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The topic of auto-enrollment in 401(k) plans and its potential impact on the employer matching contribution has sparked a scholarly rhubarb between the Urban Institute and the Employee Benefit Research Institute.

In December, researchers at the liberal Urban Institute reported evidence that the match at large firms with auto-enrollment is lower than at those without it. They warned that auto-enrollment, by lifting participation rates, could raise costs for employers and trigger cutbacks in the match or in other compensation. 

“While auto-enrollment increases the number of workers participating in private pensions, our findings suggest it might also reduce the level of pension contributions,” wrote Barbara Butrica and Mauricio Soto in their report “Will Automatic Enrollment Reduce Employer Contributions to 401(k) Plans?.” RIJ reported their findings January 13, “Will “Auto-Enrollment” Kill the Employer Match?”

National newspapers publicized that story, prompting the EBRI, which is non-partisan but whose membership list is a Who’s Who of the retirement savings industry, to fire back with a statement refuting the Urban Institute’s assertion and questioning its data.

“Our recent analysis of plan-specific data shows that, at least among large 401(k) plans, plan sponsors actually increased the generosity of their contribution rates,” said Jack VanDerhei, EBRI research director and author of the analysis, in a statement  released last week.

That was not the end of it. On Monday, Butrica e-mailed reporters a response to the EBRI report. It said that the EBRI’s data largely supported her findings, and reiterated that auto-enrollment—a key plank of the Pension Protection Act of 2006—could backfire.  

“We think auto-enrollment is a good thing,” Butrica told RIJ. “But if employers do in fact lower their match rates to offset some of the higher costs, then auto-enrollment may have some unintended consequences.”

Vanderhei told RIJ he will release a full study of the impact of auto-enrollment and other pension innovations in a February EBRI Issue Brief.

If untold billions or even trillions of dollars were not at stake here—both in terms of Americans’ retirement savings and financial service company revenues—this point-counterpoint exercise would be purely academic. But billions are at stake.

This debate also comes at a time when academics have criticized the 401(k) system and when employers have shown a readiness to suspend matches during tough economic times. The financial industry is unsurprisingly sensitive to any news that might further erode consumer faith in defined contribution pensions as the primary path to retirement security.

EBRI’s rebuttal

The EBRI challenged the Urban Institute’s methodology and its inference that match rates are already about seven percentage points lower among large plan sponsors that use automatic enrollment than among those that don’t.  

In rebuttal, EBRI cited its recent study showing that 42.5% of the defined benefit plan sponsors it surveyed had already increased or planned to increase their direct “first tier” match and/or their “second tier” non-matching contribution to their defined contribution plans.

EBRI also noted that “225 large defined contribution plans that had adopted automatic enrollment 401(k) plans by 2009, but did not have them in 2005.” The study showed that:  

• The average 2009 first-tier match rate was 87.78%, up from 81.26% in 2005.  [Note: An employer who matched an employee’s 3% deferral with a 3% contribution would have a 100% first-tier match rate.]  
• The average effective match rate for 2009 was 4.32% of compensation, up from 4% in 2005. 
• The average total employer contribution rate for 2009 was 6.35% of compensation, up from 5.46% in 2005.  

But, while showing that match rates are higher at firms with auto-enrollment, EBRI also suggested that it wasn’t because they had adopted auto-enrollment. It was because they had recently closed or frozen their defined benefit plans.

The improvements in the match “were much higher for sponsors that had frozen/closed their defined benefit plans than for the overall average,” the report said. Those companies could offer higher 401(k) match rates because they were saving money on the conversion and because they wanted to ease the sting of losing the defined benefit plan, Vanderhei told RIJ.

Points of agreement

The Urban Institute researchers, whose study was published by the Center for Retirement Research at Boston College, don’t disagree with that assessment.

“We do not believe the EBRI results necessarily contradict our results. In fact, their findings with regard to DB plans are consistent with our conclusions. And, as we have shown, the first-tier match rates and EBRI effective match rates could increase with automatic enrollment, at the same time that our match rates decline,” Butrica wrote in her response to the EBRI assertions.

“Ultimately, the main point of our paper is that automatic enrollment is not free for employers and that profit-maximizing firms might look for ways to offset the higher costs of auto-enrollment. How they will do that is still up for debate, but our results suggest that some employers may reduce their match rates,” she added.

