Allianz Global Investors white paper series Transition risk: Rethinking investing for retirement By Tim Friederich, David Karim and Dr. Wolfgang Mader Executive summary Are millions of Americans, retirement-plan sponsors and financial advisors really focusing on the right retirement goal? This white paper explores the critical but often overlooked dangers presented by transition risk the risk that investors make the transition from accumulation to income at an unfavorable point in time under unfavorable market conditions. Learn why fluctuating interest rates the most unpredictable factor in the retirement-income equation make it imperative to help plan participants shift the focus from asset value at retirement to income in retirement. Key takeaways The focus of retirement plans should shift from portfolio value at retirement to income in retirement. This shift involves transition risk; because it can have a significant impact on retirement income, it must be taken seriously. The effect of transition risk can, in some scenarios, be even more severe than the effect of falling stock markets, particularly when plan participants are close to retirement. There are thoughtful and effective ways to manage transition risk within existing retirement plans, which can help lead to a prudent retirement-income stream. Saving for retirement not only involves some of the most difficult and complex financial decisions most investors will make in their lifetimes, but it can have one of the most significant impacts on their quality of life. That is why it is so important for retirement-plan sponsors and advisors to be aware of the different dimensions of risk involved in retirement investing so they can help plan participants make the right choices for their individual retirement needs. What is transition risk? Transition risk is the risk that investors transition from accumulation to income at an unfavorable point in time under unfavorable market conditions. Transition risk may lead to a substantial decrease in retirement income even in cases where the portfolio value before the transition did not display high losses, but the cost of purchasing an income stream (e.g., annuitization) became significantly more expensive at the transition. An overwhelming focus on asset value at retirement There are several risks which should be taken into account to help investors make smart retirement choices. Some are widely known, yet others tend to be overlooked even though their impact can be crucial. One of these neglected risks transition risk is the primary topic of this paper. The most common interpretation of risk is financial-market risk, or the risk that investors could lose money if their asset prices fall. This is the risk that investors are perhaps most aware of thanks to a media environment that reports daily prices of stocks, bonds, mutual funds and other investment products. This steady flow of information keeps investors informed about what their portfolios are worth in terms of dollars, and it gets their attention by playing right into their biggest fear: the risk of declining asset values. us.allianzgi.com
Exhibit 1: How transition risk fits into the retirement equation Most plan participants spend years focusing on accumulating wealth for retirement. But transition risk can happen quickly and at a critical time, and it is often overlooked. It is important to factor transition risk into the investment strategies of retirement plans to help shift the focus from asset value at retirement to income in retirement. Timeline Savings Phase 30+ years of saving Retirement Income Phase 20+ years of spending Primary focus areas Portfolio Value Transition Retirement Income Major risks for individuals! Market Risk Did your asset value decline at an unfavorable time?! Transition Risk How much income can you afford at current interest rates?! Longevity Risk Will you outlive your money given your asset value and current rates? This fear is justified to some extent after all, asset values have a large impact on retirement savings but it is not the only risk investors should be concerned about. Moreover, the closer plan participants get to retirement, declining asset values may not even be the most important risk. The need to shift focus to income in retirement To understand which risks retirement-focused investors should concentrate on, we need to ask important questions: What are investors saving for? To have money at retirement? Or to have money in retirement? Although the difference between the two concepts is just two letters long, it is key. Because of widespread awareness of financial-market risk, there is a widely held belief that it is more important to focus on maximizing money at retirement, and therefore that accumulation is imperative. At Allianz Global Investors, we believe this view is wrong, and that plan sponsors and advisors must help participants shift the focus from asset value at retirement to income in retirement. We further believe that retirement income, in most cases, should be derived from a combination of drawing down principal and securing a guaranteed income stream 1 to meet basic needs and maintain living standards. Why is this shift in focus so important? Because maximizing or securing the net asset value of the plan participant s portfolio at retirement is not necessarily equivalent to maximizing or securing a retirement income stream. This is where transition risk comes into play (see Exhibit 1). Why transition risk is important Transition risk is closely related to longevity risk the risk that investors will outlive their money. 