The SECURE Act – So, What is a “Lifetime Income Stream Equivalent” of Your 401(k) Account Balance? How Will It be Calculated? And Why Should You Care?

In accordance with Section 105(a)(2) of the Employee Retirement Income Security Act (ERISA), as amended by the SECURE Act of 2019, defined contribution plan sponsors will soon be required to disclose two lifetime income stream equivalents (LISEs) of a participant’s current account balance under the plan at least once during each twelve-month period in participant benefit statements.  The two required LISEs are:

(1)    a qualified joint & survivor annuity for the participant and the participant’s surviving spouse, based on assumptions specified in guidance, including the assumption that the participant has a spouse of equal age, and
 
(2)    a single life annuity
 
These new LISE disclosures are the monthly lifetime payments the participant could theoretically receive if the participant’s current account balance were used to provide these two separate LISEs “based on assumptions specified in guidance to be prescribed by the Secretary of Labor.”  Because an annuity is, in its most general sense, a series (or stream) of periodic payments made at regular, fixed intervals a LISE is simply a form of an annuity.  In connection with this new disclosure requirement, it is important to understand that:

• The new law does not change actual distribution options offered by defined contribution plans.  It does not require defined contribution plan sponsors to offer lifetime payment options, and it does not require participants to elect such options.  Your benefit statements will still show your current account balance in addition to these new informational LISE amounts.
• The new law does not apply to individual retirement accounts (IRAs) 
• Plan sponsors will generally rely on plan administrators and recordkeepers to perform these new calculations, and depending on how sponsors pass the cost of such services to participants, the cost of preparing these new disclosures may be borne (directly or indirectly) by the plan participants
• Actual life annuity amounts available from insurance companies may differ significantly from the disclosed LISE amounts
• The new LISE disclosures are intended to encourage you to save more and to help you with your retirement planning
• The Department of Labor (DOL) will release “safe harbor” assumptions and model disclosures that plan sponsors and their plan administrators will generally use to calculate and disclose the new LISE amounts (so, as discussed in more detail below, these assumptions are likely to be quite important in terms of how helpful LISEs will ultimately be as a retirement planning tool)

This post will set forth several of our concerns about the new requirements and will highlight some of the open issues that the forthcoming guidance from the DOL is expected to address, including:

•    Assumptions for:

• commencement date of LISE monthly payments
• pre-commencement date investment return
• post-commencement date investment return
• mortality
• future inflation
• Whether LISE payments at assumed commencement are to be expressed in future dollars (unadjusted for inflation) or in today’s dollars (inflation-adjusted )
• Whether LISE payments after assumed commencement are expected to remain fixed or are expected to increase with inflation like Social Security benefits or increase with some other index.

In summary, while we agree that LISEs can be helpful in facilitating retirement planning, we question whether furnishing the two specific LISEs in an annual hard copy benefit statement as anticipated under the new law will be as effective as hoped.  We believe participants who aren’t afraid to crunch some numbers would also benefit from using a LISE calculation tool made available to them on the internet.

Warning:  The next two sections of this post involve a geeky actuarial deep dive into the calculation of the “lifetime income stream equivalent” of a defined contribution plan account.  If you aren’t interested in the gory calculation details, you might want to skip to Our Concerns Respecting LISE Disclosures Anticipated Under the New Law below.
 
Background
 
In May of 2013 the DOL issued an Advance Notice of Proposed Rulemaking (ANPRM) applicable to “pension benefit statements required of defined contribution plans.”  In this ANPRM the DOL indicated, “Managing finances in order to provide income for life for oneself and one's spouse is a tremendously difficult but important task.  The rule under consideration by the Department would provide participants with information that the Department believes will ease the burden of this task.”

