Comparing Retirement Income Approaches

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1 Comparing Retirement Income Approaches T. Rowe Price Investment Viewpoint Authored by: Richard K. Fullmer, CFA Executive Summary There are many approaches to addressing the retirement income challenge, each with its own set of pros and cons. The goal is to secure a lifetime income stream sufficient to sustain retirees desired standards of living. Future workers will retire with less pension income from defined benefit plans, which shifts the retirement income burden to defined contribution plan balances, and ultimately, to individuals. Many products have been developed to address the retirement income challenge inside and outside of DC plans. So far, market acceptance has been limited. Cost, portability, irrevocability, inflexibility, participant education and communication requirements, regulatory uncertainty, and questions regarding insurance risk capacity remain significant barriers for defined contribution plan sponsors to adopt these solutions. The need for long-term solutions to the retirement income challenge is real. The breakthrough solution of the future may combine the best features of products currently available in the market today. The need to secure lasting income in retirement is a challenging problem as the burden of funding retirement shifts from institutions to individuals, who as a whole may be the least equipped to efficiently tackle it. Each new cohort of retirees is likely to become more dependent on their own finances to fund their retirements. Many new products have been developed to address the retirement income challenge. So far, market acceptance has been limited. One reason is that although mass marketization works well for asset accumulation, it does not work as well for asset decumulation, when investor situations and goals tend to be more heterogeneous. Another reason is that the evolution of market demand is still in the early innings. Although fewer workers, particularly those in the private sector, will retire in the future with pension income from defined benefit (DB) plans, many current retirees do enjoy the luxury of having a pension. Yet another reason is that defined contribution (DC) plan balances today tend to be inadequate for the purpose of sustaining one s standard of living after retirement. 1 Future retirees are likely to retire with much larger DC plan balances due to initiatives designed to stimulate savings such as the Pension Protection Act of 2006, which provided plan sponsors with safe harbor legislation regarding participant enrollment and default investment

2 elections. So although product uptake has so far been slow, a tipping point that propels demand seems likely at some point in the future. There are many approaches to addressing the challenge, each with its own set of pros and cons. Ultimately, the goal is to secure a lifetime income stream that is sufficient to sustain a desired standard of living. Most people already have a significant source of guaranteed lifetime income in the form of government-provided social security. While this provides a valuable income floor, retirement savers are likely to want a higher standard of living than Social Security alone can provide. Additionally, many individuals may have secondary goals, such as leaving a bequest to heirs. The appeal of any particular approach depends on individual preferences for the desired level of income, acceptable risks to sustaining it, growth potential, costs (e.g., investment fees, insurance fees), complexity, and any constraints that limit liquidity, flexibility, portability, or access to money. Regulators and plan sponsors also have a vested interest in the merits, costs, portability, and scalability of various approaches. Because plan sponsors are subject to regulatory and fiduciary considerations, it is possible perhaps even likely that the evolution of solutions in the DC market will differ from that of the advisory and individual retail markets. The Crux of the Matter: Sustainability If income sufficiency is the ultimate goal, it can only truly be addressed by adequate saving. No financial product can be counted on to rescue those that have under-saved, because only so much juice (income) can be squeezed from an orange (nest egg). The question is: How much can be squeezed sustainability? Sustainability risk refers to the overall risk of outliving one s assets. This risk is a complex function of the following underling risk factors: life horizon, investment performance, and rate of portfolio withdrawal. Life Horizon (longevity risk) The risk to sustainability is not with living long (most of us consider that to be a goal), but rather with living longer than expected longevity risk. Although any one individual s life horizon may be unknown, the distribution of the individual life horizons for an entire population is estimable using mortality statistics. These statistics allow the computation of average life expectancy of the population as well as the probability of living to any given age. Age, gender, and health are all important determinants of this probability distribution. Investment Performance (investment risk) This refers to the rate at which investment returns are adding to (or subtracting from) one s asset balance. Both the size and timing of returns matter. Achieving higher returns decreases the risk of outliving one s assets, although the higher volatility that typically accompanies higherreturning portfolios may offset this benefit because the risk of poor returns, especially early in retirement, could impair the ability to sustain an income stream. It is the net effect between the level of returns and the volatility/timing of returns that ultimately matters. This explains why highly-diversified, balanced