2 While the demographic trend toward living longer than ever is generally a positive one, it also increases the danger that retirees will run out of money during retirement. As a result, not only is it important that investors consider guarding against longevity risk to some degree, but in many cases it will be advisable that they do so. 3 This will require prudently planning an anticipated income stream and perhaps even securing a certain retirement-income level in the form of a lifelong guarantee. The issue, however, is that although guaranteed products provide a stable and predictable income stream during retirement, the prices of these products, or the fair value of any retirement-income stream, are volatile and subject to several factors above all, interest rates. To illustrate the issue, consider this example: An investor saves for retirement in one currency (portfolio value), yet retirement income is measured in another currency (income stream). At some point in the retirement-savings process (the transition ), the investor needs to exchange one currency for another. But this exchange rate fluctuates with interest rates. If the investor has a high amount of one currency (a high portfolio value), he or she might need to exchange it for the other currency (income) at a time when rates are unfavorable. Even if an investor s portfolio value continues to increase during retirement, he or she may get less retirement income if the price of getting that income of exchanging one currency for another is increasing at a higher rate. 2
We believe that smart retirement strategies should not only aim at growing portfolio values but also at growing retirement income. That is why it is important to reduce transition risk by setting up the portfolio in such a way that it keeps the expected future retirementincome stream as stable as possible and reduces the exposure of retirement income to changes in the interest-rate environment. The impact of transition risk on retirement income The main driver of transition risk is the level of interest rates. In general, lower interest rates make the fair value of the retirement-income stream and therefore the price of guaranteed products more expensive. Higher interest rates, on the other hand, make the same income stream less expensive. Another driver of transition risk is survival probabilities in other words, life expectancies. Life expectancies, however, do not fluctuate the way interest rates do; in fact, they go steadily in one direction. Interest rates are the big, unpredictable stochastic factor in the retirement-income equation. Pricing that income stream is exactly what issuers of guaranteed products like annuities or guaranteed minimum withdrawal benefits (GMWBs) do when determining the prices for their products. To get an idea of how significant the impact of transition risk is, consider a world with flat interest-rate curves. In reality, interest rates tend to be higher for longer maturities. Exhibit 2 shows the fair value of a retirement income stream of $1,000 per month for two 65-year-old US investors one female, one male at different interest rates. As Exhibit 2 shows, female investors pay a higher amount for retirement income than male investors for a simple reason: statistically, women have longer life expectancies than men. Also of note: Given a 6% interest rate, a female investor would need to pay roughly $135,000 for this income stream. In a 2% interest-rate environment, the same retirement-income stream would cost $197,000. For a male US investor, the price would rise from $124,000 to $176,000 in the same scenario. Exhibit 2: How interest rates can affect future income Fair value of monthly income stream of $1,000 for a 65-year-old US investor at different (flat) interest-rate levels Monthly income for a 65-year-old US investor for a fair value of $100,000 at different (flat) interest-rate levels Female Male Female Male 0% $248,276 $216,153 $403 $463 1% $220,522 $194,215 $453 $515 2% $197,361 $175,644 $507 $569 3% $177,883 $159,815 $562 $626 4% $161,380 $146,235 $620 $684 5% $147,297 $134,508 $679 $743 6% $135,197 $124,322 $740 $804 7% $124,733 $115,423 $802 $866 8% $115,628 $107,605 $865 $929 9% $107,658 $100,702 $929 $993 10% $100,643 $94,575 $994 $1,057 11% $94,436 $89,112 $1,059 $1,122 12% $88,916 $84,219 $1,125 $1,187 13% $83,983 $79,818 $1,191 $1,253 14% $79,555 $75,844 $1,257 $1,318 15% $75,564 $72,241 $1,323 $1,384 Source: Allianz Global Investors. These are hypothetical examples for illustrative purposes only and do not factor in potential fees or expenses incurred by securing an income stream. See the disclosure at the end of this document for information about survival probabilities and interest rates. 3
Exhibit 3: The effect of historical interest rates on the fair value of an income stream Fair value of income stream of $1,000 monthly for 65-year-old male and female US investors over time, based on historical interest rates. $220,000 $200,000 $180,000 See Exhibit 4 Male See Exhibit 5 Female $160,000 $140,000 $120,000 $100,000 $80,000 $60,000 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 Exhibit 4: The effects of interest rates and market volatility during 2008 Close-up view of 1/1/2008 1/1/2009, comparing the same income streams in Exhibit 3 with the performance of a hypothetical 60/40 portfolio, all indexed to 100. 130 120 Female Male 60/40 Portfolio Exhibit 5: The effects of interest rates and market volatility, July 2011 to July 2012 Close-up view of 7/1/2011 7/1/2012, comparing the same income streams in Exhibit 3 with the performance of a hypothetical 60/40 portfolio, all indexed to 100. 130 120 Female Male 60/40 Portfolio 110 110 100 100 90 90 80 80 70 1/1/2008 4/1/2008 7/1/2008 10/1/2008 1/1/2009 70 7/1/2011 10/1/2011 1/1/2012 4/1/2012 7/1/2012 Source: Allianz Global Investors. The 60/40 hypothetical portfolio consists of 60% stocks (represented by the S&P 500 Total Return Index) and 40% bonds (represented by the Barclays US Aggregate Index) and is rebalanced monthly. Past performance is not indicative of future results. These are hypothetical examples for illustrative purposes only and do not factor in potential fees or expenses incurred by securing an income stream. See the disclosure at the end of this document for information about survival probabilities and interest rates. 4
