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Millions of college students across the US graduate each spring and enter the workforce. When today’s retirees entered the workforce in the early 1980s, pension plans and Social Security benefits were two of the main sources of retirement income. Just a couple decades later, defined benefit (DB) plans were overtaken by defined contribution (DC) plans such as 401(k)s, and an aging population was slowly depleting the Social Security Trust Fund. This was a massive shift in a relatively short period of time, and it forever changed one of the most important and challenging aspects of personal finance.

Workers are facing another pivotal moment in retirement saving, especially as higher interest rates change the investment landscape. Can pensions make a comeback in a world of higher interest rates? What’s increasingly clear is that employer-based plans will play a crucial role in helping people financially prepare for retirement. This episode of The Outthinking Investor brings together fresh perspectives on the future of DC and DB plans in a higher-rate environment, expanding investment options in retirement plans, retirement challenges arising from an aging workforce and growing debt, and more. Our guests are Barb Marder, CEO of the Employee Benefit Research Institute (EBRI); Brooke Masters, US financial editor of the Financial Times; and Josh Cohen, Head of Client Solutions for PGIM DC Solutions.

For more retirement insights, listen to The Accidental Plan Sponsor, a podcast series from PGIM DC Solutions.

Follow PGIM’s The Outthinking Investor in your favorite podcast app.  

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Episode Transcript

>> In the spring of 2024, 4 million college students graduated across the US. Most of these graduates will spend around 44 years in the workforce before they retire, at least by today's standards. But what will retirement look like in the year 2068? Will 65 still be the standard age of retirement? Will Social Security even exist? When today's retirees entered the workforce in the early 1980s, defined benefit pension plans and Social Security were two of the main sources of retirement income. Just a couple of decades later, DB plans were overtaken by defined contribution plans, and the aging population was slowly depleting the Social Security trust fund. Not only was this a massive change over a short period of time, but it impacted one of the most important aspects of personal finance, retirement readiness. Today, retirement seems to be at a pivotal point. As years in retirement increase, what can employer-based plans do to help close the retirement funding gap that additional longevity has created? To understand today's investment landscape, it's important to know how we got here. This is The Outthinking Investor, a podcast from PGIM that examines the past, the present-day opportunities, and the future possibilities across global capital markets. Barb Marder is CEO of EBRI, the Employee Benefit Research Institute. Brooke Masters is US financial editor of the Financial Times. And Josh Cohen is the head of client solutions for PGIM's DC Solutions. Since DC plans were created in 1978, the retirement industry has made good progress in improving plan design and investment options. But are near retirees getting better at saving? And are retirees better at planning for and managing their retirement income? Josh Cohen is optimistic, yet realistic.

>> I don't think we're quite there yet. Very famously, Nobel Prize winner Bill Sharp said the retirement income problem is the nastiest, hardest problem in all of finance, and this is someone who won the Nobel Prize. And the reason is it's not just a math problem, it's actually a behavioral problem, as well. So this really is one of the greatest challenges facing American workers and retirees today. Let's just say they've done enough to save for retirement. That's an issue in and of itself. Too many people aren't saving enough to even build that nest egg to be ready for retirement, but we're doing a lot of work there in the industry, and there's a lot of progress being made. But let's say they have built enough. How do you convert that money that you've saved and invested into an adequate income stream that will last you through retirement? There's a lot of things you have to think about. What do I invest in? How much can I withdraw each year? When should I claim Social Security? Should I buy an annuity? An annuity is one of the toughest challenges of them all. Actuaries and investment professionals will understand academically and intuitively why an annuity can really help with longevity protection, protect against market risk, but that's a very hard behavioral topic for many individuals. You know, very famously, many say I had a million dollars and now I need to live on $70,000 a year. That may be good from an actuarial perspective, but it's very hard for the average individual to turn over let's say a million dollars to an insurance company and give up those assets. So that's why it's a tough issue, and I don't think many are prepared for this at this point.

>> Perhaps that's partly driving a recent role reversal. After a long and steady shift from DB to DC plans over 40 years, we're now seeing interest grow in DB plan expansion. Brooke Masters explains.