portfolios are so commonly recommended in retirement. Rate of Portfolio Withdrawal (spending risk, inflation risk, fees) This refers to the rate at which one s retirement assets are drawn upon. The rate is influenced by the real rate of spending, the rate of inflation, and the level of fees paid for investment management or insurance guarantees. Health is an important factor here as well since retiree health care and long-term care expenses can be significant. As each of these factors evolves over time, the level of sustainability risk faced by an individual will change. This brings rise to another important consideration: cognitive risk the ability of individuals to comprehend their alternatives and manage their finances effectively and sustainably. This ability may decline in old age due to dementia, for example. Any retirement income solution must address at least one of these risks. Different approaches do so in different ways. Approaches to Retirement Income We categorize approaches as investment-based, insurance-based, or a hybrid combination of investments 1 For example, the Employee Benefit Research Institute (EBRI) estimates that nearly half of all DC plan participants are at risk of not having retirement income adequate to cover the average level of expenses throughout retirement. See the February 2014 EBRI Issue Brief No. 396, available at ebri.org. 2 T. Rowe Price investment viewpoint

3 and insurance. The primary distinction is that income guarantees are available only through insurance. While such guarantees are highly valued by retirees, many balk at the cost or restrictions. Those electing not to purchase a guarantee are essentially choosing to self-insure, which basically boils down to carefully managing their assets and spending. The decision to insure or self-insure involves a complex evaluation of the trade-offs offered by each approach. Investment-based Approaches (self-insurance) With investment-based approaches, investors can preserve liquid access to their savings and retain the potential to grow their wealth, increase their income, and leave a legacy to heirs. They also bear the risk that their savings may be prematurely depleted. Self-Managed Portfolio Withdrawals Self-managed withdrawals offer a highly flexible approach. The individual selects both an investment strategy and a withdrawal strategy. Both act as levers by which the individual can manage sustainability risk over time. The investment strategy lever can be utilized if the individual s capacity for risk taking changes materially, which may occur as the result of changes in one s health, wealth, outlook on spending, or outlook on the capital markets. Target-date strategies, offering broad diversification and age-appropriate asset allocation, are a sensible default choice. Target-risk, or balanced asset allocation, strategies are another sensible choice, provided the individual is skilled enough to determine the appropriate risk level and adjust it over time as necessary. Investors that lack these skills may look to educational guidance materials or financial advisors for help. The withdrawal strategy lever has a much greater effect on sustainability risk. Withdrawals may be adjusted in response to inflation, unexpected expenses, favorable or unfavorable investment performance, changes in health and life expectancy, or other reasons. Common approaches include: Constant Real Dollar Amount Method Select an amount to withdraw in the current year and plan to adjust it over time by the rate of inflation such that the spending plan has a high likelihood of success. To manage sustainability risk, withdrawal amounts should be reassessed at least annually because the outlook for continued sustainability will change over time. Endowment Method Annual withdrawals are specified as a constant percentage of the beginning-of-year account balance. This method results in a variable income stream that depends on investment performance. To help smooth the variability, the withdrawal percentage may be applied to the average account balance over the past year or last few years. Life Expectancy Method Similar to the endowment method, but the percentage rate applied in each year changes based on life expectancy. A simple method is to take one divided by then-current life expectancy. In this way, the withdrawal rate changes over time in harmony with the population s rate of mortality. The IRS required minimum distribution rules are an example of this method. Self-managed strategies must be monitored periodically and adjusted as necessary. Success requires both wisdom and discipline, and even then is not guaranteed. While financial guidance and advice can help provide wisdom, discipline must come from within. Managed-Payout Portfolios Managed-payout portfolios combine both investment strategy and withdrawal strategy into a single solution. Payouts may include a return of the individual s investment capital in addition to dividends and interest. Examples include: Perpetual Horizon Variable Payout Endowment Strategies Balanced portfolios that make distributions according to some version of the Endowment Method described above. Because these portfolios are designed to continue in perpetuity, the 3

