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Retirement plans
should target income
as the outcome
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1 Retirement plans should target income as the outcome
Forward-thinking plan sponsors are committed to helping their
employees reach a secure retirement, and in recent years, they
have made great strides in getting employees engaged in their
own retirement readiness. Yet too many people are still not
prepared. A number of recent surveys have found that:
W 43% of Americans are concerned they won’t have enough moneyto live comfortably in retirement.1
W 45% of workers guess how much to save for retirement, instead of
using estimates or calculators.2
W Just 21% are planning to receive income from annuities, which
generate retirement income that individuals can’t outlive.3
Despite plan sponsors’ best efforts, many employees are still at a loss—a problem that
may largely come down to perspective. Traditionally, the industry standard for retirement
readiness has been a large nest egg. Employees and plan sponsors alike have focused on
growing savings, and retirement planning has addressed how much to save each year, what
risks to assume in various investments, and how to avoid fees and other costs that chip
away at employees’ total return. This approach has resulted in little guidance on how
employees can turn their nest eggs into retirement income that may have to last for the
next 25 or 30 years.
Instead of measuring retirement readiness by looking at accumulated savings alone, plan
sponsors should focus on the ultimate outcome of their plans: the income replacement
ratio, or amount of pre-retirement income individuals will need to live comfortably in
retirement. In simpler terms, measuring retirement readiness starts with determining
employees’ expected monthly budget in retirement based on their existing pre-retirement
monthly budget.
With this metric in mind, plan sponsors can now take a strategic approach to plan design
that can help employees meet their income or budgeting needs in retirement. This means
considering the individual needs and circumstances of their employees in both the savings
(accumulation) and the distribution (decumulation) phases. It starts with giving employees
the tools to set the right goals for retirement. An effective plan design then helps
employees meet those goals and links to products that yield retirement income streams
that will last a lifetime.
To measure retirement
readiness, plan sponsors
should focus on
the ultimate outcome of
their plans: the income
replacement ratio,
or amount of pre-
retirement income an
individual will need to live
comfortably in retirement.
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Retirement plans should target income as the outcome 2
The savings phase
How much should employees save for retirement?
Experts have different estimates as to what level of pre-retirement income workers should
target as a savings goal, but it is important to note that one universal number may not be
appropriate for all. Income replacement rates can vary widely from one person to another:
In fact, research shows that typical replacement rates can range from as low as 58% to as
much as 82%4 (see Exhibit 1).
Exhibit : People with higher pre-retirement income have lower replacement rates
Replacement rates as a percentage of gross preretirement income
W Social Security W Savings
> 75th
> $86,882
50th–75th
< $86,882
25th–50th
< $49,941
< 25th
< $25,870
Total=82%
Total=72%
Total=62% Total=58%
59% 38%
31%
31%
37%
21%
23%
34%
Gross Preretirement Income
Source: Marlena Lee, “The Retirement Income Equation,“ DC Dimensions (Summer 2012).
Note: Dollar figures shown above are in 2011 dollars
The projections or other information generated by Monte Carlo analysis tools regarding the likelihood ofvarious investment outcomes are hypothetical in nature, do not reflect actual investment results, and arenot guarantees of future results. Results may vary with each use and over time. These hypothetical returnsare used for discussion purposes only and are not intended to represent, and should not be construed torepresent, predictions of future rates of return.
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3 Retirement plans should target income as the outcome
By focusing on income replacement rates as the appropriate retirement goal, plan sponsors
can help employees determine how much they need to save based on their expected income
needs in retirement. Many factors play a role in determining the actual amount that
someone should save: income levels, portfolio returns, number of years until retirement,
and current and past savings rates, among others. The reality is that each individual may
have a different retirement replacement rate and thus may need to save a different amount.
Research indicates that workers on the lower end of the income spectrum will need a
relatively high share of their pre-retirement income, but they will require a lower rate of
savings during their pre-retirement years. A different story emerges for employees earning
more than $100,000 per year; according to this study, they will likely have to save
considerably more of their pre-retirement income, despite having a lower overall retirement
replacement rate.5 Due to regulatory savings limitations within defined contribution plans,
high-income employees may find it difficult to meet these savings goals through their plans
and may have to save outside of them. Savings options outside of the plan include individual
retirement accounts (IRAs), fixed annuities and other savings and investing accounts.