The 2013 ANPRM provides us a window into DOL thinking about safe harbor assumptions that may be ultimately released for LISE calculations relative to participants’ current account balances.  The DOL also provided the DOL Lifetime Income Calculator, which is a calculation tool on its website that incorporates the assumptions and disclosures proposed in the 2013 ANPRM.  While the DOL ANPRM proposed disclosure in participant benefit statements of four LISE amounts:

• two each related to the participant’s current account balance and
• two each related to the participant’s projected account balance,

the SECURE Act only requires LISE disclosures relative to current account balances. 

For those readers interested in LISEs and how they might be calculated, we will walk through an example of a calculation of LISEs anticipated by the 2013 ANPRM relative to a participant’s current account balance using the DOL Lifetime Income Calculator.  Let’s look at a 45-year-old participant with a current account balance of $100,000 in a plan with a normal retirement age of 65.  If we go to the DOL Lifetime Income Calculator in their website and enter:

and hit the Calculate button, the calculator tells us that this participant’s single life LISE is:

• $468, relative to his current account balance and
• $1,022, relative to the projected account balance solely attributable to the participant’s current account balance (i.e., the participant’s current account balance projected to the normal retirement age)

The DOL tells us that these amounts are real dollar (today’s dollars) amounts (inflation-adjusted until Retirement Age), but are not adjusted for inflation after Retirement Age, as Social Security benefits are.
 
The reason the two LISE amounts in this example are not the same is that:

• the lower amount of $468 is determined assuming zero future investment return on the current account balance until Retirement Age, while
• the higher amount of $1,022 is determined assuming 7% per annum future investment return on the current account balance until Retirement Age.

The result of this second calculation is then discounted by an assumed inflation rate of 3% per annum to obtain a real dollar (inflation-adjusted) projected account balance attributable to the current account balance at age 65 (under these different assumptions) of $218,376 in today’s dollars (inflation-adjusted).  The same age 65 fixed dollar annuity conversion factor (based on current annuity conversion assumptions) is applied to both of the “assumed” projected current account balances to obtain the different LISEs.

This admittedly confusing example illustrates some of the assumptions that may be required in LISE calculations and their relative importance in developing a reasonable result that may be useful in retirement planning.
 
So, What Assumptions and Methods Might DOL Require for LISEs Under the New Law?
 
The 2013 ANPRM tells us the assumptions and methods that the DOL has previously recommended for calculating LISEs.  These include:

Will these assumptions and methods remain unchanged in forthcoming guidance or will they be changed?  That is the $64,000 question whose answer is unknown.

Our Concerns Respecting LISE Disclosures Anticipated Under the New Law
 
In addition to the concerns about forthcoming guidance regarding pre-commencement date investment return assumptions highlighted in the example above, we have several other concerns regarding the disclosure and calculation of LISEs under the new law.

Possible Limitations of Hard-Copy Benefit Statements
 
As well as including the two specific LISE amounts specified in the law in hard copy statements, benefit statements could also include a reference to a DOL website (or some other website) that would enable participants to calculate their own LISEs based on default or other assumptions.  In fact, referring participants to a website is the approach the DOL currently requires for discussion of sources of information on individual investing and diversification under ERISA Section 105(a)(2)(B)(ii)(III) in participant benefit statements.
 
Linking to a website could also permit participants to model LISEs developed under different commencement ages and different sets of assumptions than those specified by the DOL and could allow participants to estimate future LISEs based on future contributions to be inputted by the participant.  It would also permit participants to include other current account balances they or their spouses may own.  We believe that linking to a robust website LISE calculation tool would significantly improve participant financial planning capabilities over providing just the two LISE amounts based on the participant’s current account balance from just the one plan and DOL assumptions.
 
Since the new law requires disclosure in hard copy statements of the two specific LISE amounts discussed above rather than referring participants to an internet website calculation tool, we believe it is important that these two LISEs be based on reasonable assumptions.  We also believe that the model disclosure language developed by the DOL should still refer participants to an internet website for additional helpful LISE calculations.  For this purpose, we encourage the DOL to:

• improve their internet calculation tool,
• provide a link to it in their model disclosure, and
• explain in the model disclosure why participants should visit the website and use the tool rather than simply rely on the two disclosed LISEs attributable to the current account balance in this particular plan.