On Monday, Vanderhei conceded that he also believed that auto-enrollment could have unplanned and unwelcome consequences.

“I don’t disagree that there will be modifications seeking a long-run equilibrium [in the match]. Other papers have already said that auto-enrollment could cost employees in terms of match rates,” he told RIJ.

“My 2005 study showed that, all else being equal, auto-enrollment would work to the benefit of low-income participants but to the detriment of the highest quartile, because they may get anchored at the default rate,” he said.

“There’s no doubt that basic back-of-the-envelope math will show that, all else being equal, something will have to give. I took exception to the Urban Institute’s argument that this has already happened.

“The most important thing is that this is one input to a full study to be released [as an EBRI Issue Brief] in February looking at the overall impact of auto-enrollment on participants,” Vanderhei added. “It will cover much more than what happens to match rates, and will include auto-escalation and other things.”

© 2010 RIJ Publishing. All rights reserved.

The validity of “time-segmentation” methods of retirement income planning were the subject of a spirited, impromptu e-mail discussion last week among several members of the Retirement Income Industry Association.

The message chain, which sprang up spontaneously like a dust dervish in the desert, included commentary from well-known academics like Zvi Bodie, Larry Kotlikoff and Moshe Milevsky (at left), as well as David Macchia, purveyor of a time-segmentation tool, and others.

Time-segmentation, a core principle of certain “bucket” methods, divides a person’s retirement into periods of two to ten years each and assigns assets to each period, as a discrete source of income for that period. The later the investor plans to tap the assets for income, the riskier the assets can be.

The question for those in the e-chain was whether or not time-segmentation is a valid financial planning method and, more specifically, whether its apparent deference to the belief that equities pay off in the long run can be justified.

Let’s tune into the e-mail chain at the point where Macchia suggests that time-segmentation be debated at RIIA’s conference in Chicago on March 22-23, along with other methods that are scheduled for critical discussion.

Macchia (owner of Wealth2k, marketer of Income for Life Model): Given the rapid marketplace adoption, I feel strongly that time-segmentation must be added. The FPA recently released research indicating that 40% of advisors have adopted the concept, and we’ve seen numerous big players embrace [it], e.g. Nationwide, UBS, Bank of America, etc. Not to mention Wealth2k and Russell [Investments].

Charles Robinson (senior vice president, Northwestern Mutual Life Insurance Co.): I would heartily second David’s suggestion.

Zvi Bodie (Boston University economist; author of Worry-Free Investing, Financial Times, 2008): What is the concept of time-segmentation? Does it refer to different age cohorts, accumulation vs. decumulation, or something else?

Michael Zwecher (former Merrill Lynch risk manager; author of Retirement Portfolios: Theory, Construction and Management, Wiley, 2010): It’s the idea that both you and Moshe have debunked repeatedly—essentially that you can ‘expect’ to grow your way out of the hole.

Bodie: Then why would RIIA want to support it?

Macchia: That is [an] unfair dismissal of a concept that has proven its value in more than two decades of real world experience. I’d recommend one speak with seasoned advisors whose experience shows that it takes more than an “optimal” academic framework to make retirement investing work in the field. We shouldn’t be waging a war over approaches; the debate is largely irrelevant. Thirty-two years of working with investors and financial advisors has taught me that once theory meets practice, theory often loses.

Zwecher: I’m not trying to be smug or argue that it is just a theoretical point. [Equities] may
 have paid off for long windows in the U.S. in the past. But, if you look at option prices today for any maturity, the capital markets
 are saying that I have no better than fair odds for beating the risk-free rate going forward.

Moshe Milevsky (York University finance professor; author of Are You a Stock or a Bond?, FT Press, 2008): I have yet to see any rigorous (or even non-rigorous, for that matter) article or paper that derives “time segmentation” as the output from any sort of optimization process. I wish there was.

In fact, I have actually been thinking about this carefully, and I can’t locate any rational preference function that would lead to this type of strategy. Perhaps, prospect theory together with a mental accounting type argument might work, but that is mixing positive and normative economics.