Plan sponsors should encourage their employees to maximize their retirement savings, with
an understanding that their savings rates may fluctuate over their careers. Workers may be
unemployed for a period of time, take time off to care for children or elderly parents, or
experience financial emergencies that affect their ability to maintain their target savings
rate. For this reason, employees need to save more aggressively when they can, to offset
those periods when they are forced to save less.
The reality is that eachindividual may have a
different retirement
replacement rate
and thus may need to
save a different
amount for retirement.
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Retirement plans should target income as the outcome 4
Plan design focused on outcomes
Engaging employees with an income replacement ratio is critical, but plan design is another
area where plan sponsors can use their influence to help employees reach their retirement
goals. The right elements of plan design can improve participation and savings rates,
investment performance and other plan metrics. Three practices that a plan sponsor might
consider are the use of automatic features, offering professionally structured investment
solutions, and making advice services available.
1. Automatic processes for enrollment and contribution increases: A good starting point is to
automatically enroll employees in a defined contribution plan the moment they become
eligible. Doing so can save employees from the negative consequences of inertia: Research
shows that applying automatic enrollment (as opposed to voluntary plan enrollment) can
have a big savings impact for all employees, especially those just starting out in their
careers. Workers between the ages of 25 and 29 who are automatically enrolled in their
plans could save as much as 2.39 times more of their final salary than their peers who are
left to enroll on their own.6
For those employees who are already enrolled in the plan but perhaps are not saving the
amount necessary to reach their target income replacement ratio, dynamic auto-
escalation™—which ties savings rates to income replacement ratios—can raise savings
rates to the appropriate level. The combination of these two automatic processes—automatic enrollment and dynamic auto-escalation™—can help plan sponsors create a
more meaningful plan design. This outcome-oriented approach can help accelerate
individuals’ savings at critical junctures, prevent common investor-driven errors tied to
market timing and keep employees on track to meet their goals.
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5 Retirement plans should target income as the outcome
2. Professionally structured investment solutions: The first step in designing a professionally
structured investment solution is to determine a meaningful goal. Many “comprehensive”
investment solutions focus only on inputs such as risk tolerance, performance, fees,
investment style and account balances. In other words, the goal of these solutions is wealth
accumulation. By contrast, we believe the goal should be sufficient income to maintain a
desired standard of living in retirement.
Professionally structured investment solutions take into account a wide range of elements
to meet employees’ retirement income goals. Each of these elements is important, as even
a relatively small change in performance can have a big impact.
We believe an appropriate professionally structured investment solution should:
W Target income as the outcome.
W Consider an asset allocation strategy in which the goal is to meet future income needs.
W Provide broad market exposure that offers employees access to a wide range of asset
classes, in order to diversify and target higher expected returns.
W Consider limiting exposure to company stock (in the case of corporate plans) in order to,
among other things, potentially avoid the “crowding out” effect in which this option
competes for an allocation over other asset classes.
W Use segmentation insights based on age, account balance, earnings potential and
retirement funding status to help different employee groups reach their income goals.
W
Strive for a low-cost “all-in” fee structure that is competitively priced; the goal is notnecessarily to obtain the lowest fee for each product or service, but rather to obtain the
best value for each of them.
W Preserve income and avoid relying too heavily on equities as an employee gets closer to
retirement and his or her earnings potential is low or depleted.
W Provide the opportunity to convert assets to lifetime income. This could include the use of
a low-cost, in-plan fixed annuity within the portfolio that gives employees the option to
annuitize and create a fixed income stream.
We believe the goal of a
professionally structured
investment solution
should be sufficient
income to maintain a
desired standard of living
in retirement.
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Retirement plans should target income as the outcome 6
3. Advice or other financial planning services: Advice can play an important role in workers’
retirement readiness. It can provide employees with specific recommendations around
savings rates, asset allocation, investment options and other retirement planning needs.
