TDFs Can Support Retirement Spending, per Capital Group

As the retirement industry continues searching for ways to help defined contribution plan  participants convert savings into retirement paychecks, a new paper from Capital Group Companies Inc., “From Target-Date Savings to Retirement Income: Frameworks for Withdrawals,” argues that target-date funds may provide part of the answer.  

The firm recently published withdrawal-rate frameworks for its target-date series, offering two approaches designed to help retirees estimate sustainable spending over a 30-year retirement horizon: fixed withdrawal strategy, in which spending out of the portfolio remains relatively stable after retirement with annual inflation adjustments, and a variable withdrawal strategy, in which annual spending rises or falls with portfolio performance. 

Kelly Campbell, head of multi-asset solutions at Capital Group, says the initiative grew out of conversations with plan sponsors examining retirement-income solutions for participants. While much of the industry’s retirement-income products have focused on annuities and guaranteed income, Capital Group argues that a well-designed target-date fund can itself serve as a retirement-income solution. 

“As we’ve talked to plan sponsors, we’ve seen more and more of them reassessing their plan lineup to figure out if they have the right solutions in their lineup for retirees,” Campbell says. “Perhaps the most used strategy in your retirement plan, [the target-date fund], is your retirement income solution.” 

The paper argues that a well-designed target-date series, combined with a thoughtful withdrawal framework, can provide a simpler alternative to annuities and other retirement-income products.  

First, researchers looked at a fixed-withdrawal strategy, in which retirees withdraw between 4% and 4.5% of their portfolio when they retire and then increase that dollar amount annually to account for inflation. Under this method, someone retiring with a $1 million portfolio could initially withdraw $40,000 to $45,000 per year, with future increases tied to inflation, providing a relatively stable income stream. However, the strategy also carries the risk of exhausting retirement assets if market returns are weaker than expected over an extended period. 

The second approach, a variable-withdrawal strategy, calls for retirees to withdraw between 5% and 5.5% of the portfolio each year. Annual withdrawals are based on the current value of the portfolio at the time of the withdrawal, so income can fluctuate significantly from year to year, depending on market performance. Capital Group wrote that this method may better preserve assets, because spending automatically adjusts to market conditions, but the trade-off is less predictable income.

To evaluate the two approaches, Capital Group conducted 100,000 Monte Carlo simulations designed to test retirement outcomes under varying market environments, longevity concerns and stress scenarios, including Social Security benefit reductions and major healthcare expenses later in life.

The analysis found that the fixed approach, in which retirees maintain roughly the same inflation-adjusted spending level throughout retirement, generally provided sustainable income over a 30-year horizon at withdrawal rates of 4% to 4.5%. The variable approach, in which annual withdrawals increase or decrease based on portfolio value, also appeared sustainable at withdrawal rates of 5% to 5.5%, because spending automatically declined when markets fell.

Campbell says the withdrawal figures should not be viewed as prescriptions or guarantees.

“We’re not trying to prescribe like ‘This is the right way or that’s the right way.’ We offer a menu to help in the planning,” she says.

Capital Group’s argument also touches on a longstanding debate in the target-date fund industry over whether glidepaths should be designed primarily for participants reaching retirement or for those expected to remain invested and draw income from their savings throughout retirement. Researchers intentionally built conservatism into the ranges they considered and modeled retirees retaining a portion of their assets well into retirement, rather than assuming balances would be exhausted.

“We purposely built in a buffer. We modeled it to about 20% remaining balance [after 30 years of retirement] versus zero,” Campbell says. “You’re modeling to age 95—what if you live to 97? What if you had a big health event later in life and you needed a chunkier amount of withdrawl?”

With this research, Campbell says her team wants plan sponsors, consultants and recordkeepers to better understand the role target-date funds can play after retirement.

“Our target–date series can be robust retirement income strategies,” Campbell says. “We’re hopeful that these numbers can help demonstrate that, help folks plan, and ultimately help people know how to use their savings so that they can ultimately have a better retirement.”