I advise you to go on living solely to enrage those who are paying your annuities. It is the only pleasure I have left.

—Voltaire

In April 2007, I had the pleasure of interviewing, for PIMCO’s DC Dialogue, a friend and former fellow board member at the Financial Planning Association: Susan Bradley, CFP. Susan is a nationally recognized financial planner, esteemed author, and founder of the Sudden Money Institute, which is dedicated to working with individuals to address the emotional and financial impacts of receiving “sudden money.” Now, when we think about the idea of sudden money, what normally comes to mind are events such as winning a lottery or receiving a large inheritance—but for most Americans, receiving their retirement savings, such as funds in a defined contribution pension plan, is about as close to lottery winnings or an inheritance as they’ll ever get. Yet sudden money in all its forms—from unexpected windfalls to carefully saved retirement accounts—changes lives and adapting to this change requires transition.

In this book thus far, we have focused on how plan sponsors and participants can work to ensure the best outcomes from their DC plans, from the point of view of ensuring those plans are sufficiently funded and designed to provide the retirement income plan that participants will need. But what happens to participants, plan sponsors, and plans at the point of retirement? Should retirees leave their assets in DC plans, roll them over to an individual retirement account (IRA) to invest in capital markets, or buy an annuity to create retirement income? What are plan sponsors’ preferences? What are the options to create income in retirement that participants need, and plans should provide? Is the range of existing investment choices appropriate and sufficient?

In this chapter, we will address these questions as we shift our focus from DC plan design for the accumulation years to the decumulation or distribution phase—when DC plans may transform to delivering a retirement paycheck. We will focus on what both advisors and consultants have told us is important for retirees. Then we provide suggestions for plan sponsors as they work to retain retiree assets. We suggest an approach and analytics for evaluating the appropriateness of at-retirement target-date or other retiree-intended asset allocation strategies, and close with a discussion of the potential beneficial role of deferred income annuities (i.e., longevity insurance).

ADVISOR AND CONSULTANT RETIREMENT INCOME SUGGESTIONS

As participants get closer to retirement, their financial lives become more complex and thus the importance of individual planning comes sharply into focus. Some plan sponsors make available either internal or external financial planners, via phone or in-person meetings, to help meet individual planning needs. Preretirees can benefit from working with financial planners who are trained not only in investment management, but also broader financial planning issues such as insurance and risk management, tax and estate planning. Susan Bradley notes the importance of providing financial planning as a boost to employee loyalty—as a way to attract talented people and keep them. Ideally, she says, a preretiree has a company professional or financial planner work with them to model retirement scenarios and evaluate the possible paths. The planner may ask, “If we take this option, retire at this point, live in this house, and spend at this level, how long does our money last?” Participants may use scenarios to test whether they are both emotionally and financially ready to retire, as well as the likely longevity of their money. Providing this professional help to support the retirement decision may also benefit the employer to manage their workforce engagement and attrition.

As plan fiduciaries consider offering participants access to advisors, it is important to understand the compensation structure for those advisors who are engaged to provide advice; plans should seek advisors who will act in the best interest of their participants. In April 2017, the Department of Labor (DOL)’s conflict of interest rule is scheduled to become effective. The DOL’s intention in putting this rule into place is to help protect investors by requiring all those who provide retirement investment advice to plans and IRAs to abide by a fiduciary standard—putting their clients’ best interest before their own profits. To fulfill this fiduciary duty, advisors should make participants aware of the benefit of retaining assets throughout retirement in a former employer’s DC plan. While not all DC plans offer cost or investment advantages relative to rolling over to an individual retirement account, at a minimum DC plans provide fiduciary oversight of the investment menu and, in many states, may protect assets from creditors where IRAs may not.

In the DC Dialogue noted above, Bradley discusses the issues retirees face and how they can transition to and remain in retirement successfully. She also considers how plan sponsors can help. Among her suggestions is a call for automated asset allocation or rebalancing choices, as she observes that “people will spend less time managing their money” in retirement. She also advocates offering a diverse set of investment choices, including those that provide inflation protection. Finally, she advises plan sponsors to consider offering conservative income-paying investment or annuity choices. Bradley underscores the value plan sponsors can deliver by offering institutionally priced investments and group annuity rates, and she is not alone in her suggestions.