More important, employees seeking advice tend to take action. More than half of
employees (54%) who used an online advice service between February 2012 and January
2013 saved more, changed their future allocations or rebalanced their portfolios.7
Effective advice offerings should provide actionable recommendations; be unbiased
and personalized; and should recognize the importance of lifetime income.
Retirement planning should also take into account an individual’s complete financial picture,
including the rest of the household. Many advice services and offerings designed for DC
plans today don’t link to other employee assets such as previous employer-sponsored
plans, DB plans, outside savings, or spouses’ savings. An advisor or access to a financial
planning service can help workers aggregate their holdings in order to understand their
household balance sheet. Likewise, advisors and similar services can help employees
convert accumulated assets to lifetime income. For most, the retirement phase is the most
unique and complex financial time during a person’s life. Often, an advisor can help
coordinate an individual’s total household assets along with other goals in order to achieve
a desired standard of living throughout retirement.
Although every employee wants to live comfortably in retirement, there is no one-size-fits-all
approach to achieve that goal. Automatic features, professionally structured investment
solutions and advice services are all important elements that if used appropriately, can help
employees improve their financial well-being.
The distribution phase
Helping employees generate lifetime income
A plan sponsor’s role in retirement planning doesn’t end once an employee retires. In fact,
employees may need more help than previously as they face a daunting task: creating a
secure income stream to cover retirement expenses from accumulated savings. As they do
so, plan sponsors can help them navigate complex decisions: the risks they’re willing to
take with their accumulated assets, the rate at which they can withdraw their funds without
depleting their savings, the effect of inflation, the impact of health costs, and finally, therisk that they will eventually lose the cognitive capacity to manage their financial affairs.
By providing education on safe income withdrawal rates, plan sponsors can help retirees
address one of their most common fears: outliving their savings. This is a real possibility
because many employees do not know enough about sustainable income withdrawal rates.
A recent survey found that more than 33% of retirement plan participants had no idea howmuch they could safely withdraw; an additional 25% said they could withdraw 10% of their
assets per year and see their retirement savings persist.8 As a point of comparison, a 4%
withdrawal rate is often used as a rough rule of thumb for how much an individual could
withdraw from a retirement portfolio each year without depleting the retirement account.
A combination of annuitized income from fixed annuities,
Social Security, and pension benefits, if available, can serve as the
retirement income “floor” to cover essential living expenses.
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7 Retirement plans should target income as the outcome
But even with a 4% withdrawal rate, retirees are still exposed to many risks—such as
investment, longevity and cognitive risks—that could render the 4% withdrawal “rule”
irrelevant (see Exhibit 2).
In the face of so many risks, many employees need help in obtaining a steady income stream
that can last a lifetime, and is not affected by the highs and lows of market performance.
Fixed annuities can meet these requirements and are one of the few financial products that
can guarantee lifetime income and can only be issued by an insurance company.9
A combination of annuitized income from fixed annuities, Social Security, and pension
benefits, if available, can serve as the retirement income “floor” to cover essential living
expenses. But plan sponsors should communicate to their employees that annuitization from
fixed annuities is not an all-or-nothing proposition. Employees can determine whether to fund
their retirement solely with guaranteed sources of income or to maintain some flexibility and
control over their retirement assets by keeping a portion in other investment products.
Benefits of “in-plan” annuitization with fixed annuities
For employees to use fixed annuity options, they must first have access to them. Some
institutions offer fixed annuity products within the plan, but if they do not, then employees
must find retail fixed annuities on their own when they retire. Both “in-plan” and “out-of-
plan” fixed annuities are designed to deliver guaranteed lifetime income, but in-plan
solutions may offer employees a number of additional benefits.