>> The vast majority of employers are in DC plans and are happy in DC plans. But if you are an employer that already has a DB plan, there's been this big shift as interest rates have gone up, because as interest rates go up, you need less money in your defined benefit plan to provide enough benefits for all of your beneficiaries. It's straight accounting rules, and also it's just the fact that like, you know, you can - with cash, you can get 5%. So what that means is defined benefit plans that have a pot of money, after years of being in shortfall and worrying about whether they have enough money to take care of their participants, suddenly have basically more money than they need. Now, the way the laws are set up, that money is not useable for anything other than pensions. However, if you're a company that has both plans because you have an old defined benefit pension plan and you have a DC plan, there's an interesting maneuver, and IBM led the way by doing this in January 2024, that - they decided that for current employees, they were going to reopen their defined benefit pension plan and start giving employees some of that extra money. They're basically giving them an account, using that extra money that they suddenly now have, and then they don't, that means, have to match the employees' 401k contributions. And 401k matches are straight costs every year. They're operating and they come off the company's profits. If you can use the money that's already locked up in your defined benefit pension plan instead, that instantly boosts your profits.

>> Technically, the way IBM provided this extra DB benefit was through a cash balance plan, a type of defined benefit plan that's different than the typical pension plan. Instead of guaranteeing a set amount of money, a cash balance plan defines the share that each participant will receive. So the actual amount does depend on investment performance, but it's professionally managed and there is pooled risk.

>> There's going to be some kind of guaranteed cash pot at the end, and you don't have to worry quite so much about market risk. And so in a tight labor market, which is what we are in now, it is also an advantage. So if you're looking for ways to motivate employees, it's a clever thing to do. And in tech, for example, you know, providing solid, lifelong pension guarantees makes you different than the hope that you can invest in some loss-making startup, it may be the [inaudible], and you'll make money in years and years and years. And so it is a good way to differentiate yourself and perhaps pick up some employees.

>> What does the bigger picture look like, here? According to EBRI's research published last year, the number of organizations offering both a DB and DC plan are only about 8% of total organizations with retirement plans, and not all of these will have enough surplus to be able to consider expanding access to their DB plan. So this looks less like a sea change than a targeted and tactical opportunity. Barb Marder provides context.

>> I remember back in my actuary days when all of my time was spent trying to come up with creative uses of surplus funding that was in the defined benefit plans. But as we all know, times change. Interest rate environment changed, the markets change, and all of the sudden, those plans that had surpluses no longer had surpluses, and then often, sometimes had deficits. One of the things that's really interesting about the IBM, kind of the combination of plans now is defined benefit plans have to offer some type of annuity payment at retirement. Cash balance plans typically also paid lump sums, but their defined benefit plans are required to have an annuity option. And with all the talk now about decumulation and helping 401k participants figure out how to spend down their assets and interest in retirement income products, it's interesting to think about this contribution that's going into the cash balance plan as perhaps an annuity option for participants who want to take some of their retirement income as an annuity. So it is an interesting way to view the 2 plans together as a benefit to planned participants. On the flip side, since there's no match required any longer to get the 5% contribution that's going into the cash balance plan, will participants cut back? Because a lot of participants do contribute the amount needed to get the maximum match. So I mean that's one thing that will be interesting to keep an eye on. And then there are some interesting things about how interest credits are used in cash balance plans and while they do actually offer protection, the upside is capped as well. So participants who perhaps were more heavily invested, for example, in equities and looking for upside in the 401k plan may not realize those same returns in the cash balance plan. But again, there is a benefit to participants in terms of that downside protection.

>> Are we likely to see more plans follow IBM's lead? According to Brooke Masters, there's a lot of interest. But interest may not necessarily translate into action.

>> IBM is by far the most prominent, but when you talk to the consultants who work with companies that have defined benefit pension plans, there is tremendous amount of interest in whether people should do this, because lots of plans have moved into surplus, which means that the money saving aspect of shifting to - reopening your pension plan becomes attractive. You have to be in surplus to do it. It's not clear how many will stay in surplus and it's not clear how many will move forward, but they're asking a lot of questions about it, and there's certainly a focus on it.

>> If DC plans continue to be a main source of retirement income, participants will need more and better tools to help save for retirement and manage income in retirement.

>> Many of the investments that are on menus today are not sufficient to help retirees and the types of asset classes they need, particularly around things like additional fixed income assets, additional real assets, some alternative assets to help manage inflation risk, draw down risk, interest rate risk. We think there's probably a need for more longevity-protected solutions, you can call these annuities or other types of risk-sharing products, but I think what most people actually need first and foremost, is access to better advice and education. Again, this is a really hard problem. How do we use technology to provide more personalized education and advice to individuals that is well-priced, unbiased, and that will help people answer a lot of these questions around how much can I take out each year? What should my portfolio look like? Should I buy an annuity? We think technology is going to need to play an important role to provide more personalization and guidance for workers.

