Data & Research May 26, 2017

Retirement Savings Shortfalls to Soar If Policies Do Not Change

Longevity, lower investment returns, and inadequate savings are contributing to a growing shortfall in what individuals will need for a longer retirement, a report says.
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Since the middle of the last century, life expectancy has been increasing rapidly, a report from the World Economic Forum notes. On average, it has been increasing by one year, every five years. Babies born today in 2017 can expect to live to older than 100.

To understand the scale of the retirement challenge from increasing life expectancy, the group estimated the size of the shortfall in retirement saving—the retirement savings gap. It also projected these calculations to 2050 to determine how quickly the gap will grow if measures are not taken to increase saving levels.

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The calculations assume that for most individuals, their retirement needs will be met by a combination of income from three sources: Government-provided first pillar pension, employer (public or private sector) retirement plans, and individual savings.

The retirement savings gap for 2015 was estimated to be approximately $70 trillion, with the largest shortfall being in the United States ($28 trillion). Looking at the U.S. specifically, the gap is growing at a rate of $3 trillion each year, and will reach $137 trillion by 2050. This increase is the equivalent of five times the annual U.S. defense budget, according to the report.

One obvious implication of living longer is that individuals are going to have to work for a longer time, the report suggests. “The expectation that retirement will start early- to mid-60s is likely to be a thing of the past, or a privilege of the very wealthy,” researchers write.

The report also notes that absent any change to retirement ages, or expected birth rates, the global dependency ratio (the ratio of those in the workforce to those in retirement) will plummet from 8:1 today to 4:1 by 2050.

Another thing affecting the shortfall is that over the past 10 years, long-term investment returns have been significantly lower than historic averages. Equities have performed 3% to 5% below historic averages and bond returns have typically been 1% to 3% lower. This puts an increased strain on pension funds as well as on long-term investors that have commitments to fund and meet the benefits promised to current and future retirees. Individuals have also been impacted and have seen smaller growth in their retirement balances than in the past.           

Further, to support a reasonable level of income in retirement, 10% to 15% of an average annual salary needs to be saved. Today, individual savings rates in most countries are far lower. The report contends this will continue to be a challenge unless the importance of higher savings rates is better understood and communicated.

NEXT: Policy implications

“To protect against poverty in old age, we believe that retirement systems should be designed to provide a level playing field and equal opportunity for all individuals,” researchers write. “A well-designed system needs to be affordable for today’s workers and sustainable for future generations to ensure that all financial promises are met.”

The report notes that healthy retirement systems contribute positively towards creating a stable and prosperous economy. Ensuring that the public has confidence in the system, and that promised benefits will be met, allows individuals to continue to consume and spend through their working and retired years. “If this hard-earned confidence is lost, there is a significant risk that retirees will moderate their spending habits and consumption patterns. Such moderation would have a negative impact on the overall economy, particularly in countries where the size of the retired population continues to grow,” the report says.

The popularity of defined contribution (DC) retirement plans has been growing steadily over the past few decades and they now account for more than 50% of global retirement assets, the report notes. The way these plans are designed puts a high level of responsibility on individuals to manage their retirement savings. This includes deciding how much to save each year, which investments to choose, how long they are likely to live, when they should retire, and how to withdraw their savings when they do decide to retire full-time. The group contends that the information reported to individuals often does not make it easy to make informed decisions to try to meet a target level of retirement income. For example, the account balance does not help individuals understand what they would likely receive as a monthly income, and the investment return achieved does not help determine whether to increase savings rates, stay employed longer and delay retirement or take more investment risk.

To close the retirement savings gap, there are three key areas the group says governments and retirement policymakers should focus on which will have the biggest impact on the overall level of financial security:

  • Provide a “safety net” pension for all;
  • Improve ease of access to well-managed, cost-effective retirement plans; and
  • Support initiatives to increase contribution rates.
The report, “We’ll Live to 100 – How Can We Afford It?” is here.
The Markets May 26, 2017

Understanding Share Classes in DC Plan Funds

In the midst of ongoing litigation regarding excessive fees, plan sponsors need an understanding of the different fund share classes available and how they affect fee structure. 
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When it comes to selecting mutual funds for a defined contribution (DC) plan’s investment menu, plan sponsors can encounter an alphabet soup of different share classes with varying fee structures sprinkled in—and that’s ultimately what sets them apart.

The fee structure may be different across a fund’s share classes, but participants investing into the same fund will be investing into the same asset-class mix with the same underlining securities.  

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So to avoid confusion, it’s important to understand the basics.

All share classes come with varying expense ratios. This is typically what the participant pays for. It is calculated annually as a percentage of an investor’s assets. So a balance of $10,000 invested in a share class with a 1.32% expense ratio would mean a $132 fee out of that balance.

Built into most expense ratios are 12b-1 fees, which are charged annually for a mutual fund’s marketing and distribution costs. According to the Department of Labor (DOL), these fees may also “pay various service providers of a 401(k) plan pursuant to a bundled services arrangement.”

