"If it can be measured it can be managed." -Peter Drucker
In 2006 one of our colleagues, Steve Lansing, wrote an article for the Journal of Pension Benefits titled A Syntheti(k) Pension Plan (click to download). Steve explained how a defined contribution plan could be designed and managed to look, taste and feel like a pension program without the negatives of arcane actuarial valuations and obtuse accounting standards. In a different light, this idea has renewed application and advantages to plan sponsors and their service providers.
A Pension of One
Many people probably think of a defined contribution plan as being an aggregation of individual savings accounts. We feel this perspective is narrow and limits the creative management of the program and its outcomes. Instead, we believe a defined contribution plan could be viewed as a collection of single, one person, pension plans. There is nothing legal or regulatory to justify this concept. However, a simple thought experiment can show that this picture can easily be seen.
Everyone has their personal retirement "liability." Based on an array of assumptions, this is the amount of money a person will need at retirement to reasonably expect an adequate standard of living for the remainder of their life. Indeed, our Insights report calculates this target for a person and also permits them to change most of the variables to customize the report outcome.
With a few more assumptions you can readily compute the "cost" necessary to fund the liability at retirement. This cost is the amount of contributions the person's account needs in order to pay for the liability at retirement. Of course, the source of contributions will come from the employee and the employer. In a few plans their generous associates who terminate early and leave forfeitures will ante for the cause, too.
The contributions have to be invested somewhere, and that is accomplished by developing an investment strategy by selecting funds from the menu. Think of this as the person's investment policy.
Pity the poor participant. He or she must be a combination of an actuary, investment expert, accountant and economist. And not just for the defined contribution plan, but for personal assets, too, and perhaps spousal investments. Given the difficulty many of our nation's biggest pension plans have in getting this process correct, is there any wonder why most of the participants want help? Even more people need assistance but don't realize it.
Each participant needs, and indeed deserves, a tailored retirement plan evaluation. This can be achieved exquisitely well through our Insights report. It is constructed with the input of key service providers and fiduciaries, all professionals experienced in their specialties, and orchestrated by the plan's consultant. It is delivered in a user-friendly fashion - a printed report constructed with advanced software. Our web site allows for an infinite number of "what if" modeling scenarios. The yearly expense of Insights is about equal to the fuel cost of a couple of days' work commutes.
A Simple Heuristic for Plan Success: an 80% Rule*
Until now, employers have been operating in the dark about whether or not their plan was effective. Our definition of effectiveness relates to the depth and breadth of a person's diversification, the sufficiency of their contributions and the progress they make towards funding their retirement liability.
Instead of playing with the factors, a company can solve the equation; they can finally have an answer. The sponsors have the necessary data at their disposal. A committee can measure and manage the progress of the plan in delivering an acceptable income to the participants. Knowing this information the employer can finally bring resources to bear for treating illnesses, not just symptoms.
But what defines the health of a plan? Of course, each committee must reach its own conclusion. There are numerous approaches to answering the question. However, we suggest an effective starting point. Namely, adopt an objective of 80% of the participants with an 80% chance of receiving 80% of their income at a reasonable retirement age. There is nothing magical about this metric but it comes preciously close to what many people would define as reasonable and obtainable.
The devil is in the details, and this rule of thumb only makes sense if a broad suite of assumptions are, in aggregate, used in formalizing the analyses. And that topic will be good for numerous newsletters in the future.
Contact us to learn more about the Insights program
* The Pareto Efficiency: An economic system that is not Pareto efficient implies that a certain change in allocation of goods (for example) may result in some individuals being made "better off" with no individual being made worse off, and therefore can be made more Pareto efficient through a Pareto improvement. Here 'better off' is often interpreted as "put in a preferred position." It is commonly accepted that outcomes that are not Pareto efficient are to be avoided, and therefore Pareto efficiency is an important criterion for evaluating economic systems and public policies. Wikipedia