Income as the Outcome: Sustaining Your Participants Throughout Retirement

Zvi Bodie, PhD, with Bodie Associates, and Tim Kohn, with Dimensional Fund Advisors, discuss why DC plan sponsors should focus on retirement income and how TDFs can do this.

The COVID-19 pandemic has shaken markets and led many investors to re-evaluate their financial plans. People are rightly concerned over public health, the economy and the safety of their family and friends. In these circumstances, defined contribution (DC) plan participants who are near retirement may wonder whether they need to postpone retirement or if they will be forced to retire earlier than expected.

Target-date funds (TDFs) help guide investors throughout their careers and throughout retirement. But recent market volatility may have sown doubt among plan participants about the stability and security of their investments, including TDFs. How might plan sponsors help participants who are in or near retirement maintain confidence in their retirement strategies?

We believe target-date solutions should focus on retirement income. By contrast, most traditional TDFs aim solely to grow account balances while using short-term fixed income to reduce the risk of losses. This approach is fine when individuals want to accumulate wealth or save for a one-time purchase. However, when planning for retirement income, a wealth preservation strategy is less ideal because it is not designed to manage market, interest rate and inflation risks during the asset accumulation and decumulation phases.

Plan participants need confidence that their investment strategy is appropriate throughout their life and not just at one point in time. Plan sponsors can bolster their confidence by offering investments informed by the relevant risks they face before and after retirement. This can be achieved by focusing on income as a retirement goal, using a liability-driven investment (LDI) philosophy and selecting an asset allocation with a long-term outlook. Let’s consider each of these.

Focus on Income as the Outcome

Well-defined goals should inform DC plan strategies. However, these goals change over a lifetime. A participant’s financial needs and consumption habits at age 25 can be much different than at age 85. We can look to lifecycle finance for guidance on understanding these changes and planning for them. The goal for many people is not to merely save enough for a large, single purchase in the future, but to afford a steady level of consumption throughout retirement.

According to the Employee Benefit Research Institute (EBRI)’s 24th Annual Retirement Confidence Survey in 2014, most pre-retirees said they wanted to retire at age 65. However, when the institute surveyed 1,000 retirees, it found the median retirement age was 63. The top reasons for early retirement were individual health, health of a spouse or changing job skill requirements. One implication is that not all plan participants have the luxury of delaying their retirement to recover from financial losses.

In sum, most plan participants want steady income in retirement and many investors will have to retire early for at least one of the reasons cited. From a lifecycle finance perspective, DC plans should provide participants with clarity around the standard of living they can expect to sustain when they retire, which, in turn, requires proper risk management.

Use an LDI Philosophy

As outlined by Nobel laureate Robert Merton, retirement income is subject to three main risks: market risk (stock market volatility, for instance), inflation risk and interest rate risk. The latter two are often de-emphasized, even though they are directly relevant to the investor’s end goal. For example, a decrease in interest rates reduces the amount of retirement income that a given plan balance can support. Inflation can also erode the purchasing power of an investor’s savings. Therefore, TDFs that focus only on wealth volatility leave retirees exposed to both inflation and interest rate risk.

When focusing on income, an LDI approach implemented with Treasury inflation-protected securities (TIPS) can provide clarity on what a portfolio offers in terms of inflation-protected income. A liability-driven investment (LDI) strategy is designed to focus on assets that match future liabilities. LDI strategies contain certain risks that prospective investors should evaluate and understand prior to making a decision to invest. These risks may include, but are not limited to, interest rate risk, counterparty risk, liquidity risk and leverage risk. The key insight behind the approach, which is widely used in defined benefit (DB) plans, treats retirement income as a stream of inflation-protected payments with a present value that varies with real interest rates. With this framework in mind, one constructs a portfolio of inflation-indexed bonds that aims to track changes in the value of this stream of payments.

According to S&P Dow Jones Indices’ Indexology Blog, the problem of retirees not having enough income in retirement can be addressed by focusing on reducing volatility of income. LDI helps fulfill this goal by reducing the uncertainty around the retirement income that a plan balance can provide.

Allocate with a Long-Term Outlook

TDFs are often labeled as either “to” or “through.” Typically, a “to” glide path will have an asset allocation that hits its landing point at the target date, whereas a “through” glide path’s allocation continues to evolve after the target date. Both the accumulation and the decumulation phase come with specific risks, and an approach that manages these changing risks can offer the best of both worlds.

Target-date strategies are valuable tools to help plan participants, but only if they target the right goal: to achieve a soft landing at the end of the glide path. When implemented with a focus on income, target-date strategies help sustain participants during their career and throughout retirement.

Zvi Bodie, PhD, is an independent educator, writer, speaker and consultant on finance and financial systems. He is also a professor emeritus, finance at Boston University, where he taught from 1972 to 2013.

Tim Kohn, vice president and head of Retirement Distribution, leads Dimensional Fund Advisors’ retirement practice, where he assists retirement plan sponsors and advisers with plan design, governance and best practices.


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