In PIMCO’s 2016 Defined Contribution Consulting Support and Trends Survey, consultants reported that 51 percent of their clients either actively seek to retain client assets (21 percent) or prefer retaining these assets, but do not actively encourage (30 percent) clients to keep their assets in their plans; only 16 percent of clients prefer retirees move their assets out of the plan. Notably, compared with 2015 survey results, consultants reported a 50 percent higher percentage of clients actively seeking to retain assets in the plans at retirement, up from just 14 percent in 2015 (see Figure 10.1).

The consultants, as with Bradley, also emphasize the importance of offering asset allocation and income-focused strategies in retirement; as shown in Figure 10.2, among investment and insurance retirement income strategies, they actively promote at-retirement target dates (30 percent), cash management (29 percent), and multisector fixed income (19 percent) strategies.

At-retirement target-date strategies are all the more important given the growing percentage of retiree (i.e., participants aged 60 and up) assets allocated to these strategies. As shown in Figure 10.3, target-date funds as of year-end 2014 captured over 16 percent of assets for participants 60 years of age or older. Combined with balanced funds, these asset allocation strategies surpassed stable value assets with 24 percent versus 21 percent, respectively. If we combine money market assets (2 percent) with stable value (21 percent), the asset allocation strategies still slightly exceed these capital preservation vehicles. We anticipate this trend to continue over the coming decade.

Consultants also generally support managed accounts and a range of insurance solutions for retirement income such as out-of-plan annuities, asset allocation with lifetime income guarantee, in-plan deferred income annuities, and in-plan immediate annuities. (Note that in-plan deferred income annuities may be a component of a target-date fund or a distribution option; in-plan immediate annuities refers to purchasing an annuity at the point of retirement.) Immediate and deferred income annuities can be offered as either a plan distribution option—a qualified plan distributed annuity, or QPDA—or as a rollover to an IRA.

However, the consultants also noted in Figure 10.4 many concerns with in-plan accumulation insurance products, including portability (67 percent), cost (63 percent), and insufficient government support (62 percent).

WHY DON’T RETIREES LEAVE THEIR ASSETS IN DC PLANS AT RETIREMENT?

While advisors and consultants generally agree with the benefits of retaining retiree assets in a DC plan, retirees are often quick to roll their money out of the DC plan—often to higher-priced investment products within a retail IRA. In November 2013, PIMCO dug into why retirees may fail to retain their assets in DC plans once they hit the retirement stage of their investing lifecycle, and we published our results in an article titled “Sponsors Ask Retirees, ‘Why Don’t You Stay?’ Seven Questions for Plan Sponsors.” In our paper, we noted that while the term used to describe plan assets leaving as members enter retirement is leakage, it may be better termed a deluge as every year hundreds of millions of dollars spill out of defined contribution plans. Yet retaining 401(k) participants’ assets may yield big cost savings and other benefits, both for sponsors and investors. In an era of increased focus on fees and fiduciary obligations, we suggest that plan sponsors actively consider whether to encourage retirees to stay in their plans. Regardless of the decision, sponsors need to make sure their plans are appropriately structured for retirees.

Plans with more participants and assets generally can benefit by commanding better pricing on investment management and services. According to financial information company BrightScope (www.brightscope.com), in an analysis based chiefly on 2014 government filings, the average total cost for the largest 401(k) plans (those with more than 5,000 participants) was 52 basis points (bps). In contrast, the average cost for the smallest plans, with fewer than 200 individuals, was 107 bps, or more than double the cost in the largest plans. Because they do not share the benefits of scale in purchasing services, it stands to reason that IRA costs may be similar to those of the smallest 401(k) plans. But the cost difference can certainly add up: Compounded over many years, a reduction in fees from 100 basis points to 50 basis points could extend the potential of participants’ 401(k)s to provide retirement income by several years.

In addition, retirees who stay in 401(k) plans may access stable value, custom target-date, and other strategies that are not available in IRAs. As noted above, they may also enjoy the investment due diligence and oversight of the plan sponsor fiduciary and as plans that are qualified under the Employee Retirement Income Security Act (ERISA), 401(k)s may offer superior asset protection from creditors for retirees and beneficiaries, at least in some states. (While assets in qualified retirement accounts cannot be pursued in bankruptcy proceedings, outside of bankruptcy the extent to which creditors can pursue assets held in IRAs varies by state.)