How can transition risk be managed? There are several thoughtful and effective approaches for managing transition risk within plan-participant portfolios. Certain glidepaths can incorporate retirement income into the savings phase for example, via forward annuities. In these cases, glidepaths can gradually adjust the allocation and thereby mitigate transition risk. Other possible products that can be included in a glidepath to produce an income stream are guaranteed minimum withdrawal benefits (GMWBs), other types of variable annuities, laddered-bond portfolios or Treasury Inflation-Protected Securities (TIPS). It is important to ensure when including these investments that the glidepath accounts for their particular risk-return profile to determine the optimal allocation. Other sophisticated approaches can manage a portfolio with respect to retirement income as one dimension of risk. These approaches aim at delivering a retirement-income stream rather than maximizing the portfolio s value. They do not necessarily require investment in guaranteed products before retirement, and are designed to provide a large degree of flexibility. The optimal solution will always take into account the specific retirement plan, its characteristics and investment goals, as well as the plan s setup and regulatory requirements. Due to changing interest rates, the price of securing the same income stream increased by more than 40% in both cases. Looking at it from a different angle, the amount of retirement-income one can afford for a certain amount of money can drop significantly when interest-rates fall. For example: Assuming a 6% interest rate, a 65-year-old woman with $100,000 could transform $100,000 into a monthly income of $740. If interest rates dropped to 2%, the monthly income would drop to $507. For a man, the monthly income would decrease from $804 to $569 in the same scenario. Exhibit 3 displays the development of the fair value of the retirementincome stream depending on the actual interest-rate curve at any point in time. To illustrate the fact that transition risk does not always strike at the same time that the financial market risk causes asset values to fall, consider the following two scenarios. Over the course of 2008 (see Exhibit 4), low US interest rates caused the fair value of a $1,000 monthly retirement-income stream for a 65-year-old US woman to rise from $161,863 to $183,813. Assuming that she had the same amount of money to invest in a retirementincome product, this would mean 12% less retirement income. Depending on how high her allocation to stock markets was in 2008, this drop in income may have been even more severe than the drop in portfolio value caused by falling stock prices. In other words, by not hedging against transition risk, this hypothetical investor would have taken two big hits in 2008. Now consider the period between July 2011 and June 2012 (see Exhibit 5). The S&P 500 Total Return Index gained 5.4% in this time period. But because interest rates were moving lower, the fair value of a monthly $1,000 retirement-income stream for a 65-year-old male US investor increased from $156,297 to $179,084 (by 14.8%). Again depending on the portfolio allocation of the investor, prices of guaranteed products likely would have increased more during that time than the portfolio value. For example, an investor with a 60/40 allocation would have seen a 5.9% return in asset value during this period, which would have compensated for only half of the decline in retirement income. In general, despite rising asset prices, lower interest rates meant that the anticipated retirement income might have decreased for investors who did not hedge against transition risk. Our view Investing for retirement is a complex task that involves multiple dimensions of risk: financial-market risk, inflation risk, longevity risk and transition risk, to name some of the most important. It is crucial that plan sponsors and individual investors alike take them all into account in order to achieve their retirement goals. Accepting the need to shift the focus from portfolio value to retirement income which is exactly what we can observe in form of the DB-ization of DC plans, an important and right trend for plan participants and plan sponsors alike transition risk becomes even more important. Although underestimated or even totally neglected in the past, effectively managing transition risk can have a major impact on investment goals one that is no less significant than the impact of financial-market risk. Investment strategies must take all these risks into account to avoid losses in retirement income and provide investors with a sufficient and predictable retirement-income stream. 5