W In-plan fixed annuities are offered in a controlled setting, with pre-screening and education
from employers. This can help employees understand how fixed annuities work and the
impact of saving on future retirement income within the context of their plan: Employees
can see, in dollars and cents, how a little more saved during their working years can
translate to a higher retirement income. Making this connection makes employees more
likely to save more effectively and regularly.10
Exhibit : A single-life annuity offers consistent income throughout retirement
W Required minimum distribution W 4% withdrawal W Single-life annuity W Self-annuity
Age
$7,000
65 70 75 80 85 90 95 100 105 110 115
$6,000
$5,000
$4,000
$3,000
$2,000
$1,000
$0
A n n u a l r e t i r e m e n t i n c o
m e
This model assumes that a person has annuitized $100,000 at age 65 at a 3% interest rate. For illustrationpurposes only. Actual payouts may differ. Three percent nominal interest rate return assumption for all
calculations. Single Life Annuity (SLA) based on 3% payout rate. Self-annuity payout (in which a persontakes the needed amount out of savings rather than annuitizing) set to replicate payout amount of theSLA. Required minimum distribution payout uses Social Security unisex mortality table for remaining lifeexpectancy. All amounts are pretax.
Source: Richardson, David P. (2012) “The Role of Guaranteed Income in Improving Retirement Security.”TIAA-CREF Institute Working Paper.
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Retirement plans should target income as the outcome 8
W Plan sponsors can generally negotiate lower costs for fixed annuities than individuals
using an out-of-plan option.11 This is important, because lower costs can contribute to
higher income payouts.
W Research shows that individuals who contribute to fixed annuities while they are saving
are more likely to annuitize a portion of their savings and receive retirement income in the
form of lifetime annuity payments. Without access to an in-plan fixed annuity, employees
may not save for retirement through an outside fixed annuity and therefore may be less
likely to annuitize their savings upon retiring.12
Meeting your fiduciary obligations with in-plan fixed annuities
When considering an in-plan fixed annuity, plan sponsors often express concerns over the
fiduciary obligations associated with selecting a fixed annuity product and provider. The reality
is that the principles and processes governing the selection of a fixed annuity product and
provider are in many ways similar to those used in the selection of mutual funds and other
investment options. And those sponsors that already offer an annuity option at the point of
distribution may not realize they may already share the same level of fiduciary obligations as
sponsors that offer an in-plan fixed annuity.
In general, the standard test for meeting that fiduciary responsibility comes down to following a
careful process in the selection and then monitoring of the fixed annuities and any insurancecompanies whose fixed annuity products are made available to employees. In carrying out its
duties, a fiduciary should adhere to the so-called “prudent expert” standard, which calls on plan
sponsors to exercise “the care, skill, prudence and diligence” that would be employed by a
“prudent expert acting in a like capacity and familiar with such matters” and with the same goals.
This standard therefore calls on plan sponsors to engage in a careful assessment of
products and fixed annuity providers, guided by experts when needed and informed by a
risk-based review of a provider’s ability to honor its guarantee which may include a fixed
annuity provider’s ratings by insurance ratings services.
For those plan sponsors seeking greater assurance that they are meeting their fiduciary
obligations to a plan, they can turn to the Department of Labor’s safe harbor that became
effective in December 2008. This safe harbor follows the same basic principles we alreadymentioned, in addition to requiring plan sponsors to consider the costs versus the available
benefits and administrative services of the fixed annuity. To be clear, plan sponsors may
choose to follow the safe harbor to meet their fiduciary obligations, but they don’t have to.
Many of these issues have been tested in the courts, and the relevant rulings provide
valuable guideposts for the expectations, as well as the limits of liability, for providers.
The principles and
processes governing the
selection of a fixed
annuity product and
provider are in many way
similar to those used in
the selection of mutual
funds and other
investment options.
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9 Retirement plans should target income as the outcome
Leading the way to a secure retirement
Employees face a challenging road to retirement, but plan sponsors can help them down
this road by focusing on what our research indicates is the right goal for most employees:
an income replacement rate that will meet lifetime income needs. With this goal in mind,plan sponsors can design their plans for both the savings and distribution phases, helping
employees pave the way to a secure retirement.
Automatic features can address the need to save early and save more; professionally
structured investment solutions can set the right risk-return strategies; and low-cost
investment options can help employees make the most of their savings. However, saving
the right amount for retirement may not be enough. Retirees may also need help creating a
secure income stream that will last a lifetime. With all the risks facing retirees, the use of
guaranteed products can form the building blocks for a secure source of retirement income.