It’s important to pay close attention to expense ratios, because participants could face larger or smaller fees depending on the share class even though their money is ultimately investing in the same fund. In some cases, this can mean participants would be charged three times as much for using one share class over another, according to FeeX.

Other expenses that vary among mutual fund share classes are known as “loads.” But according to an analysis by the Investment Company Institute (ICI), “sales loads are often waved for mutual funds purchased through 401(k) plans.” In such a case, neither the participant nor the plan pay these fees, but it’s important to understand what they mean. Loads are typical in A and C Shares.  

NEXT: Explaining Share Classes

What are A Shares?

‘A’ Shares carry a front-end sales charge often called a “front-end load.” These fees are not part of the fund’s operating expenses. Instead, they are sales commissions paid to investment intermediaries such as financial planners, brokers and investment advisers.

This fee is calculated as a percentage of an initial investment and then subtracted from it. For example if a front-end load is 5.75% and $10,000 is the opening balance, the fee is $575. So the opening balance ends up being $9,425.

“Sales loads are typical of A Shares; the upfront commission that is typically paid by a retail investor, sometimes up to 5.75%,” says Matthew J. Cirillo, senior analyst, Retirement, at Strategic Insight, the parent company of PLANADVISER. “If a retirement plan is using A Shares in their lineup, these loads are waived and not paid at all.”

What are C Shares?

C Shares are often marketed as “no load” funds, according to FeeX. And although they don’t usually carry a front-end sales charge, they may come with a back-end load. This means there is no up-front charge to buy shares, but a fee goes into effect if they are sold before a certain period of time. The typical back-end fee is 1%, but they can carry larger expense ratios than A Shares. Still, some C Shares will eliminate the back-end load after shares are held for a certain period of time.

What are I Shares?

A and C Shares are generally accessible to most plan sizes. Larger plans, however, may have access to Institutional share or I Share classes. These shares typically carry far lower costs and expense ratios than A and C Shares.

For example, FeeX explains that the ClearBridge Small Cap Growth fund carries an expense ratio of 1.32% for A Shares, 2.17% for C Shares, and .90% for I Shares. But I Shares require large minimum investments. The minimum investment for the I Share in this particular fund is $1 million.

What are R Shares?

Some share classes are specifically designed for employer-sponsored retirement plans. These are known as R Shares and typically range from R-1 to R-6. The latter is designed to strip investment costs from distribution costs and other revenue-sharing costs to provide a heightened level of fee transparency.

“With the R Shares, there can potentially be a component of revenue sharing that is attached to them,” explains Cirillo. “The R6 Class doesn’t have 12-b1s or servicing fees, and there’s no revenue sharing attached to them. They’re completely stripped down.”

While R Shares typically carry no front-or-back-end loads, expense ratios can vary among the different classes. If they carry 12b-1 fees, they typically range from .25% to .50%.

R-6 Shares are typically accessible to mid-to-mega plans with assets ranging from $10 million to more than $250 million, according to research by Eagle Asset Management. Smaller plans could easily access A Shares and R-3 Shares.

NEXT: An Evolution in Share Classes

Most funds with share classes from A to R5 can have some element of revenue-sharing, where fees can be taken from investments to pay commissions for the services of third-party providers— some of which may not have a fiduciary responsibility or legal obligation to act in the participants’ best interests. Add to that confusion the varying expense ratios among share classes. Together, these make the corner stone of most litigation going on in the industry today.

In response, fund managers are developing new share classes or tweaking old ones to break apart intermingled revenue sharing.

“By stripping out the investment costs from the revenue sharing or the plan costs, you can better segment what you’re paying for,” explains David Blanchett, head of retirement research at Morningstar Investment Management.

What are T Shares and Clean Shares?

Some mutual fund shares, including T Shares, were designed in response the DOL’s fiduciary rule, which makes virtually every adviser working with an employer-sponsored retirement plan or individual retirement account (IRA) a fiduciary. And despite going through more than a year of regulatory chaos, the DOL has announced it will begin undergoing implementation on June 9.

T Shares are designed to carry a uniform upfront sales charge across all funds, so advisers won’t be tempted to push one fund over another to receive a higher commission, according to Morningstar. Advisers would also have an easier time disclosing fees and what they are for. On the other hand, the load could vary widely on A or C Shares depending on the fund and its relationship to the intermediaries receiving that fee.     

T Shares typically carry a maximum 2.5% front-end sales load, and usually a .25% 12b-1 fee.

Other shares built in response to the DOL rule are “clean shares,” which are designed to untangle revenue sharing. In a recent analysis, Morningstar concludes that these shares would aim to “charge clients for managing their money (and other associated expenses)” for a level fee that includes no charges to service providers doing something other than managing portfolios.

“Within the defined contribution space, there has been a movement among plan sponsors to strip away the investment costs from the plan costs,” explains Blanchett. “By stripping out the investment costs from the plan costs, you can better segment what you’re paying for.”

“Defined Contribution Plan Share Classes: The Role of Fund Fees in Optimizing Cost Efficiencies” can be found at EagleAsset.com.

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