Despite plan sponsors’ ability to force terminated vested participants out of the plan at age 65, the majority of plans allow retirees to stay. Notably, the larger the DC plan, the more likely retirees will be allowed to retain assets in the plan; two thirds of all DC plans allow retirees to retain their assets in-plan, which rises to 74 percent for plans with more than 5,000 participants. In the July 2014 DC Dialogue interview with Pete Apor, Director of Retirement Services at Fujitsu, he told us about the retirement income projections, planning workshops, and other efforts his company has pulled together to help retirees prepare for and successfully remain in retirement. Among these efforts, Fujitsu works together with the plan’s recordkeeper to help retirees understand the benefits of retaining assets in the plan:

We have worked with our recordkeeper to help communicate the benefits of remaining in the plan relative to rolling over to an IRA. We tend to retain DC assets for the majority of our retirees. Retirees understand the many benefits of remaining in the plan, including our institutionally priced investment management, custom target-date funds, stable value and the oversight we provide. In an IRA, they would pay a lot more and not have access to funds like stable value. They realize that we evaluate our funds and that, as a fiduciary, we have a responsibility to oversee the plan in a way that they may not get in an IRA or from an advisor.

There are other important benefits to keeping assets in an ERISA plan, including creditor protection—although you hope this isn’t an issue for retirees. Many who roll to an IRA may not realize they are giving this up. We have had retirees roll assets out of the plan to an IRA and then regret doing so, saying “If I could do it over again, I would not have left [the Fujitsu DC plan].” In response, one of our recent plan enhancements now allows terminated participants to roll their money back into our plan. And retirees are rolling money back into the plan from IRAs.

In addition to written communications, our recordkeeper trains its phone reps on how to educate participants on the benefits of remaining in the plan. The reps actively encourage participants to stay in the plan, and also help them to roll in an IRA or other retirement assets. It’s critical to find a recordkeeper that’s on your side and wants to help retain the assets in the plan. We had to change recordkeepers to get the asset retention support we needed. Our prior recordkeeper seemed to work hard to move assets out of our plan to its proprietary IRAs. At one point, this created negative cash flows in our DC plan. This negative flow stopped once we changed to our current provider, and now we experience positive cash flows. It’s been truly refreshing to have a partner that shares our objective to retain assets. They’ve been extremely helpful.

Of course, retaining assets as well as rolling in IRAs and other retirement assets also provides a lot of benefit to our active participants. They too enjoy the benefits of scale—our lower institutional investment management and service costs.

Unlike Fujitsu, however, most plans do little to actively encourage asset retention. One reason noted anecdotally by some plan sponsors for this is plan sponsors’ apprehension about extending their fiduciary responsibilities to additional participants, which is a reasonable concern. However, given that most plans already keep many participants beyond retirement, it is prudent to make sure that plans meet the needs of retirees.

In PIMCO’s 2016 Defined Contribution Consulting Support and Trends Survey, we asked consultants what strategies they thought plan sponsors should take to encourage retirees to retain their assets in DC plans after retirement. The most popular response was “add retirement education/tool,” followed by “allow distribution flexibility” and “offer drawdown retirement advice.” The results are shown in Figure 10.5—and cover a range of suggestions, from providing direct advice to the preretiree, training plan member staff to encourage retention, and offering a brokerage window. Notably, just 4 percent responded that they do not recommend that plan sponsors encourage retention.

RETAINING A RELATIONSHIP WITH YOUR EMPLOYER IN RETIREMENT: AN INNOVATIVE AND CARING PLAN SPONSOR

In February 2010, we spoke with Georgette Gestely, director of the New York City Deferred Compensation Program about the deemed traditional and Roth IRAs offered within its plan to employees, as well as to retirees and spouses. Gestely stands out in the public plan community as a leader in retirement plan design. She explains how her organization set up its deemed IRA programs, and why employees and retirees alike find the programs attractive. We asked her whether her organization encourages participants to remain in the plan after retirement:

Yes, we do. Our IRA programs help us do it by enabling participants to consolidate and continue building retirement assets in our institutionally priced programs. From an altruistic point of view, participants may be much better off remaining in our plan than they are moving outside of it because the plan aggregates those participants’ assets with everyone else’s. You’re not in an individual account but, rather, a deemed IRA within a group plan. Keeping your assets in our plans may be good for all other participants, too, as the plan receives better breakpoints on investment fees when we have more money in the plans.

In her comments, Gestely emphasized the support that her organization provides to employees considering retirement, and the importance of educational efforts that accompany the discussions employees have about their plans:

Our financial planning department provides seminars on retirement and distribution planning. The seminars walk people through each program offered by the plan, discussing the roles and characteristics—the “different pots of money,” as we call them—from pension to Social Security to DC and IRA programs. We help people understand the tax issues as well as how to access their money in retirement. This includes how to make money last throughout retirement.

