Cameron Ellis is the Hentges Fellow and Assistant Professor of Finance at the Tippie College of Business, University of Iowa. Twitter: @cellis212. Thorsten Moenig is an Associate Professor of Risk, Actuarial Science, and Legal Studies at the Fox School of Business, Temple University. Jacqueline Volkman-Wise is an Associate Professor of Finance and Associate Director of the Pedro Arrupe Center for Business Ethics at the Haub School of Business, Saint Joseph’s University.
Retirement security remains a pressing challenge for American workers. Many rely on employer-sponsored plans, yet evidence suggests that too few employees are well-prepared to maintain a comfortable lifestyle in later life. While automatic enrollment and target-date funds (TDFs) have become popular tools to boost plan participation, these funds have recently faced criticism for high fees, unpredictable performance, and lack of transparency.
In our new study, we propose an alternative approach to manage retirement savings, namely to embed Registered Index-Linked Annuities (RILAs) in a target-date framework. We call these products Target-Date RILAs (TD-RILAs). We offer several reasons that they merit serious consideration by plan sponsors, either as an option or as a default investment in employer-sponsored retirement plans.
From TDFs to TD-RILAs: What’s the Difference?
Target-date funds are designed to shift gradually from higher-risk (mainly equities) holdings to lower-risk (fixed income) assets, as the investor nears retirement. They often serve as Qualified Default Investment Alternatives (QDIAs) in 401(k) plans, given their simple “set it and forget it” appeal. Yet TDFs can be expensive—especially those with active management—and research suggests their performance isn’t always predictable or transparent.
Registered Index-Linked Annuities are insurance products linked to an equity index (such as the S&P 500) and offer partial downside protection (with a “floor” or “buffer”), paired with an upside “cap.” Because of how RILAs hedge equity exposure, they can be offered at relatively low cost compared to other annuity products, and they can be easier for investors to understand since RILA providers typically compete only via published cap rates.
So what’s a TD-RILA? A Target-Date RILA applies the RILA concept—index-based returns with built-in downside protection—on a glide path over time, much like a TDF. As the individual gets closer to retirement, the downside protection increases automatically, lowering the risk of substantial market losses at exactly the point in life where those losses would hurt the most.
Our Key Findings
Just like TDFs, a TD-RILA would automatically reduce the worker’s equity exposure as retirement approaches. Instead of moving out of equity and into bonds, however, this new product would decrease the “floor” or increase the “buffer” (and simultaneously lower the cap) over time. Our theoretical model suggests that an optimal design for a TD-RILA mimics the decreasing risk profile of TDFs, by enhancing the saver’s downside protection over time.
In our theoretical setting, we show that TDFs could edge out RILAs if both had identical fee structures. Yet TD-RILAs could be cheaper to manage than TDFs, thanks to efficient hedging via exchange-traded index options and the ability to adjust cap rates to reflect current market conditions (i.e. option prices). Once we factor in typical costs for these, TD-RILAs become equally attractive as TDFs, and in many scenarios, they deliver higher risk-adjusted value.
To gauge people’s retirement plan investment choices, we ran an online experimental survey. People who received personalized distributional estimates—that is, who were told how much monthly retirement income each product was likely to deliver—were more decisive and more responsive to fee changes. Interestingly, having a default option in the plan also shaped choices (as expected), yet receiving the individual projections about potential retirement income streams had an even larger effect on which product participants chose.
We also compared two forms of downside protection: a buffer (protecting against the first portion of losses) versus a floor (limiting the worst-case scenario). That is, for a TD-RILA with a 5% buffer, losses would be reduced by 5%; the same product with a 5% floor would indicate the investor can lose 5% of their funds at most. Both types of TD-RILAs offered improvements over TDFs and both were attractive to potential investors.
Practical Implications for Plan Sponsors
It is now well-known that automatically enrolling workers into a retirement plan leads many to remain in their employer-selected the default investment fund. While TDF defaults remain popular, a TD-RILA default could become as appealing (if not more so), for those seeking downside buffers without paying without paying excessive active management fees.
Additionally, TD-RILAs, with their straightforward and rule-based equity-to-protection glide path, have the potential to serve as a compelling alternative or complement to traditional TDFs. They might also be attractive to participants especially concerned about market downturns as they age.
Our experiment also underscored that employees are quite fee-sensitive when given easy-to-digest projections of how lower fees can translate into more retirement income. Emphasizing cost transparency in the TD-RILA context could help employees make better-informed decisions.
The Outlook
As the U.S. continues its long term trend toward defined contribution plans, we believe that enhancing the menu of investment options, particularly default investments, will help meet employees’ needs. Since TD-RILAs represent a transparent, rules-based, and cost-effective approach to targeting equity risk over time, we suggest they could stand toe-to-toe with, or perhaps even outshine, traditional TDFs in many circumstances.
Views of our Guest Bloggers are theirs alone, and not of the Pension Research Council, the Wharton School, or the University of Pennsylvania.