4 expected payout rate cannot exceed the expected long-term rate of return on the portfolio otherwise, the portfolio would eventually run out of assets. Fixed Horizon Variable Payout, Fully Decumulating Strategies Balanced portfolios that seek to fully distribute all assets over a fixed time horizon. The goal may be to minimize the variability of the payouts, keep up with inflation, or achieve some other objective. Payouts will vary depending on market returns. Target Payout Strategies These seek to distribute a targeted dollar amount in either nominal or real terms over a fixed time horizon, while also seeking to preserve and perhaps even grow the account balance over time. The ending portfolio value will depend on market returns. Amortizing Bond Ladders (ABLs) ABLs are a special form of managed-payout portfolio that seeks to fully distribute a fixed payout in either nominal or real (inflation-adjusted) terms over a fixed time horizon in a manner commonly referred to as liabilitydriven investing. The payout rate is entirely dependent on current interest rates at the time of purchase. To provide the utmost safety, an ABL can employ a buy-and-hold cash flow matching strategy using only risk-free assets such as Treasury bonds or Treasury Inflation Protected Securities (TIPS). While not guaranteed, the expected income stream of such a bond ladder may be considered safe and reliable because the holdings are backed by full faith and credit of the U.S. Treasury. The trade-off for this safety is relatively low returns. On the other hand, ABLs can be managed at relatively low cost due to their passive design. Low cost is important because fees act as a drag on the payout rate of any managed-payout strategy. Another advantage is that because the future income stream is known with a high degree of confidence, investors can more confidently plan to spend it. With other investment approaches, investors must spend more cautiously to guard against bear markets that adversely impact sustainability. Bear in mind that the managed-payout strategies offered within these investment-based solutions involve a revocable decision on the part of investors, who are generally free to buy and sell shares any time at the investment s net asset value. This differentiates these approaches from the insurance-based approaches discussed next. Insurance-based Approaches With insurance-based approaches, investors transfer sustainability risk to a third-party insurer. This is done by a formal contract requiring the insurer to pay a guaranteed income stream over the contract period, typically the investor s lifetime. Thus, sustainability risk is essentially transformed into counterparty risk on the continued solvency of the insurer. The cost of insurancebased income guarantees can be difficult to quantify since they are often embedded and undisclosed to the purchaser. 2 For example, with annuitization there is a monetary cost in the form of an unspecified interest rate spread that the insurance company expects to earn. There is also a type of nonmonetary cost in the form of lost liquidity, flexibility, and control when the ownership of assets is irrevocably transferred to the insurer. Annuitization Payout annuities provide a guaranteed lifetime income stream that begins immediately or at a specified future date. Payouts may either be fixed, escalating, inflationindexed, or variable. In all cases, payout levels depend on interest rates at the time of purchase. Fixed, escalating, and inflation-indexed annuities have no exposure at all to investment risk. With variable payout annuities, the income stream is linked to the performance of a market index, but with a guaranteed floor. People often shun payout annuities due to their illiquid and irrevocable nature. There is, however, a significant benefit to be gained by this irrevocability in the form of so-called mortality credits, which are essentially a reallocation of capital from those who die to those who survive. These credits are a powerful contributor to the payout rate, effectively increasing the rate of return without additional risk. 3 Because the rate of mortality 2 For example, with payout annuities insurers typically quote a price per dollar of lifetime income. The breakdown of this price between principal repayment, interest payments, and insurer expense/profit margins is not typically provided. 3 That the mortality credits do not create additional risk does not mean annuities are without risk. Income payouts are subject to the claims-paying ability of the insurer. 4 T. Rowe Price investment viewpoint

5 increases with age, mortality credits grow over time even as the upfront cost of annuitization falls. Thus, there is little economic incentive to annuitize at younger ages when the mortality credits being earned are low relative to the cost. Longevity Insurance Longevity insurance is essentially a payout annuity for which the payouts do not begin until very late in retirement (e.g., age 85). The payout rate is established at the time of purchase based on current interest rates. Pure longevity insurance includes no death benefit, meaning that purchasers receive nothing at all if they die before payments begin. Death benefits can often be purchased at an additional cost. Because income payments do not begin for many years, longevity insurance is perhaps the least expensive means of protecting against longevity risk. Having a sufficient amount of longevity insurance with payouts that begin at age 85, for example, makes the process of managing portfolio withdrawals much simpler, since the time horizon for withdrawals becomes known (from now until age 85) rather than unknown (from now until death). For insurers with high credit ratings, payout annuities and longevity insurance are generally considered to be relatively safe. State run guaranty associations even provide a backstop by protecting income annuity purchasers up to certain limits should an insurance company fail. Timeof-purchase risk is a factor, however, since payouts are dependent on interest rates at the time of purchase. Hybrid Approaches Hybrid approaches combine investments with insurance guarantees. These solutions emerged largely out of consumer preference for retaining ownership and control of assets. Balanced Portfolios Containing Deferred Annuities In this approach, balanced investment portfolios that include