operating costs of each fund that reduce the calculated future returns). What returns were used specifically in the pension fund I work for (Pokojninska družba A, Inc.) you can view at the end of the article.*
- From the accumulated assets at retirement, calculated under the two scenarios mentioned above, a standard life annuity is calculated for each member using current conditions for annuities of each provider (interest rates and mortality tables). The annuity has to be rounded up and given in monthly gross amount.
- Each provider must also explain to members that the projections are only estimates and that the figures are only to be taken informatively.
- If the calculation of savings at retirement does not exceed the € 5,120 threshold, the member is shown only the amount of assets and no annuity is calculated (this was added at the last minute to avoid really low annuities that would not make much sense).
The mountain trembled, but …
Everybody in the industry was anxious how our members will react to the projections. Will they be disappointed by the annuities their savings will generate for them, will they be maybe positively surprised? Will they wonder, why are we sending this projections to them, will they mix them with projections of public pensions and all sorts of other considerations were going thru our minds. We were also afraid the sheer increased volume of calls and emails would be tough to handle, so we all braced for impact but in the end guess what?
Nothing happened. All members received their projections at the end of this Januarja. We had increased volumes of calls and emails as every year, when members receive their annual statements, but not more than usual. We had in the end very little questions regarding the projections and almost no bad feedback. We had a handful of members asking if we could make projections for them with their retirement age reduced from 65 to 60 and that was it. So in short, the mountain trembled, but at least in Slovenia there was no earthquake following. I also spoke to colleagues in other pension funds in Slovenia and all had similar experiences with very little feedback from members about the projections.
Possible reasons for this could range from – people did not read the projections, people dismissed them, to that the projections were quite in line with other projections of retirement income funds in Slovenia already communicated to their members, so it did not surprise them. I can speak for the fund I work in, we already enabled similar projections of lifetime income in our online account where members can monitor their assets and also make projections of retirement income under various scenarios of investment returns that were not the same as the ones under the ministry’s guidelines, but still not that much different. And we have had these features for more than eight years, so members are aware of them and use them. We also have a mobile app ePokojnina (ePension) with similar features for more than eight years, so these kinds of projections, I would speculate, came as no surprise to a part of our members and also actual projections of income did not differ that much.
From speaking with colleagues in the US retirement industry, I know many are also guessing what the reaction from their members will be, when they will receive their lifetime income disclosures this year. Josh Cohen from PGIM and Yanela Frias from Prudential cover this nicely in their white paper analysing several potential responses members will have based on a survey they made [2]. What is especially interesting (and worrying at the same time), is that lifetime income illustrations in the US will, according to the DOL guidelines, exclude future contributions to the member accounts and also any future investment earnings. This means younger members, who just started saving and have small pension pots, will receive very low projections of income. This may cause them to question their saving and have all sorts of doubts and questions for their plan provider and as the above mentioned report nicely puts it “the illustrations will greatly underrepresent future retirement income for most plan participants other than those very near retirement.” So this is one angle where income projections could raise many questions and I’m glad we in Slovenia avoided this by including future contributions as well as investment earnings.
Future potential of income projections
All projections of the future are wrong, but I still feel that if the assumptions are as realistic as possible and most importantly show various scenarios, they still provide valuable information to members about what kind of range of income they can expect in retirement based on their current saving rates. This of course also presents a fantastic opportunity for plan sponsors to engage with their members and present to them also scenarios what happens if they increase their contributions, how is that likely to impact their income in retirement and also how will their investment choices impact potential future investment returns (here the impact of fees can also be added). So these are all key issues that can be communicated to members of retirement plans along with projections of retirement income and we plan to further incorporate the above angles in pension funds in Slovenia in the following months building on the initial projections. The reframing of retirement savings mentioned in the beginning of the article is also crucial, we must stop looking only at how much assets we will accumulate, but also what kind of income those assets will provide for me in retirement. Then we can get into specifics about what are the best vehicles to decumulate savings and probably also here there isn’t one “silver bullet” that would fit all, but a combination of products that would fit one members needs to make their life in retirement better (but that will be the topic of another future article).
*Future investment returns used in 2021 income projections for Pokojninska družba A, Inc. pension funds calculated in line with the Ministry of labour guidelines (Target scenario – Guaranteed fund +2,02%, Balanced fund +4,37% , Equity fund +5,91%; Pessimistic scenario – Guaranteed fund +0,14%, Balanced fund +1,65% , Equity fund -1,67%). These numbers will be updated every year.
References:
[1] Blanchett, D., Kowara, M. and Chen, P. (2012). “Optimal Withdrawal Strategy for Retirement Income Portfolios”. Retrieved from: https://investmentsandwealth.org/getattachment/90eb6376-d090-4904-9f82-786553ff5ed9/RMJ023-OptimalWithdrawalStrategy.pdf
[2] Cohen, J. and Frias, Y. (2021). “Lifetime income illustrations: Preparing for participant reactions (PGIM / Prudential Retirement)”. Retrieved from: https://www.pgim.com/white-paper/lifetime-income-illustrations-preparing-participant-reactions
Irrational Retirement 