Don’t Leave Retiring Plan Participants Hanging

Many people are confused about how to invest in retirement, so they will need help before and after they do so.

Retirement plan sponsors may be providing investment guidance to participants as they are saving for retirement, but what happens after they retire?

A survey by global asset manager Schroders found more than half of respondents (54%) lack an understanding of how to invest in retirement. The majority (58%) of the youngest age cohort surveyed, ages 45-59, say they do not know how to invest their own money when planning for, or during, retirement.

In addition, 43% say they won’t change their asset allocation in retirement.

A risk for near-retirees and retirees is “sequence of returns” risk—the risk of a market downturn at an inopportune time, such as right before retirement or at some point in retirement. The traditional school of thought is that investors need to invest more of their portfolios in conservative, or fixed income, assets near and during retirement to protect their principal or what has already been saved.

But considering the low interest rate environment’s effects on fixed income investment vehicles, Jon Barry, senior retirement strategist, and Jessica Sclafani, DC strategist, at MFS in Boston, suggest plan sponsors also revisit participants’ fixed income investments, including both core options on the defined contribution (DC) plan investment menu and fixed income allocations in qualified default investment alternatives (QDIAs) such as target-date funds (TDFs).

Sclafani notes that traditional U.S.-based core (and core plus) fixed income funds have been the most prevalent in DC plans. “We think because of the low-rate environment and other reasons, plan sponsors should broaden and diversify access to fixed income investments in their core investment menus as well as TDFs,” she says.

TDF hold more assets now than ever before because of their popularity as the QDIA in DC plans and their simplicity as an all-in-one investment options for participants. Yet Doug Sue, an asset class strategist at QS Investors, a subsidiary of Legg Mason, notes that “even as investors approach their typical retirement age—65 in the U.S.—TDFs often still allocate approximately 40% to 50% of their assets to equities. This means up to half of the assets that older plan participants are relying on for retirement are completely exposed to market downturns. That may be too much equity exposure at the worst possible time.”

He suggests plan sponsors consider a managed volatility approach to TDFs. “Managed volatility strategies seek to capture broad equity market returns, as defined by market-cap-based indices, and dynamically adjust equity exposure to produce efficient portfolios with more stable stream of returns. Equity exposure can be adjusted by shorting—i.e., selling—equity futures to effectively reduce the size of the equity allocation,” Sue explains.

Some DC plan participants may stay in their plan after retirement and rely on TDFs’ asset allocation for retirement income for possibly 30 years or even more.

Ideas for updating TDFs to provide better retirement income include adopting a “hybrid” QDIA, in which plan participants are defaulted into a TDF and then moved into a managed account when a certain trigger is met, such as age. According to Holly Verdeyen, senior director, defined contribution strategy at Russell Investments in Chicago, a properly structured managed account will be able to adapt to changing participant circumstances and market conditions; if market conditions lower a participant’s funded status, a managed account could adjust for that. Likewise, if market conditions improve a participant’s funded status, a managed account could derisk, like a pension plan, to preserve the higher funded status.

Another idea is to diversify a TDFs portfolio by including fewer liquid assets. Research has found that including private equity investments in balanced funds and TDFs both improves performance and has diversification benefits that lower overall portfolio risk.

Jason Shapiro, director, investments, Willis Towers Watson, puts forth the idea of an “unwrapped” TDF—a hybrid combining traditional model portfolios and custom TDFs. He explains that a plan sponsor or adviser develops a series of model portfolios that suit the demographics and behaviors of an employee base, and they are assigned spots on a glide path, according to their risk levels and any other objectives (e.g. ability to generate income).

Academic research from Wade D. Pfau, professor of retirement income, The American College; and Michael E. Kitces, partner, director of research, Pinnacle Advisory Group, “Reducing Retirement Risk with a Rising Equity Glidepath,” argues that, after workers navigate the risk zone, for many of them it makes sense to actually start ramping up equity risk, in a controlled and rational way that balances the need for current and future consumption against the fact that the individual is aging and closing in on the end-date of their lifetime wealth trajectory.

Most retirement plan participants don’t know the term “sequence of returns” risk or have the investing acumen to guard against it, so they need the help of plan sponsors.

In the Schroders survey, the majority (60%) of respondents say their primary investment objective in retirement is “steady income generation.”

Joel Schiffman, head of intermediary distribution, North America, Schroders, says, “With ‘steady income generation’ being the primary investment goal in retirement for the majority of respondents, we see a meaningful opportunity to create enhanced retirement tools that help meet this goal, while providing the necessary investment returns to ensure individuals do not outlive their assets.”

When the pre-retiree and retiree respondents were asked where they receive or plan to receive investment advice, 48% stated they do not receive or do not plan to seek investment help from anyone, believing they can manage their assets without professional guidance. Twenty-one percent do or plan to seek investment advice from an investment adviser, 10% from a family member, 10% from the internet, 6% from an employer-sponsored pension plan resource, and 5% from friends.

“With nearly 50% of all respondents choosing to invest without assistance, we believe this further validates the need for greater investment-education programs,” Schiffman says.

The survey also indicates a need for more Social Security education. The majority (67%) of respondents do not believe that the monthly amount they receive from Social Security will be enough to live on. It probably won’t for many, but do participants understand that according to the Social Security Administration’s website, Social Security will replace about 40% of an employee’s pre-retirement income after retirement? This is more than half of what the average person will need.

And participants may not understand how they can increase the amount they receive from Social Security by selecting the right date to claim their benefits. According to the Schroder’s survey, 39% of those who reported being retired began taking Social Security benefits at age 62, forgoing greater monthly benefits by deferring benefits to a later age.

In addition, among the youngest cohort (ages 45 to 59), 52% are unsure how much Social Security income they can expect.

“We find it concerning that not only are the vast majority of respondents concerned about not being able to live on what they receive from Social Security, but such a high number of retirees are beginning to take Social Security at the age of 62 when pay-out benefits are the least,” Schiffman says. “This either reflects a lack of education on how Social Security benefits grow as the time-to-activate is delayed, or a strong desire to retire earlier in life, with less money.  In either case, we see a great opportunity to help educate people on these trade-offs.”