In other words, just because you can explain observed behavior with a distorted loss-function, doesn’t mean it should be advocated for the masses. Of course, if the justification for a strategy or product is that practitioners have been using it for decades and have been “quite happy” with the outcome, then we have bigger problems.

Macchia: To be clear, I’m not advocating anything for the masses—including time-segmentation. I do believe that time-segmentation can be appropriately employed for some investors, especially when it is combined with a floor of guaranteed lifetime income. There are many approaches to this issue, and we can’t know which among these will yield the best results in practice.

Francois Gadenne (chairman of RIIA): I wonder if we are all seeing the same thing when we read the words: time-segmentation. How many of us see time segmentation to mean buckets of risky assets? How many of us see it to mean a mix of buckets, including precautionary reserves, longevity (risk pooling), floors (risk transfers) and risky assets?

Milevsky: I don’t think “buckets” diversify risk. I provided a counter-example in the attached article (“Spending Buckets and Financial Placebos”).

Chris Raham (leader of Ernst & Young’s Retirement Income Practice): I think it depends on what you put in the buckets.

Laurence Kotlikoff (creator of ESPlanner software; co-author of Spend ‘til The End, Simon & Schuster, 2008): I looked at David’s movie about his product and it’s possible that there is less disagreement here than meets the e-mail eye. My sense, based on the video, is that the product puts people into safer securities for the short term and less safe securities for the long term (at least as Zvi, Michael, Moshe, and I would describe them). There are three ‘buts’ here, however.

‘But’ number one is that if households are borrowing-constrained [unable to borrow] because they hav e short-term saving goals, like getting together a down payment for a house or paying tuition, they are, in effect, facing sure liabilities that need to be matched with safe assets of equal maturity. This may be what David has in mind in encouraging safe short-term investments.

Second, I took David’s product to be trying to provide a floor to the household’s living standard via its focus on inflation-projected bonds or annuities. This seems reconcilable with habit formation—with the fact that people do not want their living standard to decline.

Third, if the households David has in mind are borrowing-constrained, they may, indeed, optimally allocate more to risky investments (i.e., stocks) over time because their short-run liquidity constraints make them effectively highly risk-averse in the short run, but less risk averse in the long-term.

For example, if I have $100,000 and absolutely need $101,000 to buy a house in a year and have no other assets, I’m going to invest in safe one-percent Treasury bills. But in ten years, once I’ve accumulated enough wealth to bother thinking about investing, I may well opt to start investing in equities.

This isn’t to say that equities are safe in the long run, but that a person’s long-run risk aversion can differ from his or her short-run risk aversion. I don’t at all like suggesting that equities are safer the longer you hold them, because I don’t see a scientific basis for that statement. But I do find it reasonable to say that many risk-averse households may find equities a more attractive way to invest for the long-term than the short-term.

Keith Piken (managing director, Bank of America): It’s a dialogue worth having and I know our advisors and their clients continue to struggle in search of the “right” answer.

Kerry Pechter (RIJ editor; author of Annuities for Dummies, Wiley, 2008): I recently asked Meir Statman [the behavioral economist at Santa Clara University] if he thought time-segmentation was “natural.” Here’s his reply:

“Portfolio bucketing is the new version of the old tin cans or envelopes system. How the brain developed is speculative, but we need not jump very far to see that we prefer to solve easy problems rather than difficult ones.

“We simplify a big problem, like budgeting for a household or constructing a portfolio, by breaking it into smaller problems. First we divide them into envelopes or buckets, and then we spend from them. Compare arranging the documents and receipts you need at tax time in one big heap or in an accordion folder by topic.

“Buckets also help because they link money to goals, and an overall portfolio does not. Last but very much not least, buckets help self-control. Putting your hand into the electricity bill envelope for cigarette money makes you feel guilty, perhaps stopping you. Same for dipping into your child’s college fund to buy a shiny car.”

© 2010 RIJ Publishing. All rights reserved.

The U.S. Treasury and Labor Departments are nearing a request for public comment on ways to promote the conversion of 401(k) and IRA savings into annuities or other steady payment streams.

There is “a tremendous amount of interest in the White House” in retirement security initiatives, Assistant Labor Secretary Phyllis C. Borzi told Bloomberg News. Borzi heads the Department of Labor’s Employee Benefits Security Administration.

