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A New Way of Thinking about Your 401(k)

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Matt Schifrin of Forbes was absolutely correct when he described the retirement crisis as a gigantic socioeconomic problem that should be weighing heavily on policymakers. Schifrin cites Federal Reserve data showing that only 52% of Americans have saved anything for retirement, and for those aged 55 to 64 who have retirement accounts, the median balance was $100,000. Based on recent price quotes obtained by IFA for single premium immediate annuities, for a 67-year-old male, $100,000 will buy an annual lifetime payout of either a constant $7,456 or $5,417 that increases with inflation. For a 67-year-old female, the amounts are $7,020 and $5,161, respectively. If a retiree’s only other source of income is Social Security which currently has a maximum benefit payment of $30,396 for somebody retiring at Full Retirement Age, then his total income may be substantially lower than what he had anticipated. Factoring in ever-increasing life expectancy, many soon-to-be-retirees are in for a rude awakening, or as Bill Bernstein would say, they had better learn to like vacations very close to home.

Dimensional Fund Advisors (DFA) has taken an important first step in addressing this issue. As DFA’s founder and chairman, David Booth put it:

“Once you’re lucky enough to be a firm of our size [$315 billion under management], you kind of start to think about what it is that you really want to do. Helping people solve this problem is just about as cool as it gets. And we’re in a position with these great financial thinkers that we’d like to take a crack at that. That’s kind of going to be the focus of the firm, going forward.”

Mr. Booth was referring to the Dimensional Managed DC program which is a personalized investment strategy designed to help participants convert their working income into an inflation-protected retirement income. It creates and regularly updates a custom portfolio allocation for each participant, steadily targeting a monthly income in retirement. Upon retirement, the account balance can be used to purchase an annuity with inflation-protection, using institutional pricing without commissions, or it can be taken as a lump sum. Leading the great financial thinkers of Managed DC is 1997 Nobel Laureate MIT economist Robert C. Merton. The all-star team also includes the newly minted Nobel Laureate Eugene Fama of the University of Chicago Booth School of Business and his long-time collaborator Ken French of the Tuck School of Business at Dartmouth College. The underlying software of Managed DC is SmartNest, which was developed in the Netherlands by Robert Merton and Boston University professor Zvi Bodie. SmartNest adheres to the principles of liability-driven investing. Rather than showing plan participants the size of their current account balance, it communicates the amount of income they can expect to receive upon retirement, and more importantly, they can immediately see the potential impact of changes to their savings rates or their planned retirement age. As Michael Lane, the chief executive of Managed DC, explains:

“In some ways it’s a back-to-the-future movement. SmartNest wanted to create a defined contribution plan that looked like a defined benefit plan in terms of reporting, where you’d see everything in income terms. Because it doesn’t matter what it is in principal value—what matters is what it’s going to give you every month.”

Managed DC takes the problems of determining asset allocations and appropriate savings rates out of the hands of plan participants, most of whom are not qualified to do so, through no fault of their own. As Merton hilariously describes it:

“It is like being a surgical patient who, while being wheeled into the operating room, has the surgeon lean down and say, ‘I can use anywhere from 7 to 17 sutures to close you up. Tell me what number you think is best.’”

Managed DC shows plan participants the things that they should actually care about: a desired income target based on a percentage of pre-retirement income, the probability of achieving the desired income, a conservative income target that can be achieved with a 96% probability of success, planned 401(k) contributions as a percentage of income, and planned retirement age. Since the system is fully integrated into the company’s 401(k) plan, it will know your current income, your projected Social Security benefits, and any company match to your 401(k) contributions.

Each plan participant is invested in a mix of three DFA portfolios: a global equity fund and two inflation-protected fixed income funds of differing maturities. DFA’s fund management fee is 0.30%. DFA’s approach to determining the asset allocation for each plan participant is markedly different than merely assigning them to a target date fund, as it fully considers where the participant stands relative to his target income that will begin on the target date. In the case where the participant is assured of meeting his goal, risk can be taken off the table. Managed DC also addresses the problem of inertia wherein plan participants fail to act upon advice received in a timely manner. In the Dutch companies where it was offered, SmartNest was used by as many as 50% of plan participants, and of those, 50% ended up saving more.

To learn more about Dimensional Managed DC, please take a few minutes to watch the video below.

If you would like to learn more about how IFA can help you establish a fiduciary-guided retirement plan that is truly in the best interest of plan participants, please fill out IFA’s Retirement Plan Scorecard.