Administration August 23, 2021

What DC Plan Participants Should Know About Their Own ‘Funded Status’

Plan sponsors can help participants understand how interest rates and inflation affect lifetime income disclosures to help them avoid panicking and prepare for retirement.
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Defined benefit (DB) plan sponsors must keep tabs on their plans’ funded statuses for reporting purposes and to determine their required annual contributions, and they often have a very good understanding of how interest rates affect funded status.

Soon, defined contribution (DC) plan participants will see a version of their own funded status—via the lifetime income disclosures on their plan statements required by the Setting Every Community Up for Retirement Enhancement (SECURE) Act. Retirement plan industry experts say helping those participants understand how interest rates affect the numbers they see might help prevent confusion and even panic.

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An article on October Three’s website explains that as interest rates go down, participants will need more savings to produce the same amount of income. “Even if your stock portfolio has done well for the year, if interest rates go down enough, you may fall behind on your retirement income goal,” the article says.

Under the Department of Labor (DOL)’s interim final rule on lifetime income disclosures, plan administrators must calculate monthly payment illustrations as if the payments begin on the last day of the benefit statement period. They must assume that a participant is 67 years old on the assumed commencement, which is the Social Security full retirement age for most workers, or use the participant’s actual age, if older than 67.

Plan administrators must use the 10-year constant maturity Treasury rate (10-year CMT) as of the first business day of the last month of the statement period to calculate the monthly payments. The 10-year CMT approximates the rate used by the insurance industry to price immediate annuities. They must use the gender-neutral mortality table in Section 417(e)(3)(B) of the Internal Revenue Code (IRC)—the mortality table generally used to determine lump-sum cash-outs from DB plans.

John Lowell, an Atlanta-based partner and actuary for October Three, tells PLANSPONSOR that the assumptions the DOL is asking plan sponsors to use if they want to escape liability will lead to confusion among plan participants, “and it will not be a happy confusion.” The lower the interest rate, the less lifetime income their account balances can buy, and vice versa, he explains. “People might see a large account balance and the small amount [of monthly income in retirement] it will buy and that will lead to panic,” he says. Lowell adds that if some individuals see a future that looks bleak, they might reason that it’s something they can’t fix and not bother trying to improve their financial situation.

Lowell says he believes the assumptions the DOL dictates in its interim final rule are a disservice to plan sponsors and participants. He notes that plan sponsors might want to develop or contract with someone to develop a modeling tool or set of tools that use different assumptions or a range of them. “I would let people reflect on what they think their future behavior might be to see some palatable moves to an achievable future,” he says.

Lowell says the lifetime income estimate could go down—it’s not necessarily what will happen but it’s not outside the realm of possibilities. “Suppose prevailing interest rates stay where they are and also assume the stock market is currently overvalued and a correction happens,” he says. “Even if a participant continues contributing to his plan, at best, the lifetime income estimate will stay the same, but it could go down.”

Tim Kohn, head of DC services at Dimensional Fund Advisors (DFA), says he breathed a sigh of relief that the interim final rule allows plan sponsors to also use other lifetime income illustrations—the DOL says it recognizes that some plan sponsors/providers are already printing lifetime income illustrations on participant statements that use different assumptions than what is prescribed in the rule. He says some illustrations that are already being provided might use more realistic assumptions.

What About Inflation?

Lowell says the purchasing power of the income participants will receive in retirement is not reflected in the lifetime income estimate on their account statement, so participants might also need more savings than the estimate shows because of inflation. “These are things that legitimately should give plan participants at least cause for pause,” he says.

Kohn sees it as a positive that lifetime income disclosures show plan participants that retirement income should be the outcome for their savings efforts. Although the assumptions might be flawed, he says, it provides a sea change in the vocabulary for DC retirement plans. However, he adds, getting participants to think about what the monthly income they see on their statements will pay for could cause them concern. DFA offers a retirement income calculator to help participants understand their buying power, and other providers have based their tools on guidance on income illustrations the DOL issued in 2013. “Some calculators take into account not only interest rates, but inflation,” Kohn says.

