Summer 2008

Pensionizing Defined Contribution Assets

Submitted by: Institutional Retirement Group, Genworth Financial

Background

Healthier lifestyles and advances in medicine mean that many Americans can look forward to longer, more active retirements. However, the decline of corporate pensions, concerns about social security and rising health care costs mean that planning for a secure retirement requires a different approach.

Accumulation vs. Income

Financial education focuses largely on teaching individuals the mechanics of accumulation investing. Simply put, this strategy puts the emphasis on building a nest egg that can be drawn upon in retirement years. Unfortunately, most people have difficulty estimating how large a nest egg is needed to meet their retirement needs. In addition, once these savers reach retirement, they may struggle to shift their thinking from this accumulation mindset to a spend-down mindset.

Target date funds are an excellent example of a product built for the accumulation mindset. These funds choose a starting asset allocation that assumes riskier assets (stocks) will earn a return premium over less risky assets (bonds and cash) and then lower the allocation to the riskier assets to limit volatility as the target date approaches. Once the target retirement age is reached, the fund generally invests the majority of assets in lower risk investments such as bonds and cash. This provides a more stable return for a retiree who is drawing down assets.

This approach has many merits, including:

  • Making the process simple
  • Frequent rebalancing of the portfolio
  • Professional management

However, it does not:

  • Help determine how much needs to be saved in order to have an adequate retirement income
  • Provide a method for how much to withdraw each year in retirement
  • Provide much opportunity to income growth over a potentially long retirement

By contrast, an "income strategy" focuses on creating guaranteed streams of retirement income while working. This is done by contributing to retirement vehicles that provide explicit income guarantees with each contribution so that the investor has a clear line of sight to how much lifetime income they can expect at retirement. If the income strategy invests in underlying funds that invest in a balance of stocks and bonds, there is an added advantage of having the potential for income growth in retirement. This helps to eliminate the guesswork of how much to withdraw from a nest egg and helps smooth the transition from saving into receiving income in retirement.

There are merits to both accumulation and income strategies and the most effective retirement plan should combine both. An income strategy can be used to create a base of income for necessities while a more traditional accumulation strategy can be used to build a nest egg for discretionary income. For example, an investor can contribute a portion of his or her savings to a vehicle that guarantees a specific amount of income at retirement. Through this approach, the investor will have a clear line of sight to a reliable monthly retirement income without worrying about the investment or interest rate environments in those critical years just before retirement.

The remaining portion of their savings can be invested in a diversified investment fund or funds in which greater risk can be taken over the long run. This "Income and Investments" approach is also a more natural way to think about retirement - a guaranteed income stream to pay the bills and savings to pay for extras and emergencies.

Market Response

Income based options are gaining acceptance in the defined contribution plan market. At least four insurers have launched products in the last two to three years. Many major recordkeepers have formed units dedicated to "retirement income," and one national consulting firm now recommends annuities in defined contribution plans so that participants can turn retirement savings into lifetime retirement income.

But the question remains - will these advances provide Americans with the means to achieve a truly broad-based secure retirement in a self-funded world? They are a great first step, but much more can be done. The greatest hurdle may yet be ahead of us - namely, creating a mind-shift from a focus on asset balances to a focus on income. To do this, we must stop paying so much attention to the mechanics of retirement funding and pay more attention to the goal of retirement funding: the creation of reliable income streams.