The next step in the transition from defined benefit to defined contribution (DC) retirement plans is for DC plans to offer retirement income programs that retirees can use to convert their account balances to periodic retirement income, the Stanford Center on Longevity and the Society of Actuaries Committee on Post-Retirement Needs and Risks say in a research paper.
The research report helps plan sponsors, advisers, and retirees achieve this goal by demonstrating an analytical framework and criteria for helping them evaluate and compare a variety of possible retirement income solutions. The goal is to further understanding about how to use various retirement income generators (RIGs) to meet specific retirement planning goals.
The Society of Actuaries and the Stanford Center on Longevity analyzed retirement income generators and found there are several ways for DC plans, advisers and participants to approach lifetime retirement income.
The first strategy focuses on straightforward RIGs that can currently be made available in DC plans, including single premium immediate annuities (SPIAs), guaranteed lifetime withdrawal benefit (GLWB) annuities, and systematic withdrawal plans (SWPs) using invested assets. Within a DC retirement plan, an SWP can be implemented as an administrative feature using the plan’s investment funds.
The report notes that SPIAs provide higher expected lifetime retirement income than investing approaches that self-fund longevity risk. As a result, dedicating more savings to annuities guarantees that retirees cannot outlive their income and increases expected lifetime retirement income. But devoting savings to annuities reduces accessible wealth and potential inheritances throughout retirement.
RIGs that invest savings provide access to unused savings throughout retirement, whereas annuities generally do not provide such access. As a result, dedicating more savings to investing solutions increases accessible wealth and potential inheritances, but decreases expected lifetime retirement income. Having access to savings provides flexibility and the ability to make mid-course corrections throughout retirements that can last 20 to 30 years or more. Note, however, that there will be no further income and no accessible wealth and inheritances if retirees outlive their savings due to living a long time and/or poor investment experience.
GLWBs are hybrid solutions that both guarantee lifetime retirement income through longevity pooling and provide access to savings. These products project less lifetime retirement income than SPIAs and less accessible wealth than pure SWP strategies, but may represent a reasonable compromise between competing retirement income goals.NEXT: Other retirement income strategies
The second strategy—using retirement savings to enable delaying Social Security benefits—increases projected average retirement incomes for all retirement income solutions studied, the report notes. Researchers’ projections assumed retirement at age 65, with the retiree withdrawing from savings the amounts sufficient to replace the Social Security benefits that are being delayed to age 70. The estimated amounts needed to replace Social Security benefits between ages 65 and 70 were assumed to be set aside at age 65 and invested in cash investments.
The third strategy is to combine qualified longevity annuity contracts (QLACs) with SWPs. A QLAC is a type of deferred income annuity (DIA) that delays the start of income until an advanced age such as 80 or 85. The potential attraction of a strategy that combines SWPs and QLACs is to try to realize the best features of both systematic withdrawals and annuities. To achieve this goal, a large portion of assets remain invested to generate retirement income and are accessible and liquid. A relatively small portion of initial assets are devoted to the QLAC to guarantee a lifetime payout, no matter how long the retiree lives.
The report notes key challenges of the third strategy for retirees and their advisers including determining the percentage of initial assets devoted to the QLAC; developing an SWP withdrawal and asset allocation approach that minimizes disruptions in the amount of income between ages 84 and 85; and deciding whether to purchase a QLAC that pays a death benefit before age 85, producing lower retirement income.
Key challenges and decisions for plan sponsors include:
- QLACs pose communication challenges due to the potential for disruptions in income between ages 84 and 85, and if there is no pre-85 death benefit.
- Should plan sponsors just make QLACs available to plan participants and their advisers to utilize on their own, or should they attempt to package SWPs and QLACs into an integrated retirement income solution for retirees to elect?
- Any type of annuity presents a challenge to explain to participants, and QLACs may provide an additional communications challenge. Due to the complexity of QLACs, plan sponsors who offer QLACs may want to offer the option for accessing financial advisers who are qualified to provide advice on QLACs.