In its comments on the DOL’s interim final rule on lifetime income illustrations on participant statements, DFA urged the agency to require inclusion of numerical illustrations showing inflation’s impact on a portfolio to help participants understand how it diminishes the purchasing power of retirement income. “The department acknowledges the importance of inflation in the preamble accompanying the interim final rule, but strives to avoid ‘complex methodologies for what should be a simple hypothetical illustration,” the comment letter says. “In keeping with the department’s emphasis on consistency and simplicity, a single inflation rate could be used for illustrations. The Federal Reserve has an explicit inflation target of 2%, which provides a useful starting point.”

DFA says an example would help, such as explaining to participants:

“Unlike Social Security payments, the estimated monthly payment amounts in this statement do not increase each year with a cost-of-living adjustment [COLA]. Therefore, as prices increase over time, the fixed monthly payments will buy fewer goods and services. For example, with a 2% inflation rate, $1,000 would buy $820 worth of goods and services after 10 years, and $673 after 20 years.”

Mathieu Pellerin, senior researcher at DFA, says the DOL-prescribed assumptions simply tell participants how much in lifetime monthly payments they could get if they were to annuitize their savings at age 67. But he also says participants need to think also about that income’s purchasing power.

On the positive side, plan sponsors can explain to participants that the monthly income number is more meaningful than their total balance, because most of them need to think about how to replace income in retirement, Pellerin says. However, the illustrations participants will be given are in nominal dollars and there is no accounting for inflation going forward. “The illustrations are expressed as what a participant could buy at age 67 using the current balance. The purchasing power of that retirement income will be lower by the time they reach 67 and will continue to drop during retirement due to inflation,” he explains.

Avoiding Panic and Helping Participants Prepare

Lowell says the more paternalistic plan sponsors—and those that do not also sponsor a DB plan as the predominant vehicle that will give employees retirement security—might want to actively communicate more information than what the law requires about the lifetime income disclosures.

“In addition to explaining what the government-required disclosures are and what they are not, plan sponsors should explain that when thinking about retiring, employees need to consider all sources of income,” he says. “And maybe they want to offer employees some realistic modeling tools.” Kohn notes that the S&P’s “Cost of Retirement Income” dashboard, for example, can illustrate how a change in interest rates could affect investment portfolios.

Kohn adds that plan sponsors can help by providing much more detailed calculators that take into account inflation and other factors affecting expected income in retirement. “Inflation has a corrosive effect on savings,” Kohn says. “What we want is for someone entering retirement to have that same standard of living as they had in year one at year 25.”

As such, he says plan sponsors, advisers and providers need to help participants face a trinity of risks: market risk, interest rate risk and inflation risk. “The DOL’s rules are going in the right direction, but participants should have the ability to work with other provider tools that home in on their unique situations,” Kohn says. “Some participants have a DB plan and some don’t. Some retire at age 67 and some don’t. But we can’t predict what things will cost, say, 50 years from now.”

Additional education will help participants plan a retirement based on the spending behavior of the lifestyle they want to lead, Pellerin says. And participants will need help finding resources to help them achieve that goal.

“Social Security is one and now they will see a nominal annuity, but it doesn’t take into account inflation,” he says. “It will show resources in the first year of retirement, but as time goes by, that amount will lose its purchasing power. It’s like comparing apples and oranges and doesn’t give clarity about what they can expect in future years.”

But, Pellerin says, once participants are aware of their risks, they can take steps to prepare, such as investing in assets that help control inflation, saving more and using savings as a Social Security bridge so they can wait to claim.

Lowell says plan sponsors should have counsel review any communications or additional disclosures they add to their statements. For additional disclosures or modeling, he also suggests that plan sponsors get participants to sign a release saying they understand these are estimates that might or might not come true.  

“Perhaps these [lifetime income disclosures on] statements will create a call from participants for more guaranteed income, and maybe DB plans of one type or another will become more of a recruiting tool for employers again,” Lowell says.

In a recent FAQ document providing clarity on the timing of providing lifetime income illustrations, the DOL said it will issue a final rule “as soon as practicable.” So, for now, the industry waits to see if the agency will provide more flexibility on assumptions used to provide estimates and whether disclosures will take into account how inflation affects the purchasing power of estimated retirement income.