By offering fixed annuities, plan sponsors can go beyond today’s requirements and set a
higher standard of fiduciary responsibility.
In the end, what matters most to many retirees is not how much they have saved, but howtheir accumulated savings can translate into a lifetime of income. Plan sponsors can help
them achieve their goals by promoting active savings, smart investing, and wise choices in
products that guarantee a lifetime of income.
What matters most to
many retirees is not howmuch they have saved,
but how their accumulated
savings can translate
into a lifetime of income.
Fiduciary checklist
Plan sponsors may find it easier to follow an established checklist
to help guide the processes of selecting a fixed annuity provider
and conducting due diligence. This fiduciary checklist should
include a review of a fixed annuity provider’s:
W Strength and stability, which can be assessed through the insurance company’spublicly available information;
W Ratings and financial strength;
W Track record and reputation as a well-known insurance company in the fixed
annuity field;
W Costs that can reduce financial benefits to the participants through sales charges,
commission, surrender fees and other expenses;
W Transparency to determine whether the information to be reviewed is clear and
readily available; and
W State guarantees, which consider the availability of state guarantee insurance in
the states where the plan sponsor is located (and where most plan participants
reside) and the extent of guarantee coverage for fixed annuity contracts.
This checklist is not intended to define the fiduciary process for selecting a fixed
annuity provider but to provide a list of some best practices that will assist
fiduciaries in performing their duties. In this light, the checklist should be viewed as
a tool that fiduciaries may consider using in helping them fulfill their duties and
documenting that they have done so.13
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Retirement plans should target income as the outcome 10
1 The findings come from TIAA-CREF’s first Lifetime Income Survey, conducted by an independent research
firm between January 3 and 5, 2014. Polling was among a national random sample of 1,017 adults, age
18 years and older.2
Employee Benefit Research Institute, 23rd Annual Retirement Confidence Survey, 2013.3 The findings come from TIAA-CREF’s first Lifetime Income Survey, conducted by an independent research
firm between January 3 and 5, 2014. Polling was among a national random sample of 1,017 adults, age18 years and older. Income from an annuity is based on the claims-paying ability and strength of theissuing company.
4 Marlena Lee, “The Retirement Income Equation,” DC Dimensions (Summer 2012). See “MethodologySupporting Savings Rates and Replacement Rates” in the disclosures.
5 Marlena Lee, “The Retirement Income Equation,“ DC Dimensions (Summer 2012)6 Employee Benefit Research Institute, Issue Brief No. 341, April 20107 Based on 2013 TIAA-CREF proprietary research of 17,741 TIAA-CREF participants who used TIAA-CREF
Retirement Advisor (online advice) from February 2012 through January 2013 and took action within thesame time period.
8 DrinkerBiddle, “Lifetime Income in Defined Contribution Plans: A Fiduciary Approach.”9 Source: American Council of Life Insurers (ACLI). Guarantees based on the financial strength of the
issuing company.10 Paul J. Yakoboski, “Retirees, Annuitization and Defined Contribution Plans,” Trends and Issues, TIAA-CREF
Institute, April 2010.11 TIAA-CREF, “Investing for a Lifetime. Guaranteed.”12 Paul J. Yakoboski, “Retirees, Annuitization and Defined Contribution Plans,” Trends and Issues, TIAA-CREF
Institute, April 2010.13 DrinkerBiddle, “Lifetime Income in Defined Contribution Plans: A Fiduciary Approach.”
Dimensional Fund Advisors LP (“Dimensional”) is an investment advisor registered with the U.S. Securitiesand Exchange Commission. Dimensional does not issue or distribute annuities or insurance products orprovide legal or tax advice.
The information herein is for informational purposes only and is not intended to provide legal advice. Pleaseseek advice from appropriate counsel before taking any action.