LISE Calculations Should Anticipate Post-Retirement Inflation Increases
 
While we agree that LISEs should be expressed in real (inflation-adjusted) dollars, we also believe it is preferable that these theoretical lifetime payment amounts also anticipate annual cost of living increases similar to those provided under Social Security.  To facilitate retirement planning, it would be more helpful to be able to add expected LISEs to expected amounts from Social Security on an “apples to apples” basis.  If one of the purposes of the LISE disclosures is to nudge participants to contribute more to their plans, we see little justification for overstating the theoretical real dollar (inflation-adjusted) lifetime income that may be derived from a given account balance.
 
LISEs for Couples
 
While ERISA requires the normal form of annuity distributions from qualified plans to be in the form of a qualified joint & survivor annuity determined using unisex assumptions, showing LISEs on this basis is not necessarily consistent with providing helpful retirement planning information.  Neither is the assumption in the law that the participant’s spouse is assumed to be the same age as the participant.  Since these calculations are theoretical in most instances, we believe they should reflect actual ages, marital status and sexes of the participants and beneficiaries (which is yet another reason to refer the users to a calculation tool rather than simply providing simplified information in a hard copy statement).
 
Understanding LISEs

Behavioral economists and many others believe that disclosure of reasonable LISEs is very important in helping individuals and couples plan for retirement and will generally encourage (nudge) plan participants to save more.  We agree that reasonable LISEs can be another important data point in the planning process, but we aren’t convinced of how effective LISEs are at increasing participant savings rates or improving participant retirement planning.  Many participants already understand that in order to afford retirement, they are going to need to accumulate total savings equal to some multiple of their annual recurring expenses not expected to be funded by their expected annual Social Security benefits.  For example, many Financial Independent Retire Early (FIRE) advocates employ the 4% Rule to target accumulated savings of 25 – 30 times their expected annual recurring expenses in retirement.
 
As discussed above, determining a reasonable real dollar (inflation-adjusted) lifetime income value of one’s defined contribution account balance (LISE) is not a simple exercise.  The “best” procedure will depend on many factors and may vary depending on who you might ask.  For example, a financial economist may answer that the LISE should be the estimated monthly amount that may be purchased (in actuality or in theory), with the current account balance, under an inflation-adjusted life annuity contract in the current insurance market.  A financial advisor, however, may employ a Monte Carlo model and tell you that depending how you invest the account balance and historical rates of return and variances for those asset classes, you have an 85% probability of being able to spend $X per month for the rest of your life.  FIRE advocates and others will tell you to accumulate your current account balance to your expected retirement age using expected returns (using either deterministic or stochastic assumptions) and then apply the 4% Rule to this projected account balance.  The exercise is even more complicated for married couples than for single individuals.
 
Again, while furnishing two LISEs based on DOL guidance will be a good first step, we believe more robust LISE calculations are better handled through an internet calculation tool rather than through just the use of fixed “safe harbor” assumptions.
 
Summary
 
We are in full agreement with the statement by the Department of Labor that “Workers participating in defined contribution plans, like 401(k) plans or similar savings plans, are responsible for managing their retirement savings while employed and during their retirement years.”  We are also in general agreement with the DOL claim that “Showing participants their retirement plan account balance as level monthly payments for their lifetime will help them assess their retirement readiness and plan for their retirement”, but we believe the LISE payments should be level real dollar (inflation-adjusted) payments and the guidance and tool associated with the 2013 APNRM can and should be improved.  We also believe the model disclosure language should refer participants to an internet calculation tool for more robust and useful LISE calculations.  We encourage the DOL to look at the Actuarial Lifetime Income Retirement Estimator (ALRIE) tool we developed (as discussed in our post of June 9, 2018 and available in our “spreadsheets” section) as an example of such a more robust tool.