Investing August 18, 2021

Climate Change and Benchmarking Risk for Retirement Plans

Experts discuss how to conduct climate-change analysis and whether such an inquiry is a fiduciary duty, as forces are aligning in support for greater inclusion of such analysis in retirement plan management.
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Institutional investors generally don’t mine coal, make cement or indiscriminately strip large forests. But the companies in which they invest might be engaged in such activities that experts say will prove incompatible with the shift to a lower-carbon world. And, they add, a retirement plan’s holdings of these at-risk investments could have negative consequences for plan participants.

Plan Exposures

Climate change risks can affect plans in several ways, says Therese Feng, vice president of research for The Climate Service, a climate risk analysis firm in Durham, North Carolina. Physical climate risks such as droughts, fires and rising sea levels can result in both market and credit losses in a portfolio. For example, imagine that drought conditions continue to worsen in California, which accounts for almost 15% of the U.S. economy. At some point, the lack of water and resulting rationing conceivably could constrict the state’s businesses, particularly agriculture, and reduce employment levels. The resulting slowdown to such an important component of the U.S. economy could then affect national business conditions and stock market values.

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For corporate and government instruments, losses from physical damages and diminished asset values can lead to lower instrument values, increased return volatility and increased credit risk, Feng says. Instruments collateralized by physical assets, most notably mortgages, carry increased credit risk due to physical climate risk.

Investors also face climate transition risk, she adds. Transition risk is the potential financial impact of the economic transition to lower greenhouse gas emissions, which includes a shift to using lower-carbon energy sources and increased use of lower-emission technologies. To date, investors have focused more on transition risk than on physical risk due to access to data and methodology, says Feng. “But institutional investors need to be knowledgeable of how both physical and transition risks can affect their strategies, both in the near- and medium-term,” she cautions.

Source: GAO analysis of reports from Merce and TCFD.: GAO-21-327


Additional Exposures

Adam Gillett, global head of sustainable investing at Willis Towers Watson in London, says institutional investors also should consider regulatory pressure related to climate change. For example, a blog post from law firm Dentons’ UK-based associates notes the United Kingdom’s Pension Schemes Act 2021 “allows the government to make regulations that impose climate change governance and disclosure requirements on trustees of large trust-based pension schemes (whether defined benefit [DB] or defined contribution [DC] schemes).”

“It wouldn’t surprise me at all if other regulators from around the world who had a similar agenda looked at [the UK’s Act] and thought, ‘Well, let’s do something similar,’” says Gillett. “‘Let’s put in similar instruments, in whatever context, to accelerate action.’”

In fact, the United States might not be too far behind the UK, he adds. On May 20, President Joe Biden issued an executive order on climate-related financial risk that called for “consistent, clear, intelligible, comparable and accurate disclosure of climate-related financial risk … including both physical and transition risks.”

On an agency level, in June, the Government Accountability Office (GAO) issued a report criticizing the Federal Retirement Thrift Investment Board (FRTIB), which oversees the $735 billion Thrift Savings Program (TSP) for federal employees, for not taking “steps to assess the risks to TSP’s investments from climate change as part of its process for evaluating investment options.”

Sources note that it’s still unclear how climate-benchmarking risk concerns will influence companies’ DC plans. Sponsors control plan lineups and could increase the presence of environmental, social and governance (ESG) funds, but participants still choose their own investments. DC plans, and the way they’re set up with a menu of options, present a slightly different challenge than DB plans, in which the sponsor can take a holistic portfolio view, says Gillett. It’s perhaps harder to assess risk looking at an individual investment offering or option, because each investment might have different roles in that menu’s structure of options, he adds.

TCFD 101

The UK’s regulations and the GAO’s report both reference the Task Force on Climate-Related Financial Disclosures (TCFD)’s recommendations. TCFD’s supporters believe the recommendations will benefit investors, particularly those with a longer-term focus like plan sponsors, by providing “clear, comparable and consistent information about the risks and opportunities presented by climate change.” Per the report: “Compounding the effect on longer-term returns is the risk that present valuations do not adequately factor in climate-related risks because of insufficient information. As such, long-term investors need adequate information on how organizations are preparing for a lower-carbon economy.”

The TCFD recommendations form a voluntary framework for climate-related disclosures, covering governance, strategy, risk management, and metrics and targets, explains Joost Slabbekoorn, senior responsible investment and governance specialist at APG Asset Management in the Randstad, Netherlands. “The TCFD can be used by corporates as well as asset managers and asset owners. Right now, the TCFD is a voluntary framework but elements of it have already surfaced in regulation, for example, in the EU Sustainable Finance Disclosure Regulation [SFDR],” Slabbekoorn says.