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This material is solely for informational purposes and shall not constitute an offer to sell or the solicitationto buy securities or investment services. The opinions expressed herein represent the current, good faithviews of [Dimensional] at the time of publication and are provided for limited purposes, are not definitiveinvestment advice, and should not be relied on as such. The information presented in this article has beendeveloped internally and/or obtained from sources believed to be reliable; however, [Dimensional] does notguarantee the accuracy, adequacy or completeness of such information. Predictions, opinions, and otherinformation contained in this article are subject to change continually and without notice of any kind andmay no longer be true after the date indicated. Any forward-looking statements speak only as of the datethey are made, and [Dimensional] assumes no duty to and does not undertake to update forward-looking
statements. Forward-looking statements are subject to numerous assumptions, risks and uncertainties,which change over time. Actual results could differ materially from those anticipated in forward-lookingstatements. This material is directed exclusively at investment professionals. Any investments to which thismaterial relates are available only to or will be engaged in only with investment professionals.
The material is for informational purposes only and should not be regarded as a recommendation or an offerto buy or sell any product or service to which this information may relate. Certain products and services maynot be available to all entities or persons. Past performance does not guarantee future results.
TIAA-CREF products may be subject to market and other risk factors. See the applicable product literature,or visit tiaa-cref.org for details.
Annuity account options are available through contracts issued by TIAA or CREF. These contracts aredesigned for retirement or other long-term goals, and offer a variety of income options, including lifetimeincome. Payments from the variable annuity accounts [and mutual funds] are not guaranteed and will rise orfall based on investment performance.
Annuity contracts and cer tificates are issued by Teachers Insurance and Annuity Association (TIAA) andCollege Retirement Equities Fund (CREF), New York, NY.
©2014 Teachers Insurance and Annuity Association of America-College Retirement Equities Fund, New York,NY 10017
Methodology Supporting Savings Rates and Replacement RatesDimensional simulated income and portfolio paths of 10,000 households. The working years are age25 to 65, and full retirement occurs at age 66. Final pre-retirement income matches the actual incomedistribution of households age 60 to 64 in 2009. i Pay raises and port folio outcomes are jointly drawnfrom historical distributions of changes in real per-capita income and real stock and bond returns overthe period from 1930–2010.ii Each year, the households save a fixed fraction of their gross income in aRoth retirement vehicle. The portfolio is invested in stocks and bonds, with the percent invested in stocksequaling 100% – age.
We assume households with below (above) median final income want to replace 100% (90%) of pre-retirement spending, where pre-retirement spending equals gross income—less savings, federal incometaxes, and FICA taxes—estimated using current tax laws and standard deductions.
A household’s spending is partially funded by Social Security, but any shortfall is financed using personalsavings. The table below shows the savings rates needed to achieve this spending level (or more) with
75–90% probability, assuming the price of a $1 real annuity is $20. Even with a Social Security replacementrate of 59% for the lowest income quartile, savings must be about 10% to maintain at least the same levelof pre-retirement spending in about 85% of the simulations. For households with annual income exceeding$25,870, a savings rate in the low teens is required to maintain spending levels with high probability.
Notesi. Source: US Census Bureau. 2010 Current Population Survey. Annual Social and Economic Supplement.
ii. Real changes in per-capita income obtained from Bureau of Economic Analysis. National Income andProduct Accounts tables. The assumption that the household does not defer taxes allows me to completethe analysis without having to make predictions about future tax rates.
The projections or other information generated by Monte Carlo analysis tools regarding the likelihood ofvarious investment outcomes are hypothetical in nature, do not reflect actual investment results, and arenot guarantees of future results. Results may vary with each use and over time. These hypothetical returnsare used for discussion purposes only and are not intended to represent, and should not be construed torepresent, predictions of future rates of return.
Circumstances can cause substantial deviation from the estimates. This could result in declines in anaccount’s value over short or even extended periods of time. Results may vary with each use and over time.
Percentage of pre-retirement income
< $25th 25th–50th 50th–75th > 75th
Pre-retirement income range < $25,870 < $49,941 < $86,882 more than $86,882
Median effective tax rate 8% 14% 18% 21%
Savings rate 9%–11% 13%–15% 12%–14% 13%–16%
Spending adjustment 0% 0% 10% 10%
Replacement Rate
Total 81–83% 71–73% 61–63% 57–59%
Social Security 59% 38% 31% 21%
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