The Markets August 6, 2014

Can Social Security Be a Silver Bullet?

Employers can quickly boost outcomes in their defined contribution (DC) retirement plans by improving participants’ Social Security withdrawal behaviors, a new analysis suggests.
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In a new report, Mercer and the Stanford Center on Longevity suggest retirement plan participants make a variety of common and costly mistakes when it comes to optimizing their retirement readiness. But one of the most widespread problems is a lack of awareness around how to most effectively time the start of Social Security payments.

The Mercer/Stanford analysis cites recent data from the Social Security Administration to show that the Social Security program provides 50% or more of all retirement income for two-thirds of U.S. retirees, and 90% or more of all retirement income for one-third of all retirees. With such a significant dependence on Social Security benefits, low- and middle-income workers who optimize those benefits can significantly improve their financial security in retirement, according to the report.  

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While there is unending minutia involved in the difficult calculation of what one’s monthly Social Security benefit may actually be, the main hurdle to increasing the benefit may also be relatively simple to overcome (see “It Is Difficult to Factor Social Security Into Retirement Planning”). Mercer and Stanford researchers suggest the overwhelming problem is that people simply draw Social Security too early—roughly half of all Americans now start Social Security benefits at age 62. As the report explains, this is the earliest possible age at which one can take Social Security, when the retiree will get the lowest amount of retirement income on a monthly basis.

This claiming behavior is suboptimal for people in average or above-average health, the report explains. For these people, retirement security can be enhanced substantially by just delaying the start of Social Security income. For example, delaying the start of benefits from age 62 to age 66 can increase annual Social Security income by 33%, the report says.

Near-retirees may be hesitant to defer income that can be accessed today, but the report suggests delaying to age 70 can increase annual Social Security income by as much as 76%, more than making up for the delay. Of course the ability to delay federal retirement dollars depends on the individual having sufficient savings from which to draw down or other sources of income, the report notes.

John Shoven, director of the Stanford Institute for Economic Policy Research, explains that it may be advantageous for U.S. workers to delay Social Security payments to age 70 even at the cost of depleting personal retirement savings in the early years of retirement. 

As Shoven explains, currently most Americans use retirement savings to supplement their social security income and start withdrawing from savings upon retirement—a method he describes as the “parallel” strategy. Instead of this, he advocates using a “series” strategy, in which retirees first draw down personal retirement savings to pay for living expenses and delay the start of Social Security benefits until age 70. In effect, retirees will use their retirement savings to “buy” a higher annuity from Social Security. This method is likely to result in higher amounts of lifetime income for retirees, Shoven says.

In today’s market, the effective “Social Security annuity purchase rate” is a much more favorable rate than the cost of annuities purchased from private insurance companies, Shoven adds. The reason is that Social Security’s delayed retirement credits were developed when interest rates were higher and life expectancies were lower compared with today. As a result, Social Security’s delayed retirement credits are more than fair actuarially for someone in good health, he explains.

Shoven says both single retirees and couples alike can increase their retirement incomes by several hundred dollars per month at age 70 if they delay Social Security benefits for the primary wage earner. The increase in retirement income from deploying this strategy translates to anywhere from $1,000 to $1,400 per month by age 90, he says. In some hypothetical examples, the gain in the expected value of total retirement income was $200,000.

A full summary of the Social Security research from Mercer and the Stanford Center on Longevity is available here. Mercer and Stanford researchers also recently collaborated on research examining participant statement best practices, available here.

The Markets August 6, 2014

Process for Terminating Investment Managers Is Important

While much time is spent selecting investment managers, not nearly enough time is spent in establishing a processing for terminating such managers, says a recent paper from the Strategic Investment Group.
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“The Art and Science of Manager Termination” looks at reasons retirement plan sponsors may want to terminate investment managers and offers investment committees criteria by which they can evaluate the underperformance of investment managers.

There are many sound and valid reasons to terminate and replace an investment manager, once the facts have been properly analyzed and considered, says the paper. These reasons can apply similarly or differently for defined benefit (DB) or defined contribution (DC) plans, says Ronald Klotter, managing director of the Arlington, Virginia-based Strategic Investment Group. These reasons can include:

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  • Adverse organizational change. An investment manager handing off their investment management duties to more junior staff, high turnover in the research staff, or instability within key management are all elements to consider. “How these organizational changes are dealt with by both DB and DC plans are probably very similar,” Klotter tells PLANADVISER, “with the plan sponsor or investment committee still having a duty to oversee these managers and their performance.”
  • Unfavorable market conditions. If a plan sponsor or investment committee believes a future market environment will be inhospitable for a manager’s strategy for an extended period, they may want to consider terminating the manager, even if the strategy is otherwise sound.
  • Redundancy or irrelevancy. Manager terminations may be initiated if it becomes apparent that their strategy is no longer needed or able to fulfill its role. This reason is less of a factor with DC plans, says Klotter, since investment options are usually structured to be there for specific reasons, with alternative options being offered to participants, such as passive and active investments.
  • Failure to meet return expectations. Every manager must meet return expectations. In determining whether or not to terminate, plan sponsors or investment committees should investigate and answer why a manager did not meet those expectations. It also helps for plan sponsors and investment committees to have clear criteria for return expectations and for monitoring managers, says Klotter. Communications can also be a factor, he says, with DC plans disclosing this information to participants, while DB plans would not be required to do so.
  • Fiduciary, ethical or operational risks. In this area, plan sponsors and investment committees need to look at operational risks and whether the manager has a poor control environment. However, if lapses by the manager are found to be due to an underlying ethical problem or a lack of timely action, that may prompt immediate termination. Fiduciary concerns are important, says Klotter, regardless of whether the plan is DB or DC in design.

The paper offers a number of steps plan sponsors and investment committees can use to evaluate underperformance by investment managers. Termination should be decided based on both quantitative and qualitative data. Klotter points out this might be more of an issue for DC plans, which tend to use more of a quantitative, rules-based system to evaluate performance. “Plan sponsors and investment committee members need consider factors beyond just performance,” he says.

While performance measurement tools can be used to examine quantitative factors such as the duration of manager underperformance and the volatility of the investment strategy during different market cycles, the paper recommends that plan sponsors and investment committees also use qualitative tools, such as regular calls and meetings with the investment manager, to make a final decision about termination.

Other steps that can be used for evaluation include:

  • Getting the facts and investigating the cause of underperformance. Analyze the manager’s situation on the basis of facts and not ill-defined negative feelings.
  • Do a case-by-case analysis. Do not have pre-determined tolerance bands for managers for deviation from the benchmark. Discern what is driving the underperformance and judge if it is likely to persist in the market environment.
  • Know the investment managers. Seasoned, senior executives should manage the sourcing, due diligence, hiring and firing decisions, and monitoring of investment managers.
  • Factor in shifts in the market environment. When looking at underperformance, remember to take into account that a change in the market environment may change things over an extended period of time.

The paper concludes that plan sponsors and investment committees must regularly revisit their reasons for investment manager terminations to make the most intelligent decisions possible.

A copy of the paper can be found here.

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