Commentary: 5 ways to make the SECURE Act meet participants’ needs

In late 2019, Congress passed the Setting Every Community Up for Retirement Enhancement Act. Section 203 of the SECURE Act introduces lifetime income disclosures, and on Aug. 18, the Department of Labor's Employee Benefits Security Administration announced an interim final rule for compliance with this provision of the SECURE Act.

I applaud this long-anticipated action and as invited by EBSA, offer the following comments on the interim final rule's assumptions and methodologies. First, simplicity in regulatory rule-making is a virtue that can become a vice of ineffectiveness if the rules are too simple to perform their intended function. Therefore, I urge the Department of Labor to consider flexibility in its general regulatory assumptions rather than the proposed framework — which assumes that all participants are age 67, start annuity payments at age 67 and have an equal-age spouse, regardless of actual marital status, spousal age or a spouse's own earned retirement benefits. By assigning the same retirement income number from a given account balance to a 37-year-old retiring in 30 years as to a 67-year-old retiring now, the rule reflects neither the growth in balance nor the impact of inflation on the income received by starting payouts at materially different dates.

I offer five principles of retirement income. EBSA is on track to complete the first principle and I urge them to consider incorporating the four remaining principles.

1. Account balances should be converted into monthly income estimates. Employees typically have little financial expertise. Many, including finance professionals, have no idea how much money they might need for retirement. Rather than trying to make employees smarter about investments, let's start communicating in terms they already understand, such as how much monthly income they may expect from their account balance. Identifying the right goal — retirement income as opposed to an account balance — is a fundamental shift that the DC retirement industry must make, and the Labor Department's rule is an important step in that direction.

Reporting account balances instead of retirement income adversely affects investment choices because the measure of risk is volatility in wealth when it should be volatility of retirement income. The lowest-volatility asset (in wealth terms) is a U.S. Treasury bill, which is among the most volatile assets in terms of income. The lowest-volatility asset for retirement income is a long-duration Treasury inflation-protected security, despite having stock market-like volatility in wealth terms. When statements report account balances instead of income, participants are "trained" to measure risk in wealth terms and, in turn, asset managers are "forced" to invest fixed-income assets in shorter-duration bonds to reduce volatility in wealth terms. When statements prominently report retirement income, participants will become "retrained" to measure risk correctly and asset managers will have incentives to manage risk correctly.

2. Participants should know how much of their pre-retirement income will be replaced in retirement. A plan participant earning $100,000 a year may have a goal of replacing all that income in retirement. Again, a lump sum represented by an account balance is insufficient information for participants to determine their sustainable standard of living in retirement. A better approach: Communicate what percentage of current income will be replaced in retirement based on the income generated from the account balance. That percentage can be combined with the percentage of income from projected Social Security benefits to yield a realistic measure of income replacement.

3. Current market bond yields should be used to calculate future annual payouts. The goal is to communicate how much a total account balance is worth when converted into a real (inflation-adjusted) income stream for life — which accounts for a reduction in purchasing power due to inflation. The current bond yield is the appropriate conversion rate to calculate the actual price of purchasing a real monthly payout. The yields on TIPS reflect the market price of hedging inflation risk and incorporate up-to-date market expectations about future inflation.

Applying a statutory interest or inflation rate to convert wealth into real income adds no information. Using a non-market interest rate has the same flaw as reporting account balances using non-market prices. Neither conveys the actual amount of income that can be purchased. This is true whether the income is purchased explicitly (through a life annuity, for instance) or derived from savings.

For example, how much income does a $1 million portfolio generate at retirement? If retirement lasts 25 years, a 4% rate can support a lifestyle of $61,544 a year. This calculation is based on a TIPS investment portfolio that is converted into a level of sustainable, inflation-protected income. Using this approach, a zero rate can support $40,000. However, current real rates — nominal rates minus the expected inflation rate — are below zero, which provides even less income; a rate of -1% supports a lifestyle of only $35,362 a year. Again, using current retirement income projections in a language employees understand is crucial.

4. Future income numbers should be presented in current 2020 prices. If the goal is to have enough money to spend in retirement, showing participants' income projections in today's dollars is the only meaningful measure of future buying power. We should not compare today's income to prices in 2047, when a cup of coffee could be $12. Future account balances in today's dollars should be converted into a monthly payment using an estimate of the cost of a real annuity, i.e., an annuity that guarantees a lifetime payment in inflation-adjusted dollars. The cost of a real annuity measures how much money needs to be set aside today to secure lifetime payments that rise (or fall) with inflation, which track the cost of spending more closely than nominal dollars. In this sense, the real annuity provides a better measure of the living standard that a given account balance can support. At the very least, if income projections are in nominal terms, benefit statements should clearly illustrate the impact of inflation over time, using market-implied future inflation rates from TIPS and U.S. Treasuries.

5. To account for uncertainty, plan participants should be provided with a range of potential outcomes. Employees need to know the range of projected incomes that they can expect to generate from their retirement savings (including Social Security income). They need a clear picture of where they are today — and where they might end up — if they're going to make informed decisions. Relating risk to the range of possible retirement incomes is an important part of that picture. The range will help people understand that there is uncertainty in future outcomes tied to future changes in market prices, inflation and real interest rates. The possibility of generating less monthly income than they might see as viable could persuade some participants to save more and retire later.

Dimensional Fund Advisors, where I am resident scientist, previously wrote a letter to the Labor Department encouraging the department to give DC plan administrators flexibility in the creation of predictable retirement income projections. I encourage others to get involved, we must communicate in ways participants already think and understand. Only then will we be able to take advantage of the income disclosure rules mandated by the SECURE Act.

Robert C. Merton is the distinguished professor of finance at the MIT Sloan School of Management and professor emeritus at Harvard University, Cambridge, Mass. He is also resident scientist at Dimensional Holdings Inc. and provides consulting services to Dimensional Fund Advisors LP. Mr. Merton received the Alfred Nobel Memorial Prize in Economic Sciences in 1997 for a new method to determine the value of derivatives. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.