The researchers analyzed the following strategies to protect retirement income in the period leading up to retirement:
- Invest in target-date funds (TDFs) that reduce exposure to stocks as the worker ages, then employ a systematic withdrawal plan (SWP) to generate retirement income;
- Buy deferred income annuities (DIAs); and
- Invest in guaranteed lifetime withdrawal benefit (GLWB) annuities.
The researchers noted that TDFs remain vulnerable to stock market crashes and may not offer down-market protection in the period leading up to retirement. Their projections show that fixed DIAs offer the best protection against the possibility that an unfavorable economic scenario will result in retirement income being much less than expected, compared to the other RIGs and strategies analyzed. DIAs deployed at age 55 offer the most protection, although a laddered approach (purchasing small amounts of a DIA each year) produces projected results that are almost as favorable as buying the DIA at age 55.
However, the paper notes, many workers will not want to invest all their savings in a DIA, since a DIA does not have liquidity throughout retirement, a desirable feature of SWPs. In addition, using a DIA results in reduced upside potential when market returns are favorable, compared to using TDFs with SWPs.
An alternative to investing in a DIA during the period leading up to retirement is to invest a portion of retirement savings to intermediate and long-term bonds (or mutual funds), and then purchase a single premium immediate annuity (SPIA) at retirement. The goal is the appreciation or depreciation in these assets due to interest rate changes will be approximately the same magnitude as related changes in annuity pricing. Such a strategy requires sophistication from a near retiree (or an adviser) and may not deliver the same eventual income as a DIA. However, this strategy may give the near retiree more flexibility and liquidity, particularly if the near retiree is uncertain about the timing of retirement.NEXT: Considerations for plan sponsors and advisers
When designing a retirement income program, DC plan sponsors will want to weigh the administrative and communication burdens of various RIGs and retirement income solutions versus their potential advantages, the researchers say. DC plan sponsors could help meet the varying goals of participants by starting with a straightforward retirement income program that offers the following basic RIGs:
- The ability to purchase SPIAs that are fixed, inflation adjusted, or adjusted by a growth factor such as 3%;
- An installment payment feature that implements a SWP with a few different withdrawal strategies, together with a few different funds with varying asset allocations;
- Withdrawal strategies could be the Internal Revenue Service (IRS) required minimum distribution (RMD), or use fixed percentages such as 3%, 4%, 5%, or 6%. As a practical matter for tax-qualified plans, after age 70-1/2 the RMD would override the fixed percentage if the RMD results in a higher withdrawal amount; and
- A period certain payout to enable delaying Social Security benefits.
A basic retirement income program could also help by packaging retirement income solutions. A few examples are:
- A handful of packaged combinations of SPIAs and SWPs together with appropriate investment funds, for retirees who want to choose among a limited menu of solutions;
- The ability to custom-mix SPIAs and SWPs in whole percentages, for “do-it-yourselfers” or individuals working with advisers; and
- A designed default retirement income solution that might meet the needs of many employees.
The researchers note that the above RIGs and packaged retirement income solutions are readily available to most DC plans.
The analyses in the report can be used by financial institutions and advisers to help form recommendations for constructing retirement income portfolios that are in the best interest of their clients who are close to or in retirement. Advisers and financial institutions can best serve their clients if they’re able to recommend diversified retirement income portfolios with the potential to be allocated among different common retirement income classes, including Social Security benefits, invested assets, and annuities. Other assets and resources such as home equity and continued work might also be considered.
Ideally, financial institutions and advisers will want to understand each client’s goals and circumstances that can influence the retirement income allocation decision, including:
- The desired amount of retirement income expected throughout retirement;
- The expected pattern of change in retirement income over time, for example, to keep pace with inflation;
- The amount of protection that’s needed against decreases in retirement income due to investment losses and interest rate changes;
- The portion of income that the retiree wants to be guaranteed for life, no matter how long the retiree lives;
- The current health status and life expectancy of the retiree and spouse/partner, if applicable;
- The desired protection against the threat of long-term care, and the potential influence on the retirement income allocation decision;
- The specific needs and desires for liquidity and access to savings throughout retirement; and
- The retiree’s desires to leave a legacy upon death.
Each of these goals has the potential to conflict with other goals, so an important task for the adviser is to help the retiree prioritize and make tradeoffs among competing goals, the report says.The report may be downloaded from here.