allocations to traditional asset classes such as stocks and bonds will also include an allocation to deferred income annuity contracts. Under some designs, investors may be free to sell shares without penalty any time before the annuitization commencement date. At the annuitization commencement date, the portfolio would essentially be broken apart. Shareholders would receive an annuity certificate representing their share of the portfolio s allocation to the annuity. They would also continue to own shares of what remains of the balanced portfolio its allocation to stocks, bonds, and any other non-annuity assets. Target date portfolios are a natural design for this type of hybrid because their targeted retirement dates provide a logical date for the deferred annuity payouts to commence. In addition, recent guidance from the U.S. Treasury and Department of Labor has clarified the conditions under which deferred income annuities may be included in target date portfolios within qualified retirement plans. 4 Guaranteed Minimum Withdrawal Benefit (GMWB) The GMWB is a benefit rider that protects the ability of investors to sustain a lifetime income stream from an investment made in a variable annuity contract (VA). The guaranteed withdrawal amount is specified as a fixed percentage of the current benefit base each year, which is a notional value that the insurer tracks separately for each investor. Withdrawals may continue even if the VA account value drops to zero. Initially, the benefit base is equal to the VA account value. If the account value increases from one anniversary date to another, then the benefit base resets to the higher value. Otherwise, the benefit base remains unchanged. Increases to the benefit base allow the income stream to grow, albeit with no guarantee that it will actually do so. Because there is no annuitization, investors retain liquidity and control of their assets. Any remaining account value at death is available to beneficiaries. Investors may take any withdrawal amount up to the guaranteed minimum amount each year without affecting the amount of protection provided by the contract. While they are free to withdraw more than this, any excess withdrawal reduces the benefit base and therefore the amount of guaranteed income that may be withdrawn in future years. Thus, although it is often said that GMWBs provide both liquidity and a guarantee, a better way to think of it may be that they provide the option of either liquidity or a guarantee. This is because exercising 4 Treasury/IRS guidance Notice , available at: 5

6 the liquidity provision (whether by transferring out of the contract entirely or making excess withdrawals) effectively reduces the amount of the guarantee. When this occurs, guarantee fees paid to-date are not reimbursed. Thus, the guaranteed minimum amount in any given year should perhaps instead be thought of as the guaranteed maximum allowable without adversely affecting coverage. VA s are generally more expensive than investmentonly solutions because they include so-called mortality and expense (M&E) fees in addition to investment management fees. GMWB riders add a third fee layer to cover the withdrawal guarantee. This fee is paid continually for as long as the account value remains above zero. No benefit is received unless and until the account value reaches zero, after which time the insurance benefit begins to pay. GMWBs give investors flexibility to determine when and how various features of the contract take effect. These decisions ultimately affect the insurance coverage, so investors need to be aware of the consequences of their decisions. Investors may require education and ongoing guidance to make these decisions wisely. Comparing Outcomes with Guaranteed Products Comparing outcomes is challenging since different products have different payout structures. We prefer to assess their effectiveness as part of an overall financial plan for individuals with various types of goals. For example, a retiree may seek an inflation-adjusted standard of living equal to 75% of final salary, using income funded through social security and retirement accounts. Of course the results will vary depending on the goals, but directionally we find that annuitizing a portion of one s retirement assets, whether via immediate payout annuities, deferred payout annuities, or longevity insurance, can be beneficial to outcomes. 5 Compared to completely self-managed portfolio withdrawal strategies, partial annuitization can: 1) increase goal success rates, 2) reduce the magnitude of potential shortfalls, and 3) increase the total amount of payouts received over the course of one s lifetime, on average. The trade-off for these benefits is reduced liquidity and a lower residual balance for heirs. Economically speaking, annuitization represents a good deal for many people. Behaviorally speaking, it is a Managed Payout Portfolios Amortizing TIPS Bond Ladder Annuitization and Longevity Insurance Self-Managed Feature / Attribute Withdrawals Lifetime protection No No No Yes Yes GMWB Guaranteed benefit No No No (But extremely likely) Yes Yes Inflation protection No (Returns may not keep up with inflation) No (Returns may not keep up with inflation) Yes Possible (For inflation-indexed annuities only) No (Benefit base increases may not keep up with inflation) Liquid access to funds, Inheritance potential Yes Yes Yes No Yes (But excess withdrawals reduce the guarantee) Exposure to market risk Yes Yes Yes No Yes Upside potential Significant Depends on design None None Moderate (Guarantee fees act as a drag) 5 This assumes fair and free market pricing of annuitization, and not an environment where market externalities could allow annuity costs to be artificially high. Other studies support these findings. For example, see the May 2011 EBRI Issue Brief No. 357 titled Retirement Income Adequacy with Immediate and Longevity Annuities available at ebri.org. 6 T. Rowe Price investment viewpoint