>> Can we expect DC plans to increase offering alternative investments, like private equity and real estate.

>> I'm a big believer in providing the typical American worker more access to the types of investments that high net worth investors and institutional investors have used for a long time in their portfolios and are continuing to look for to generate returns. There's real tension going on with planned sponsors who believe this from an investment perspective but are concerned and they're not moving forward significantly because of their risk management and concerns from a fiduciary perspective. I think the workplace savings plans is a natural place to provide this access to the typical American worker. These plans have strong fiduciary oversight and professional management. There is a planned sponsor and often a consultant and an advisor who has high fiduciary standards who is looking after this, and picking the investments, and deciding how to put it in a menu. You can embed them in professionally managed solutions like a target date fund. And retirement is a long-term horizon. These private assets are longer-term investments. Unfortunately, we provide daily trading and the ability to have daily valuation in DC plans, and there's some reasons to be able to have that liquidity, but most investors don't trade everyday or every year, even. I think the stats show maybe 15% of defined contribution participants make a trade every year, and the next year, it's 13% of that, 15%. It's the same folks who are trading. Eighty-five percent of people are rarely making trades in their DC plan. So why not invest in things that have more liquidity and you can reap the benefits of that over the long term. Very interestingly, we've done research that shows expanding the portfolio to include investments outside of traditional stocks and bonds can add 5 plus years of additional income for retirees. I think it's a real fairness issue.

>> In reality, that's not happening much. At least, not yet. Only about 5% of DC plans offer some kind of alternative investment option. Barb Marder highlights some of the key factors.

>> It certainly creates an interesting opportunity for investors, but there are also typically higher fees associated with private equity and alternatives, and those fees typically do get passed back to participants, as well as liquidity concerns with many of the private equity and alternative investments. I did see one plan that is offering, I believe a real estate investment option. Not an REIT, but an actual daily traded real estate fund, and what that sponsor did was they placed a 25% limit on investing in that. So no one could put 100% of their money in an end up in a bad situation, but they also were clear to pick a fund that did offer this daily liquidity, as well as daily valuation. So will the market emerge with more options like that where you can still dabble in alternatives, private equity, real estate, but still be able to have daily liquidity, daily valuation, and reasonable fees so that plan sponsors will feel more comfortable going in that direction?

>> Recent EBRI research echoes Bill Sharp's observation that retirement income is the nastiest problem in finance.

>> We asked workers and retirees that as they think about their financial priorities in retirement, which is more important: income stability or maintaining wealth? Nearly three-quarters of workers and two-thirds of retirees prioritized income stability. So you would think, if that were true, that three-quarters and two-thirds of retirees would be actively looking and choosing between some of these products that offer income stability. But that's not the case. There's relatively low usage of retirement income products, at least the traditional ones. We were trying to understand why do people say they want something, but yet do something different? I do think a big piece of that is just a lack of understanding of what's out there and how these different products work, and if they actually did understand, they'd be much more inclined to go in that direction.

>> The same study also provided behavioral insights on workers and retirees that helped to explain the underutilization of retirement advice and retirement income products.

>> What that same study showed is that half of retirees prefer managing assets on their own, rather than purchasing a guaranteed lifetime income product. For many people, they've built up this nest egg that could be larger than almost any other pool of income or assets that they have, and now we're saying okay, turn it over to someone else who is going to provide me with that stability. That leap is very hard, that giving up of control. So again, some of the newer products that don't require giving up all of that amount to buy something, where you give up a partial amount of assets or you're actually building up almost a side account to buy something with it. I think getting to that behavioral issue around being able to give up control is really important. The second thing is around confidence. When we asked how confident workers will be and retirees actually are, that they know how much money to draw from their retirement savings to fund their retirement, close to two-thirds of workers and three-quarters of retirees say they're confident they know how to draw down their retirement saving. So if that's true, why would anyone need to turn money over to someone else to manage it and to provide that income stability? The workers and retirees are saying I've got confidence that either I will be able to do that, or I can do it. The question I would have is is it confidence or is it overconfidence?

>> Might any of the regulatory changes that are currently in discussion help to improve retirement outcomes?