In addition to annuities, the inquiry is likely to cover other approaches to guaranteeing income, including longevity insurance that would provide an income stream for retirees living beyond a certain advanced age.

AARP is interested in the issue. “There’s a real desire on a lot of people’s parts to try to encourage something other than just rolling over a lump sum, to make sure this money will actually last a lifetime,” said David Certner, legislative counsel for the huge Washington-based advocacy group for retirees.

So is the Treasury Department. “There’s been a fair amount of discussion in the literature taking the view that perhaps there ought to be more lifetime income,” agreed Mark Iwry, a Treasury official who works on retirement income. “The question is how to encourage it, and whether the government can and should be helpful in that regard.”

Fools rush in?

But there’s no clear indication from Washington yet regarding the kind of annuity the administration favors, or whether it understands the differences between immediate and deferred, fixed and variable, single and joint, or life and period certain annuities—in short, all the nuances that make annuity decisions so complex and problematic.

Americans undoubtedly need help with retirement income. The average 401(k) fund balance was $60,700 as of last September 30. That was better than the $47,500 in March 2009, but still shy of its average of $69,200 at the end of 2007, according to a Fidelity Investments review of 11 million accounts it manages.  

Those humble balances argue against income annuities as much they argue for annuities, because small balances buy very little monthly income. If the government mandated partial annuitization, the resulting income streams would be even smaller.  

Adding lifetime income to 401(k) plans is “a great idea, but how much are people really going to get out of it?” said Karen Ferguson, director of the Pension Rights Center in Washington, D.C., who would like to see a revival of defined benefit plans.  

The public isn’t exactly clamoring for annuities. All but about two percent of 401(k) plan participants take their savings as a lump sum on retirement, according to the Washington-based Retirement Security Project. When they can, even workers with defined-benefit pensions tend to take their benefits as lump sums rather than as annuities. 

“Households’ views on policy changes revealed a preference to preserve retirement account features and flexibility,” said a report by the Investment Company Institute, which represents the mutual fund companies whose products 401(k) participants invest in.  Seven in 10 U.S. households would object to a requirement that retirees convert part of their savings into annuities, the report said.  

Recipe for politicization

A government push for annuities—either life annuities or deferred variable annuities with lifetime income riders—could put it squarely between the insurance companies and mutual fund companies that are in a zero-sum competition for the trillions that Americans hold in retirement accounts.

Mutual fund companies, represented by the Investment Company Institute, clearly don’t want to see 401(k) assets move out of their products and into the general funds of insurance companies, as they would if more Americans bought income annuities at retirement, as many Britons do.

John Brennan, the former chairman of Vanguard, the giant mutual fund company, criticized private annuities as expensive and offering little inflation protection. Americans already have “the best annuity in the world, which is Social Security,” he said on Bloomberg Television.

AARP’s Certner said policy makers could reduce annuity costs by encouraging the use of group annuities, which are bought by employers rather than individuals and often carry lower fees, or using approaches that provide retirement income without commercial annuities.

© 2010 RIJ Publishing. All rights reserved.

Anyone searching for a “visible hand” among the causes of the financial crisis should read the analyses written last year by professors at New York University’s Stern School of Business.

The overleveraging that made the collapse of the subprime housing crisis so deadly didn’t just happen, they say. It was pushed. 

So argue Viral V. Acharya and Matthew Richardson in a paper called “Causes of the Financial Crisis,” which appeared in Critical Review last year.  They also worked on a related paper, “On the Financial Regulation of Insurance Companies,” with NYU colleagues John Biggs and Stephen Ryan.  

Regulatory arbitrage

In their Critical Review article, Acharya and Richardson explain why the banks themselves were caught holding so many toxic assets:

Instead of acting as intermediaries between borrowers and investors by transferring the risk from mortgage lenders to the capital market, the banks became primary investors.

Since-unlike a typical pension fund, fixed-income mutual fund, or sovereign-wealth fund-banks are highly leveraged, this investment strategy was very risky. The goal, however, was logical: namely, to avoid minimum-capital regulations.

One of the two primary means for this “regulatory arbitrage” was the creation of off-balance-sheet entities (OBSEs), which held onto many of the asset-backed securities. These vehicles were generically called “conduits.” Structured investment vehicles (SIVs), which have received the most public attention, were one type of conduit.      