7 different story because people prefer not to give up control of their assets in exchange for a long-term promise of benefits illiquidity is a nonmonetary cost that many individuals perceive to outweigh the economic benefit. GMWBs are likewise a good source of sustainability protection, although its trade-offs are more nuanced. Outcomes are highly sensitive to the level of fees, which act as a drag on the potential for benefit base increases. Withdrawal benefits offered by GMWBs are guaranteed only in nominal terms. Cost-of-living adjustments are not guaranteed. For retirees who wish to sustain their standards of living, we find that GMWBs actually tend to decrease goal success rates compared to completely self-managed portfolio withdrawal strategies. The reason is that the withdrawal benefit may fail to keep up with inflation when investment returns are insufficient to overcome the withdrawal rate and fee drag. GMWBs also decrease the average size of payouts received over the course of investors lifetimes, largely as the result of fees. More positively, GMWBs do reduce the potential magnitude of shortfall because at least some level of income continues even if the account balance falls to zero. So although investors might be less likely to get all the income they hoped for after taking inflation into account, they are protected on the downside. In summary, GMWB s significantly improve worst-case outcomes, although these outcomes are relatively unlikely to occur. This gives GMWBs a similar feel as traditional insurance products such as fire insurance in terms of providing protection against a severe, yet unlikely, event. 6 Conclusion Adequate saving and sound guidance are necessary to achieve successful retirement outcomes. There are several approaches to the retirement income challenge, each with its advantages and drawbacks. Many innovative approaches have been brought to market, albeit with relatively low adoption of any particular product. We expect that will eventually change as fewer people retire with pension benefits and more people retire with larger DC accounts. DC plan sponsors are keenly interested in the retirement income challenge. The vast majority of those we have spoken with express a sincere desire to provide plan participants the ability to efficiently, easily, and safely draw upon their retirement plan assets over the course of their retirements. While insurance solutions can guarantee this, sponsors express apprehension over issues that arise with these solutions, such as the additional burden of due diligence, lack of portability, high cost, irrevocability, regulatory uncertainty, and product complexity. Such sentiment helps explain the low rate of adoption for retirement income products within plans to date. Yet the need is real, and so a breakthrough seems likely at some point in the future. Exactly what the breakthrough product, whether in-plan or out-of-plan, will look like is yet to be determined. It is difficult to see payout annuities becoming a more general solution in the DC plan marketplace absent legislation to compel adoption because voluntary adoption rates on payout annuities are very low. The future adoption rate of GMWBs in DC plans is less clear, although cost, complexity, portability, due diligence requirements, participant communication, and questions regarding insurance risk capacity needs are all significant hurdles. The breakthrough solution may very well exhibit elements of the various approaches described here, although perhaps in a combination not yet conceived. However it evolves, the future state of the retirement income landscape will depend heavily on the will of regulators, plan sponsors, and participants. Stay tuned as we discuss the issues in more depth in a forthcoming paper on the policy considerations of retirement income approaches. 6 The similarities end there, however. We discuss this topic and highlight the implications of the differences in a forthcoming paper on the policy considerations of retirement income approaches. 7

8 T. Rowe Price at a glance Established in 1937 by Thomas Rowe Price, Jr., T. Rowe Price is headquartered in Baltimore, MD, with offices located in North America, Asia, Australia, and Europe. It has over 5,000 associates worldwide, including 424 investment professionals. T. Rowe Price is a publicly traded firm (TROW) and is one of the few independent investment management firms included in the S&P 500 Index. Important Information This material is provided for informational and educational purposes only and is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. This material provides opinions and commentary that do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision. Information contained herein is based upon sources we consider to be reliable, we do not, however, guarantee its accuracy. Past performance cannot guarantee future results. All charts and tables are shown for illustrative purposes only. The views contained herein are as of December 2014 and may have changed since that time. T. Rowe Price (including T. Rowe Price Group, Inc. and its affiliates) and its associates do not provide legal or tax advice. Any tax-related discussion contained in this article, including any attachments, is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding any tax penalties or (ii) promoting, marketing, or recommending to any other party any transaction or matter addressed herein. Please consult your independent legal counsel and/or professional tax advisor regarding any legal or tax issues raised in this article. T. Rowe Price Investment Services, Inc., distributor. C17K6HLS8 12/ US-5811