Endnotes 1. One straightforward way to achieve such a combination is with a deferred annuity, as suggested by the DBDC Index. See Sexauer et al (2012): Making Retirement Income Last a Lifetime, Financial Analysts Journal, Vol. 68. No. 1. 2. In 1989, Z. Bodie highlighted the importance of longevity risk and the guarantee aspect of pensions in his NBER paper, Pensions as Retirement Income Insurance. 3. See A Pension Strategy That s Worth The Wait by Professor Shlomo Benartzi, published in the Financial Times, July 8, 2012. About the authors Tim Friederich Vice President, Solutions Specialist Mr. Friederich is a solutions specialist and a vice president with Allianz Global Investors, which he joined in 2009. As a member of the AllianzGI Global Solutions team, he is responsible for solutions services in the North American market, working with local business units to develop investment solutions tailored to clients individual investment needs. Mr. Friederich has an M.S. in finance and information management from the Technical University of Munich and the University of Augsburg. He is currently working on his Ph.D. thesis in financial mathematics at the Technical University of Munich in cooperation with the University of Toronto. About the Authors David Karim Vice President, Analyst, risklab* Mr. Karim is a vice president at risklab, the expert for risk within the Global Solutions division of Allianz Global Investors. As a member of the DC & Retirement Strategies team, he is primarily responsible for designing investment strategies and for managing defined contribution (DC) mandates. Mr. Karim has an M.Sc. in applied mathematics and scientific computation from the University of Paris. He is an honorary lecturer in finance at the University of Paris and has worked with the OECD to publish studies on the management of DC pension plans. About the Authors Dr. Wolfgang Mader Managing Director, Head of Asset Allocation Strategies Dr. Mader is a managing director at risklab. As Head of Asset Allocation Strategies and Economic Scenario Generation, he is primarily responsible for the fields of strategic asset allocation, dynamic asset allocation and risk management. Before joining risklab, Dr. Mader was an asset-management consultant to insurance companies and investmentconsulting firms. He also worked as a lecturer in banking and finance at the University of Augsburg. Dr. Mader has a diploma in business management from the University of Augsburg; he earned a Ph.D. in finance in 2005 with a thesis on Hedge Funds Alternative Investment Strategies and Portfolio Models. *risklab GmbH ( risklab ) is an Allianz Global Investors company registered with Bundesanstalt für Finanzdienstleistungsaufsichtt as a provider of financial services in Germany. The risklab brand name is used according to the trademark license agreement between risklab GmbH, Germany (licensee) and Algorithmics Trademarks LLC and Algorithmics Incorporated, Canada (licensor) (both companies now IBM). risklab provides risk management and strategic and dynamic asset allocation solutions to support the investment advisory activities of the properly registered and licensed affiliates of Allianz Global Investors, including Allianz Global Investors U.S. LLC, an SEC registered adviser. While risklab is not registered with the SEC, AllianzGI US may use the resources of its investment advisory affiliates ( Participating AllianzGI Affiliates ), including risklab, to provide portfolio management, research and trading services to AllianzGI US clients. Under collaboration agreements, each of the Participating AllianzGI Affiliates and any of their employees who provide services to clients of AllianzGI US are considered associated persons of AllianzGI US as that term is defined in the Investment Advisers Act of 1940, as amended. 6
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About AllianzGI Global Solutions AllianzGI Global Solutions is a leading provider of risk management, fiduciary management, asset allocation and retirement solutions. We tailor our services to meet the specific requirements of our institutional clients through a broad range of customized service offerings. About Allianz Global Investors Understand. Act. This two-word philosophy is at the core of what we do. To stand out as the investment partner our clients trust, we listen closely to understand their needs, then act decisively to deliver solutions. We are a diversified active investment manager with a strong parent company, a culture of risk management and $496 billion in assets under management.* With 24 offices in 18 countries and over 500 investment professionals, we provide global investment and research capabilities with consultative local delivery. Survival probabilities are based on the Period Life Table of the Social Security Administration of the USA, as of 2009. Interest rates are the US Treasury Constant Maturity Rates as published by the St. Louis Fed. Interest rates for maturities between reported maturities are interpolated. *Combined worldwide assets under management as of June 30, 2015. The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Forecasts and estimates have certain inherent limitations, and are not intended to be relied upon as advice or interpreted as a recommendation. Allianz Global Investors U.S. LLC ( AllianzGI US ) is an SEC registered investment adviser that provides investment management and advisory services primarily to separate accounts of institutional clients and registered and unregistered investment funds. AllianzGI US manages client portfolios (either directly or through model delivery and wrap fee programs) applying traditional and systematic processes across a variety of investment strategies. AllianzGI US may also provide consulting and research services in connection with asset allocation and portfolio structure analytics. NFJ Investment Group LLC is an SEC registered investment adviser and wholly-owned subsidiary of AllianzGI US. 2015 Allianz Global Investors. All rights reserved. WP-13-0615 AGIUS-2015-09-30-0728 01012