The biggest pension finance challenge defined benefit (DB) plan sponsors have faced over the last nearly four decades has been interest rate risk. To deal with this risk, sponsors, consultants, and financial engineers have developed a set of tools, including zero-coupon bonds and interest rate derivatives.
It is a strange fact of the current state of 401(k) fund menu construction that this risk—which in 401(k) plans falls on the participant, not the sponsor—is largely ignored and that those tools are not made available to plan participants.
In what follows, I discuss the significance of this risk for plan participants and how 401(k) fund menu options might be enhanced.
Stocks for the long run?
The Department of Labor’s (DOL)’s 2006 proposed qualified default investment alternative (QDIA) regulation, which marked a shift away from guaranteed investment contracts (GICs) and money market funds to target-date funds as the default 401(k) investment, included the following by way of rationale: “Investments in capital preservation vehicles deprive investors of the opportunity to benefit from the returns generated by equity securities that have historically generated higher returns than fixed income investments.”
That regulation resulted in a lot of glidepath theory that focused on significant allocations to equity investments all the way to (and conceivably “through”) age 65. The example glidepath in the DOL’s May 6, 2010, Investor Bulletin: Target Date Retirement Funds showed a 60% allocation to equities at retirement.
But – have “equity securities … generated higher returns than fixed income investments?” Consider: the CAGR (compound annual growth rate) on Aa 30-year zero-coupon bonds over the period 2007 to 2019 was 11.7%. The CAGR on the S&P 500 (with dividends reinvested) was only 8.5%. And that wasn’t a fluke. Interest rates have been declining since 1983. Since 1983, the 30-year CAGR on Aa 30-year zero coupon bonds has been 14.9%. The CAGR on the S&P 500 only 11.1%.
The story is a little different if we look at shorter durations, where the effects of interest rate changes are discounted over shorter periods.
But with respect to (truly) long-term future income (say 20 to 25 years and up), the performance of interest rates has outweighed the risk premium paid on equity investments. Indeed, what would these performance numbers (30-year Aa zero-coupon bonds vs. the S&P 500) look like if we ran them through a Sharpe Ratio analysis?
Pension finance—since well before the Employee Retirement Income Security Act (ERISA)—has been premised on a bet (of sorts). Initially, in the era of defined benefit plans, a bet that a plan sponsor investing in equities could outperform the rate of return on the typical annuity provider’s fixed income portfolio. In the 401(k) era, the same sort of thinking lay behind the DOL’s authorizing a default to an equity-heavy portfolio for anyone younger than 65.
The fundamental insight underlying the QDIA regulations was that participants with longer investment horizons—that is, younger participants—could take on more risk, via equity securities, and thereby get more reward. And in a period of stable interest rates, that insight (it seems to me at least) is valid.
But interest rates haven’t been stable. From 1950 until 1982-83 they went in (more or less) one direction: up. Since then, they have gone (more or less steadily) down. This trend has affected, e.g., the returns on long-term bonds and on stocks.
Higher asset valuations do not necessarily mean more retirement income
As Larry Summers has pointed out, most of the increase in stock market wealth has not come from an increase in the amount of future income that a share of stock represents. It has come from an increase in the value/cost of future income:
“Wealth can go up because future income streams go up … or wealth can go up because the discount factor goes down. … The Shiller Price Earnings Ratio is 76% more than its post-war average. That would explain all of the increase in wealth relative to income.” (Remarks of Lawrence Summers, Would a “Wealth Tax” Help Combat Inequality? A Debate with Saez, Summers, and Mankiw, Peterson Institute for International Economics, October 18, 2019.)
Investing for future income
The significance of declining interest rates for retirement finance is more straightforward for the DB plan sponsor than for the 401(k) plan participant. The DB sponsor is, by definition, funding against a future obligation to pay a plan participant income in the future. From this sponsor’s point of view, increases in asset values that do not reflect an increase in future income don’t improve funding. In accounting terms, what the sponsor gains on plan assets is offset by what it loses on plan liabilities.
