By: Brett Hammond
Brett Hammond heads the MSCI’s fixed income and multi-asset class applied research team, which focuses on the multi-asset class investment problems of MSCI’s largest Asset Owner and MAC manager clients.
In the old days, many Americans had a defined benefit (DB) pension that paid them a steady guaranteed income in retirement. But the pension landscape has shifted dramatically: now more than half of all US retirement assets are in self-directed defined contribution (DC) plans, such as 401(k)s and individual retirement accounts (IRAs) – and the figures are rising. These DC plans and IRAs do offer millions the chance to build up and control their own nest eggs, but what they don’t offer is a guaranteed income in retirement. Instead, retirees must manage their nest eggs themselves and hope that their decisions – how much to save, where to invest, and how much to take out each year – and the ups and downs of the market, will permit their money to last as long as they do.
Unfortunately, this is not an easy task and attention is increasingly turning to the retirement income problem: what can be done to assist individuals who want to make their money last a lifetime but are not sure how to do it or whether they have the tools.
One option is that people can turn to a trusted financial advisor. A rule of thumb among financial advisors, all else equal, is that an individual or couple can create a retirement income by withdrawing about four percent per year from their nest eggs, starting at age 65. So, if they have saved $1,000,000, then they can enjoy an income of $40,000 per year in retirement. So far, so good.
But there are two problems. One is whether such an income is actually “adequate.” How can a couple know, many years in advance, what they might need to live on in retirement? What will be their basic food, shelter, clothing, health care, and transportation expenses, as well as the additional discretionary spending on travel, entertainment, etc.? In the old days, DB pension income was partially related to how much the individual made before retirement: the higher the salary and the more years he or she worked, the higher the pension benefit. By contrast, with the DC or IRA, how much you have depends on how much you save and what investment returns you experience. If you didn’t save enough and/or your investments didn’t return what you hoped for, then you might end up with retirement income worth only a fraction of your income prior to retirement.
A second problem is that there are no guarantees. Even for a couple sitting on a nest egg of $1,000,000, taking out a mere $40,000 per year means the couple has an 8-10% chance that the money won’t last until the last of the couple passes. In the old DB pension system, the survivor would continue to receive an income for lifetime. Benefits are less certain in the DC and IRA world, since investments could return much less than the historical average during retirement, and/or at least one member of the couple could live far longer than average. It is possible to run out of money.
So what can be done to meet future income needs and manage the uncertainty of future retirement income?
One answer is Social Security, which provides retirees with a guaranteed DB pension. Currently, starting at age 62, 66, or 70 (you get more if you wait), you will receive a benefit that is indexed to the Consumer Price Index, and lasts as long as you do. Individuals who work for many years receive benefits linked to their preretirement pay, and Social Security replaces about 40% of an average US preretirement income (lower-paid people receive 60% or more, and the higher-paid receive 20% or less). Yet Social Security isn’t enough for many people, leading retirees and their advisors to seek ways to increase the levels of predictable retirement income.
This can be done by incorporating some guaranteed returns and income solutions into the asset mix, both for savings and for retirement income. To illustrate how this could work, we could save using a low-cost index target date fund (TDF) that consists of US and international stocks, bonds, and inflation-linked bonds. If we imagine that the worker saves an initial $571 per month adjusted upward with salary increases by 2% per year, from age 35 to 65 (15% of salary throughout). Using historical returns and allocations of this TDF, the person would accumulate $1,000,000 by age 65. (Note: While hypothetical, those calculations are based on an actual low-cost target date fund family allocations and their historical average returns. The hypothetical guaranteed fund figures that follow are based on actual historical returns and annuity and mortality calculations from a well-known fixed participating annuity with an additional 75 basis points of expenses per year.)
But instead of using the 4% rule, allowing her to spend $40,000 per year until she died or the money ran out, let’s try something different. Instead of putting all of the money in a TDF, let’s say that she instead replaced the domestic and international bond funds (about 22%) in the account with a different insurance company-based fund that guaranteed a return of at least 3% per year, but that historically paid more than 5% per year over the past 40 years. At retirement her total accumulation would still be $1,000,000, but three things are now different.
- First, the individual’s total retirement income will go up. She would only have about $690,000 in her TDF (minus the bond portion), which can be used to produce a retirement income of $27,500 per year (the 4% spending rule applied to $690,000). But the money in the guaranteed fund ($310,000) can now be converted to a guaranteed benefit of about $18,800 per year. All told, her combined income is now $46,500 per year, or about $6,500 higher than in the all-TDF case. This increase is not due to any extra returns on the assets: rather, it arises because the assets held in the guaranteed fund are pooled by the insurer with assets from other individuals who want a guaranteed income. Because some people will die earlier than others, actuaries can calculate how the whole group can share the risk and how to pay out the future income from the pool. And this safety is not free: the assets paid into the guaranteed income fund revert to the insurance company pool, so the retiree cannot pull the money back out.
- Second, the volatility of the individual’s savings from year to year are dampened a bit because some of the assets are invested in a guaranteed investment that can never go down, as compared to the all-TDF case where all of the assets are subject to market ups and downs.
- And third, the individual’s income is guaranteed to last as long as she lives. In addition, this case assumes that she has requested that that the benefit be paid for sure for 20 years, even if she died before that, with the remainder going to a beneficiary.
While this is a hypothetical illustration, since we can’t know how either the target date fund or the guaranteed fund will behave in the future, it is intriguing in that with the same path of lifetime contributions, the worker can create additional guaranteed income to go with the guaranteed income from Social Security. Insurance-based funds such as these are commonly sold by brokers with commissions and fees that can reduce the benefits, but there are lower-cost versions – called deferred fixed annuities – that can be purchased through some DC retirement plans. Moreover, the US Internal Revenue Service and the US Department of Labor are encouraging plan sponsors to include these guaranteed income options in retirement plans. These are useful to enable retirees to supplement Social Security income guarantees and get back some of the key attractive features of the old DB plans.