Mark Shemtob FSA CFP
There is little doubt that for the foreseeable future the Thrift Savings Plan (TSP) will continue to be the primary retirement program for federal employees. The TSP does offer retirees the option to have part or all of their accounts used to purchase a guaranteed lifetime income annuity from an insurance company. However these annuities tend to be unpopular for several reasons. Among them is the high cost relative to the benefits being provided. This is especially true in a low interest rate environment. Those that do not purchase an annuity must manage a retirement income through pre planned structured withdrawals from their investments. This approach may not provide sustainable lifetime income nor does it take advantage of longevity risk pooling which enhances retirement income security. By using longevity risk pooling, larger benefits can be paid through redistributing funds from those that die earlier and are no longer in need of the income.
So are there other approaches that might be explored? The answer may lie in what is referred to Collective Defined Contribution (CDC) arrangements.
With a CDC, at the time that a retiree plans to start drawing on his or her retirement savings he or she would be permitted to transfer some or all of their retirement savings into a separate Trust invested in a professionally managed balanced portfolio similar to how an ongoing defined benefit plan assets might be invested.
The Trust would then directly pay to the retiree a monthly annuity income. The retiree would select the form of the annuity. The annuity form options would include life only, life with a term certain, joint and survivorship and possibly others. The initial monthly benefit amount the retiree would be entitled to, would be calculated based upon the amount of his or her retirement savings transferred to the Trust, the ages of the retiree and co-annuitant (if applicable), an assumed investment rate of return based on the portfolio composition, assumed life expectancies for the covered group, and the annuity option selected.
Like most collective trusts the fee structure would be driven by the underlying investments, the size of the asset pool, and efficiency of administrative services.
An example where this plan currently exists is the Evangelistic Lutheran Church of America Retirement Plan. https://gcfp.mit.edu/wp-content/uploads/2020/07/DLucas-and-DSmith-CDC-Plans.pdf
There may also be an adjustment to the initial annuity payment amount based upon how well funded the Trust is at the time the annuity payments starts. This is explained in the next paragraph.
However unlike traditional defined benefit plans and insured fixed income annuity contracts, the benefit payment is not a fixed amount but a variable amount subject to periodic (likely annual) changes, which could be increases or decreases. The changes would reflect the actual investment performance compared to the rate of return assumed on the portfolio, and the actual lifespan experience of the retirees compared to what was assumed.
Additional changes to benefit levels might occur if it seems appropriate to adjust the future investment return or life expectancy assumption. Such assumption changes would be appropriate to reflect changes in the investment environment and future anticipated life expectancy of the covered group. In order to prevent large swings in benefit amounts (either up or down) benefit adjustments may not immediately reflect the full changes but be spread over several years.
It is for this reason that the initial benefit determination may require an adjustment as noted above, since the actual liabilities that the Trust is expected to satisfy may not be fully reflected due to the delay in recognizing some changes. Note that the use of more conservative investment and life expectancy assumptions would have the impact of providing smaller initial benefit levels but with a greater likelihood of future benefit increases. It may also be possible to have alternative Trusts with different underlying investment portfolios. Those that are concerned with too much volatility would select a more conservative option and those willing to take on the risk that is accompanied by a larger potential benefit amount would select the less conservative option.
There is a potential for significantly larger benefits from this approach, compared to insured annuity purchases through traditional fixed income annuity contracts. This results from higher expected investment returns from the Trust as well as lower operating expenses, including elimination of sales compensation costs, insurance company profits, investment guarantee margins, and mortality guarantee margins.
Based on studies done in Canada where similar variable benefit type programs are now being offered, It is estimated that benefits upwards of 25% larger might be provided by this arrangement over the purchase of insured fixed income annuities. Some may argue that there is a risk that benefit levels may decrease from the initial levels. However this is also the case with individuals that manage their retirement income through investment portfolios.
A CDC arrangement would be a valuable option for individuals that are seeking predictable lifetime income, but are dissatisfied with the benefit levels that can be purchased through an insured fixed income annuity. Note that retirement programs using similar variable income benefit approaches are already being used in the Netherlands, Great Britain, Canada, U.S. Church Plans, and elsewhere.
Mark Shemtob FSA CFP, is a Fellow of the Society of Actuaries, Member of the American Academy of Actuaries, an Enrolled Actuary, a Fellow of the Conference of Consulting Actuaries, and a Member of the American Society of Pension Professionals and Actuaries. He is also a Certified Financial Planner and can be reached at firstname.lastname@example.org.
*The views and opinions expressed in this article are those of the authors and do not necessarily reflect the views, policy or position of this publication.