>> We're still bedding down the changes that were made in what's known as Secure 2.0. I think once that beds down, there will probably be more effort to address this question of longevity. One of the things that was part of Secure 2.0 is they started letting companies count payments on a student loan to get the employer match on retirement savings. So that means a kid who's come out with $100,000 worth of debt and really cannot afford to be putting 10% or 5% into their retirement can count their payments on that towards their 401k match, so they at least get the employer side of it. And so that will start to mitigate the problem of people who just have nothing in their plans.

>> Added to this are the many initiatives looking to expand access and increase participation.

>> One thing that we're hearing more about is a concept more around universal coverage and whether it's the TSP, the Thrift Savings Plan for all where there would be mandates to enroll everyone in some type of federal plan, or it's the state-by-state mandates of offering the IRA type plans. That feels like the biggest trend at the moment, and I believe either all or many of those proposals include auto-enrollment so that new plans are established, everyone would be automatically enrolled. So not only do you address coverage, but you also address participation. Now, of course, people can opt out, and many do, but you're still maximizing the opportunity to cover as many people as possible and have as many people as possible participating in the plan, as well.

>> The underlying challenges around retirement are not unique to the US. Other countries are facing similar hurdles, and some are coming up with different solutions.

>> Many countries are facing very similar issues to the US. This shift DB to DC is a global phenomenon. A lot of that is the low interest rate environment, but greater longevity, an aging workforce, a mobile workforce, and strains on Social Security systems are really a lot of the forces that are happening globally. The Netherlands, which was a traditional DB system, was always a top 1, 2, or 3 ranked system. They are moving this highly ranked system from a DB to a more DC type of approach. Now, it's not going to be completely DC. There is some more collective risk sharing in their new model, but it is more to a DC approach where risk is shared more amongst the pool of retirees instead of by the employers. I think the UK has also been a fascinating system. About 10years ago, they mandated that all employers of any size had to offer a plan and automatically enroll participants. We're seeing very low opt out rates, so a lot more people are saving for retirement, but they're also realizing things like people need help with emergency savings. If we're forcing or defaulting a lot of people to save more, do they have enough if their car breaks down, if they have a medical emergency and they need some more liquid savings? The other trend that I'm really seeing is the public and private looking for more alternatives in the retirement system. Australia has done this in their well-regarded superannuation system, but many are realizing there's a lack of private investments as we move from DB to DC. The UK had a very interesting initiative called The Mansion House Compact where between government and retirement plans, there's an agreement to include more liquid private assets.

>> At the other end of the spectrum, pension risk transfers are also getting a second look.

>> While interest rates stay high, I think we will continue to see these transfers, and they will probably also be more scrutiny of them, and probably they will be better handled, and the awful, worst case, long-tail things that can happen will be more addressed. We'll figure out how to avoid problems. It makes a lot of sense that insurers who are used to managing for 30-year liabilities take over this responsibility because that's what they do for a living, as opposed to a sort of you know, your average car company. They're not experts at doing this, and particularly if they're mid-sized, they don't even have the staffing to do a good job of managing these benefits. So they're invariably paying other people to do it already. So just pushing it off to somebody, as long as it's somebody reputable with a proper capital structure, it makes a lot of sense.

>> Funding a secure retirement may indeed be the most complex and challenging problem in finance. It takes diligence, creativity, and commitment.

>> Retirement is such a long-term issue, but many of us are short-term thinkers. That includes individual savers, that includes companies who are very focused on their quarterly earnings and bottom line. That includes politicians who are very concerned about the next election. But figuring out and having robust retirement systems and saving, that takes a long-term mindset.

>> A long-term mindset is indeed what's needed to make significant progress in the US. In the 2023 Global Pension Index produced by Mercer and the CFA institute, the US retirement system was graded C-plus. According to the report, it has some good features, but also major risks and/or shortcomings, and long-term sustainability can be questioned. So not only is there room for improvement, but major improvement is critically needed to sure up the key component of the country's economy, and time may be running out. Thanks to our experts, Barb Marder, Brooke Masters, and Josh Cohen. The Outthinking Investor is a podcast from PGIM. Follow, subscribe, and if you like what you hear, go ahead and give us a review. If you enjoyed this episode and want to hear more on all things DC, listen to PGIM's The Accidental Plan Sponsor podcast series. Just click on the link in the show notes.

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