And the TCFD recommendations are gaining global acceptance. The Financial Stability Board’s 2020 “Status Report” states that more than 1,500 organizations have expressed their support for the TCFD recommendations and nearly 60% of the world’s 100 largest public companies support the TCFD, report in line with the TCFD recommendations, or both. 

Scenario Analysis

The GAO and TCFD also both cite the need for organizations to conduct scenario analysis, which is an analytic technique for projecting the possible impact of climate-related change.

“Scenario analysis is trying to ask, in the future world, when we do respond to climate [change] and we have the policies in place that respond to it, what does that actually do to your business?” says Laura Zizzo, co-founder and CEO of climate-risk consulting firm Manifest Climate in Toronto. “For instance, if we can no longer run internal combustion engines, what does that actually do for my business?”

Sarah Bratton Hughes, head of sustainability, North America at Schroders in Brooklyn, New York, says Schroders has built its own toolkit for scenario analysis, but she warns there is “no silver bullet” or perfect scenario analysis.

“We’re focused on assessing [companies’] physical risk, their transition risk in our carbon value-at-risk model, which is essentially stress-testing portfolios for carbon pricing, and we’re focused on understanding stranded asset risk—how exposed they are to what we would consider climate growth around a technological perspective,” she explains. “And the next area that we’re really focused on is climate alignment: How aligned is this company’s future trajectory with a one-and-a-half-degree world, which is essentially the same thing as being net-zero?”

The Benchmarking Challenge

Investors can choose from a range of benchmarks to track their investment results and operational performance. Benchmarking a portfolio’s investments for climate change risk is more of a challenge, however.

Zizzo says she believes the problem arises because traditional financial benchmarks are not risk-adjusted for climate change. “I think we have to think about that and figure out how we risk-adjust our financial benchmarks for climate change, because we are seeing contraction of GDP [gross domestic product] based on physical risk alone that is not factored into the benchmarks,” she says.

Current fund benchmarking focuses on assessing fund impacts on the environment, Feng explains. “The converse––benchmarking for the climate risk of investments––is nascent, as risk methodologies to estimate climate impacts continue to evolve to represent both physical and transition risk, and physical asset data become more reliable,” she says.

Feng reports that The Climate Service has recently calculated the climate-related financial risk for the S&P 500 within its Climanomics platform, allowing users to benchmark and compare global industry classification sectors. “By year-end, we will have climate financial impacts for major U.S. corporate bonds and global listed equities, followed in 2022 by coverage of sovereign and municipal bonds,” she adds.

Is It a Fiduciary Duty?

Even if an institutional investor agrees that including climate-change risk analysis in its investment management makes sense, does its inclusion rise to the level of fiduciary duty?

Thomas Tayler, a senior manager in London-headquartered insurer Aviva Investor’s Sustainable Finance Centre for Excellence, says he believes it does. Fiduciary duties require investors to act in the best interests of their beneficiaries and to take all material factors into account when making decisions, he explains. Climate risks are financially material risks to the investments that sponsors or their delegated asset managers make on behalf of their beneficiaries and therefore should be taken into account alongside any other risk with the potential to have a material impact.

“The longer term the investment horizon, the more likely it is that climate will not only be a material risk, but the most material risk,” Tayler maintains.

Feng expresses a similar sentiment. In the absence of a legal redefinition under the Employee Retirement Income Security Act (ERISA) by the Department of Labor (DOL) of fiduciary duty to include ESG factors, at the most fundamental level, sponsors need to assess if climate change has an impact on fund solvency and the ability to pay benefits, Feng says. She believes that in the same way a corporation’s failure to disclose risk or mitigation means it is difficult to assess the impact on share price, a fund’s lack of understanding and disclosure of climate risk make it difficult to assess the impact on portfolio performance and for plan participants to be fully informed.

Looking Ahead

The sources interviewed all agree that market and regulatory forces are aligning in support for greater inclusion of climate-change analysis in retirement plan management. And, given the Organisation for Economic Co-operation and Development (OECD)’s estimate that pension funds held more than $35 trillion of assets worldwide at year-end 2020, the result could be a profound impact on global capital flows.

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