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PERSPECTIVES: Leveraging 401(k) power to secure retirement savings for employees

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PERSPECTIVES: Leveraging 401(k) power to secure retirement savings for employees

Employers who proactively develop a retirement income strategy will generate a competitive advantage in terms of employee retention, engagement and productivity, according to Mercer L.L.C. retirement savings plan experts Amy Reynolds and Bill McClain.

Nearly a generation ago, organizations began the transformation from defined benefit pension plans to the prevailing defined contribution model for employee retirement. For most of today's workforce, the defined contribution plan represents the primary employer-sponsored retirement benefit. Despite concerns about retirement adequacy in a world of 401(k)s and other defined contribution plans, few employers are considering a return to the defined benefit model.

While the emphasis on individual participation and savings has been a powerful and challenging legacy of the past two decades, employers now have a critical—and rewarding—role to play in preparing their workforces for retirement. In our view, employers who proactively develop a retirement income strategy will generate a competitive advantage in terms of employee retention, engagement and productivity.

Indeed, the facts call for proactive intervention. More than 75% of workers near retirement who responded to Mercer's 2012 Making Smart Benefit Choices survey say they are either “very” or “fairly concerned” about their retirement readiness. Workers are increasingly aware of the shortfall they face, and of their need for support and advice in making the critical decisions about how they utilize their retirement resources.

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Employers can and should intervene, for a number of reasons. Basically, it's the right thing to do from a social responsibility standpoint, thus enhancing any organization's brand. In addition, the employment relationship forms a natural basis for acting collectively, since it improves buying power and leverage in managing vendors on behalf of employees, reducing costs and improving the level of services. The latter is especially important in helping employees make optimal decisions regarding complex financial products and investments. Improved employee decision making can greatly improve retirement outcomes in the face of limited employee and employer resources.

Intervening also plays a practical role in workforce management. The 2012 Mercer Workplace Survey of more than 1,600 active 401(k) participants at companies of every size revealed that nearly half (44%) of employees are thinking of delaying their retirement since they can't afford to stop working. That poses a challenge for many employers in managing their retirement-age employees and controlling health care and severance costs. Delayed retirement due to financial necessity can also lead to disengagement and lower productivity. A retirement-ready workforce can increase management flexibility and reduce the potential negative effects of employee financial distress.

Less obvious, though, is that efforts to secure retirement outcomes for employees can often better leverage investments already made to plan infrastructure. For example, many employers have devoted resources to the design of target date mutual funds that anticipate a certain pattern to drawing down retirement assets. However, when retirees draw down their defined contribution plan balances too quickly, the intended investment strategy no longer matches cash flow. Making sure that plan structures align with the employee behavior in generating retirement income is reason enough to play an active role in employees' retirement income strategies.

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We've developed a number of retirement income principles to guide employers in determining the preferred approach for their employees. When structuring your thinking around target levels of retirement income, it's useful to consider the following two tiers:

• Tier 1: The minimum requirements—the level of income required for basic day-to-day living expenses.

• Tier 2: Replacement—the level of income required to broadly preserve current living standards, taking into account that expenditures tend to vary during retirement.

Given the history of low levels of retirement savings, many employers know that meeting Tier 1 requirements may be all that's attainable for some employee groups. That said, a solid income floor should include an insured element to protect against longevity risks, perhaps through an existing benefit from a defined benefit plan, by purchasing an annuity with a portion of the retirement pot, or through basic longevity insurance for retirees who live beyond a certain age, say 85. But it's not wise to weight things too heavily toward traditional insurance, which could result in more coverage than what's needed, thereby eroding retirement savings.

When planning for longevity, it's important to take into account the uneven spending pattern that typifies retirement. Retirees tend to consume more in their early, active retirement years. Income needs level off as they enter a more passive phase, only to increase again toward the end of life with additional medical and care expenses. Post-retirement income structures should accommodate this U-shaped spending pattern while maintaining the best possible income floor.

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How can employers get started on developing a retirement income strategy for their employees? Segmenting the workforce is the best way to understand employee levels of preparedness. Initially, the workforce can be segmented into the underfunded, those on track, and the overfunded. Further segmentation by demographic characteristics such as age, service, salary and job allows employers to see trends and workforce implications.

From there, the workforce can be further analyzed based on how individuals want to manage their retirement planning: some want their employer to do it for them; others want some help; and the rest choose to do it for themselves. This segmentation process allows employers to develop retirement income menus and tools that allow employees to customize their retirement income approach to their needs and preferences. Employers who take advantage of new technology that allows this level of customization will realize a much greater return on their efforts, resulting in increased engagement and more effective workforce management.

In summary, here are some guiding principles to help in developing a retirement income strategy:

Provide assistance: This makes a material difference, and demand is usually highest among workers nearly ready to retire and recent retirees. Assistance can include retirement readiness seminars and planning tools, access to individual advisors and guidance from financial institutions.

Put all wealth to work: Rather than focusing narrowly on the employer's own retirement plan, consider external assets and alternative income sources in the planning process such as home equity, for example, as well as the ability to continue working in retirement.

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Manage market risk: Implement approaches that manage market and, indirectly, inflation risks by gradually reducing elements of the retirement portfolio that are not required to build the retirement income floor.

Manage longevity risk: Some plans, out of convenience, default to a draw down of retirement funds based on required minimum distribution rules. Since these rules were developed for taxation purposes, and don't take into account market events and longevity risk, more sophisticated planning and annuitization need to play a role.

Leverage buying power: There's a significant difference between retail products and those available to employers through group purchase. But it's more than a question of price; employers with a clear picture of their employees' needs can better align the solutions.

Integrate workforce planning into retirement income strategy: Retirement income strategy should reflect the organization's view on the duration of the employment relationship. Some employers eager to engage with older customers or retain key technical expertise have policies that accommodate part-time schedules or flexible work arrangements to manage the transition to retirement more gradually.

Avoid too-rapid income drawdown: The strategy must address this employee tendency through education and appropriate draw down strategies and default approaches.

Manage through life cycles: Since there's no clear point when employees can be classified as “near retirement,” retirement readiness must be managed as a long-term challenge and savings as a lifetime habit. It calls for a pragmatic approach to structuring the accumulation phase.

Know your fiduciary position: Retirement income strategy is not isolated from the broader governance and fiduciary structures under which a defined contribution plan operates. Engaging with the appropriate internal committees and external advice can ensure consistency and alignment.

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Utilizing scarce resources to help generate sustainable income for retirees never has been more challenging. These strategic guidelines, along with a diligent application of retirement income principles, can lead employers to an approach that provides customized choices for participants, better retirement outcomes, tighter alignment between retirement and workforce management, and a major dividend in the form of enhanced employee engagement.

Bill McClain is U.S. defined contribution intellectual capital leader and a principal based in the Seattle office of Mercer L.L.C. He can be reached at bill.mcclain@mercer.com or 206-214-3627. Amy Reynolds is the U.S. defined contribution consulting leader and a partner in Mercer's retirement business based in Richmond, Va. She can be reached at amy.reynolds@mercer.com or 804-344-2639.