With loans placed in conduits rather than on a bank’s balance sheet, the bank did not need to maintain capital against them. However, the conduits funded the asset-backed securities through asset-backed commercial paper (ABCP)—bonds sold in the short-term capital markets.

To be able to sell the ABCP, a bank would have to provide the buyers, i.e., the banks’ “counterparties,” with guarantees of the underlying credit-essentially bringing the risk back onto itself, even if it was not shown on its balance sheet. These guarantees had two important effects, however.

First, guaranteeing the risk to banks’ counterparties was essential to moving these assets off the banks’ balance sheets. Designing the guarantees as “liquidity enhancements” of less than one year maturity (to be rolled over each year) allowed banks to exploit a loophole in Basel capital requirements. The design effectively eliminated the “capital charge” and thus banks achieved a tenfold increase in leverage for a given pool of loans.       

They conclude that

The genesis of it all was the desire of employees at highly leveraged LFCIs (Large, Complex Financial Institutions) to take even higher risks, generating even higher short-term “profits.” They managed to do so by getting around the capital requirements imposed by regulators-who, in turn, were hoping to diminish the chance that deposit insurance, and the doctrine of “too big to fail,” might cause LCFIs to take just such risks.

Taking on more assets that were backed by insurance rather than reserves may have “looked like the desirable thing to do” for a department within a large bank, but it “would create excessive risk for the bank as a whole,” Acharya told RIJ. “From [the department’s] standpoint it all makes sense. The risk was hedged and most of the losses would be felt by the creditors if it failed.”

The banks were not unlike a balanced fund manager who over-weights equities during a boom. Until the market turns, investors see the profits that the “style drift” produces but not the risks. Such strategies—which some fund managers couldn’t resist during the dot-com boom—proved fatal to many of those funds and their investors in 2000.  

Slippery slope

In the case of ABCP conduits, banks largely provided insurance themselves, Acharya told RIJ. But in the case of AAA-rated tranches of sub-prime mortgages and corporate bonds and loans, they often bought insurance from elsewhere.  This reduced capital requirements on these tranches practically to zero. That’s why the credit default swaps (CDS) prolifically written by AIG became so important.

The purchase of the credit default swaps by banks to insure against these tranches—in place of reserves—can be traced in part to the purchase of $350 billion worth of such insurance purchased by European banks “as a temporary fix for the fact that capital requirements in the Basel I agreement had placed European banks at a competitive disadvantage to U.S. investment banks, which were given a head-start on Basel II treatment by the Securities Exchange Commission (SEC) in the United States,” Acharya told RIJ.  That turned out to be a slippery slope.

“The moment you allow one player in the financial sector easier access to leverage, then everyone has to do it,” he said.

Moral hazard was ultimately responsible for the crisis, the NYU authors conclude. Federal deposit insurance for banks, state guaranty funds for insurers, belief in the principle of “too big to fail” and the limited liability of shareholders versus creditors all encouraged managers at large complex financial companies to take risks they otherwise would not have.

They recommend tighter regulation of banks and insurance companies and/or taxes that would force financial institutions to internalize the risks they are imposing on the financial system as a whole.  In their August 2009 white paper, the NYU authors conclude: 

“Insurance companies should not be able to offer “insurance”/protection against macro-economic events that yield systemic risk unless the insurance is fully capitalized. This would cover CDS on AAA-tranche CDOs, insurance against a nuclear attack, the systematic portion of insurance on municipal bonds, and so forth.

“A reworking of the accounting system for insurance companies to better aid the regulator and investors would also be desirable:

• The accounting for insurance policies should be made more/reasonably consistent with the accounting for substitutable risk-transferring financial instruments, such as derivatives. Fair value accounting, the usual accounting approach for these other financial instruments, is the best way to do this, but a not-too-distant alternative such as fulfillment value accounting may be adequate.
• The income smoothing mechanisms in statutory accounting principles (SAP) should be eliminated.
• Better financial report disclosures are needed for insurance policies that are written as put options on macroeconomic variables. These disclosures should clearly indicate concentrations of risk, how historical data is used to value the positions, and other important estimation assumptions.”

© 2010 RIJ Publishing. All rights reserved.