The situation is more complicated for 401(k) plan participants. There is reason to believe that not all of them are saving in order to produce retirement income. But if the primary purpose of 401(k) savings is to finance retirement income, then 401(k) plan participants face the same challenge DB sponsors face: investing to produce future income in an environment of declining interest rates. Because those declining interest rates mean that the cost of future income is (seemingly continuously) going up.
One of the problems that DB plan sponsors seeking to hedge their future-income-obligation risk know well is that the further into the future you go, the harder it is to find financial assets (e.g., zero-coupon bonds) of suitable duration. This is due (at least in part) to a radical uncertainty about the very-long-run future. When bond issuers and bond buyers look, say, more than 30 years into the future, they are confronted by a kind of uncertainty that cannot be tamed by the law of large numbers or historical performance. A remark of Keynes is apposite here:
By ‘uncertain’ knowledge, let me explain, I do not mean merely to distinguish what is known for certain from what is only probable. The game of roulette is not subject, in this sense, to uncertainty: nor is the prospect of a victory bond being drawn. …Even the weather is only moderately uncertain. The sense in which I am using the term is that in which the prospect of a European war is uncertain, or the price of copper and the rate of interest twenty years hence, or the obsolescence of a new invention, or the position of private wealth-owners in the social system in 1970. About these matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know.
The risk/uncertainty with respect to, say, a 40-year bond is this sort of risk—radically uncertain. As a result, even though a 35-year old participant has a need for income 40 years into the future—when she is 75—there often isn’t an available financial asset—like a 40-year zero-coupon bond—that corresponds to it.
Available 401(k) investments
But even where—say, with respect to the need for income 30 years into the future—there are corresponding financial assets, under current 401(k) fund menu practice, the participant does not have access to them. That is, our 35-year old 401(k) plan participant does not (typically) have the option to buy, e.g., a 30-year zero-coupon bond. Notwithstanding that such an investment may be the perfect hedge to the liability she is carrying—a need to produce income at age 65.
Instead, if this participant wants to hedge this obligation, she may buy an interest in a “long-term bond” fund. But the typical long-term bond mutual fund has an effective duration of less than 15 years. And, obviously, will lack any transparency. For her, that is not an adequate hedge.
Annuities as a non-solution
Another alternative not (currently) typically available—but being heavily touted by many thought leaders—is to make available to this participant an annuity investment.
Which is a pretty inefficient way to hedge this risk for several reasons. The annuity market itself is not very efficient. The risk here isn’t longevity and does not require the pooling-of-lives that a life annuity requires. And annuities are not (very) liquid. Whereas as a long-term bond can be sold (relatively) easily in a (relatively) liquid market.
As noted at the top, zero-coupons (as well as interest rate derivative hedges) are widely used by DB sponsors and annuity carriers to manage this very risk. Why shouldn’t 401(k) plan participants have available to them the same tools? Why not—for a large plan—a series of funds that simply buy and hold zero-coupons of specified durations?
Blaming the participant
To say that the average participant “wouldn’t understand” this issue, or that sort of fund, is to argue that the 401(k) system—with its preference for subjective decision-making by participants—can’t deliver the one thing that, as a retirement system, it is supposed to: retirement income.
And, by the way, what makes anyone think that an annuity is easier to understand than a zero-coupon bond?
But interest rates can’t possibly go lower
Yes, maybe we are at a bottom. The only thing is, we’ve been saying that for 25 years. Long-term interest rates on Aa bonds have declined another 40+ basis points since the beginning of this year. And I (for one) don’t see anything in the fundamentals—critically, anything in world demographics—that makes it likely that interest rates are going to go back up significantly in the near future.
Moreover, if you’re going to start encouraging young participants to buy annuities, you’re already committed to a fixed income strategy.
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I don’t know what it takes to solve this problem—but it seems to me there is a simpler way to package and sell “future income” than a life annuity. And that there should be—within constraints set by supply in the bond market—funds available to 401(k) participants that allow them to explicitly and transparently match/hedge out their duration risk.
Michael Barry is president of O3 Plan Advisory Services LLC. He has 40 years’ experience in the benefits field, in law and consulting firms, and blogs regularly http://moneyvstime.com/ about retirement plan and policy issues.This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of Institutional Shareholder Services or its affiliates.
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