Some plan sponsors may think they have no way to know or influence how much money participants will save for retirement, making it “impossible” to achieve objectives and quantify risk, but this is not true, Rod Bare, defined contribution consultant for Russell Investments, told PLANSPONSOR. Bare is the author of the report “Quantifying Key Risks in Retirement,” written on behalf of the Institutional Retirement Income Council (IRIC).
Even basic assumptions about savings trends can help tremendously to improve a plan, Bare said. Plan sponsors must keep in mind that helping participants is not necessarily about investments; it is about finding ways for participants to save, and implementing tools – such as automatic escalation – that can help them achieve this goal. “Finding ways to boost contributions is equally, if not more impactful, [than investment selection],” he said.
Here are the six most common risks, according to Bare, and how plan sponsors can tackle them:
Sequential risk highlights the importance of the sequence of investment returns, especially for a retiree making regular withdrawals to cover expenses.
Poor returns early in retirement are much more harmful to one’s retirement prospects than poor returns later in retirement, the report said. A participant heavily invested in equities at retirement is exposed to excessive sequential risk.
Plan sponsors can mitigate participants’ sequential risk by encouraging them to invest more conservatively during the years close to retirement. This can be through education, asset allocation solutions like target-date funds (TDFs) or guaranteed retirement income products.
Price increases can hurt retirees' standard of living. In order to maintain their standard of living in retirement, plan sponsors can offer participants the option to take automated systematic withdrawals with a cost-of-living adjustment (COLA) or to purchase an annuity with a COLA, the report said.
This does not necessarily mitigate inflation risk because the retiree’s purchasing power is based on expected inflation rather than actual inflation. As a result, some insurance carriers offer annuities with the benefit linked to the Consumer Price Index, but the report pointed out that the tradeoff is lower initial annual income.
The risk of living beyond one’s life expectancy can put stress on a retirement portfolio. To tackle this problem, the report suggests plan sponsors offer participants an immediate or deferred life annuity in the plan. Variable annuities with a guaranteed lifetime withdrawal benefit rider can also address longevity.
Interest Rate Risk
Interest rate risk is the possibility of low bond returns and high annuity prices. Low interest rates depress the coupons paid out by bonds, and if interest rates rise, the market value of the bonds will decline. Low interest rates usually lead to an increase in annuity prices, the report said.
Plan sponsors should give participants the option to invest in a short-term bond portfolio in order to avoid locking in low interest rates for the long term. For purchasing an annuity, dollar-cost-averaging into an annuity – or holding long-duration bonds that closely track annuity prices – can mitigate interest rate risk, according to the report.
Health Care Risk
Participants may have high, unexpected health care risks in retirement due to a chronic illness that can lead to long-term care needs. Plan sponsors must educate participants on the cost of nursing homes and other long-term care expenses, Bare said.
“It’s a cost that’s larger than most people realize,” he stressed.
To counter this risk, plan sponsors can offer access to institutionally priced long-term care insurance, along with education. Employee health and wellness programs are becoming more important to companies, the report said.
Behavioral risk is the possibility of human biases getting in the way of good retirement decisions. An example is a participant who spends too much early in retirement, which puts pressure on the portfolio to perform well.
According to the report, this may be the most difficult risk for plan sponsors to help participants overcome. One solution is to offer them a default investment option that helps protect them from themselves by combining liquid assets and retirement income-oriented insurance products.
Plan sponsors can also focus communication around the amount of guaranteed lifetime retirement income they are accruing instead of around the volatility of their account value. In addition, participant advice is important in order to help them make important decisions.
Participants need help mitigating longevity risk, as well as the discipline to withdraw at an appropriate rate, Bare said. “Assuming you can keep from having your own mind sort of betray you [as] you build up a nest egg, then you have another set of behavioral biases about what to do with that nest egg,” he added.