For most of the 20th century, people who worked hard and remained loyal to the company were rewarded with a pension in retirement. This pension provided a systematic income stream, typically through an annuity. With it came the guarantee that this income stream would last as long as the retired worker lived.
Today, the number of retirees covered by a traditional pension or defined benefit plan has been steadily decreasing. Only about 20% of private sector workers are covered by traditional pensions, according to the Bureau of Labor Statistics. And approximately 44% of private sector workers have neither pension nor savings plan, according to the Employee Benefit Research Institute.
This movement away from defined benefit plans has set in motion some developments that require advisors and clients to be more involved in retirement planning than ever before–and to become aware of the associated risks.
For instance, it helped spur growth of defined contribution plans, most notably 401(k) plans. These DC plans place more emphasis on self-directed accounts and portability from company to company. They were developed in part to shift some of the burden of planning for retirement off of employers and onto employees.
While the shift to DC plans provided employees with more control over where their retirement funds are invested, employees unfortunately lost 2 very valuable benefits in the process:
1. The security that comes with a guaranteed source of retirement income.
2. The advantage of “risk pooling.”
Historically, when individuals received a pension, they were participating in a mortality risk pool, where plan sponsors assume that some retirees will die before life expectancy and others after life expectancy, and are therefore able to allocate benefits as if all retirees will live to life expectancy. Excess assets allocated to those that die prior to life expectancy are used to fund the retirements for those that live past life expectancy. (See Chart 1.)
The logic of this scenario, which at its most basic level functions because some retirees will live a long time and others will not, is essentially what makes risk pooling work.
The advantage gained through the participation in a risk pool is the ability for individuals to take income as if they were only going to live to life expectancy, and, at the same time, receive a guarantee that they will never run out of money, even if they live well beyond this date. This dynamic also benefits those who die before life expectancy, because they could not have safely taken out as much as they were able to with risk pooling since they did not know their deaths would occur before life expectancy.