Employees also can obtain program educational materials from the financial planning department that explain the accounts’ advantages and differences. People need to take some time to figure out what’s best for them.

Gestely mentioned that the New York City Deferred Compensation Program also provides an online financial planning software tool that helps estimate the amount of money employees may have in retirement: “It’s helpful software, especially when employees also attend a retirement planning seminar. We use a program that’s customized for our plans and participants.” Overall, she emphasized the importance of support and education as participants work their way through the retirement choices they need to make:

Education is very important. I can’t stress that enough. To make any of this work, you must have in place a robust educational program because it’s impossible for people to understand all the benefits, pros and cons of each of the programs. Make sure people don’t make any decision until they understand each plan’s benefits. It’s easy to give this message: People must take time to go through the choices. But you also need education with it.

MUTUAL BENEFITS: RETAINING RETIREE ASSETS MAY HELP BOTH RETIREES AND PLAN SPONSORS

In summary, our findings (published in our November 2013 “Why Don’t You Stay?” paper) are that retaining retirement assets in a DC plan may offer significant benefits to both retirees and other plan participants. Doing so may allow retirees to maintain access to institutional investment strategies and, if the sponsor allows, a drawdown plan that can provide consistent monthly income. For plan sponsors, retaining retiree accounts can increase assets and bolster leverage to negotiate lower fees. This benefits all participants—and may help employers attract and retain workers. By raising retiree awareness of the many benefits of remaining in the plan, more retirees are likely to retain their money in the plan and potentially increase the life of their retirement assets. More retirees will likely respond, “Thank you, I think I will stay.”

TURNING DC ASSETS INTO A LIFETIME PAYCHECK: EVALUATING THE DC INVESTMENT LINEUP FOR RETIREE READINESS

For retirees who “stay”—that is, keep their assets in the DC plan—they likely will need help in creating a lifetime income stream. In our 2015 DC Research paper, “Turning Defined Contribution Assets into a Lifetime Paycheck: How to Evaluate Investment Choices for Retirees,” we suggest an approach for evaluating the DC investment lineup for retiree readiness.

We note that to generate steady and sustainable retirement income—that is, a lifetime paycheck—retirees seek opportunity for return as well as the ability to manage specific risks, chief among them: market, longevity, and inflation risk. Each imposes unique demands on a retiree’s portfolio.

• Managing market risk requires structuring an investment portfolio to seek retirement income with stable payouts and minimal disruption from market shocks.
• Managing longevity risk requires assessing how long assets might last.
• Managing inflation risk requires populating a portfolio with assets that seek to keep pace with inflation.

We propose a set of measures to evaluate portfolios on their appropriateness to retirees’ needs:

1. Correlation to retirement liability: How well does the strategy correlate to the PIMCO Retirement Income Cost Estimate (PRICE)?
2. Information ratio relative to retirement liability: What is the information ratio relative to PRICE?
3. Downside risk: What level of value-at-risk (VaR) is appropriate given a retiree’s risk capacity?
4. Asset longevity: How long are assets likely to remain during the distribution phase?
5. Inflation beta: To what extent is a retiree’s account likely to keep pace with inflation and retain purchasing power?

In the analysis that follows, we examine four strategies. First, we take two approaches: target-date (at-retirement vintage) and fixed-income strategies. For each of these two approaches, we look at two strategies: For target-date funds, these are the Market Average and the Objective-Aligned glide paths (at-retirement vintage); for diversified fixed-income strategies, we model the Barclays Aggregate Bond Index and a multisector bespoke blend of major U.S. and non-U.S. bond indexes. This gives us a total of four strategies to evaluate, as outlined in Figure 10.6.

The concept of the PIMCO Retirement Income Cost Estimate (PRICE) is discussed in Chapter 2. In short, the PRICE methodology proposes that the cost of retirement can be defined as the amount an individual must pay to buy an annuity that provides lifetime income sufficient to maintain his or her lifestyle during retirement. Interest rates, in turn, will largely determine the cost.

Figure 10.7 shows the correlation of the four retirement income strategies noted in Figure 10.6 to the objective of securing retirement income as defined by PRICE. Between the target-date strategies, the Objective-Aligned approach correlates better than the Market Average glide path. Between the diversified fixed-income strategies, the Barclays U.S. Aggregate Index has a slightly higher correlation than the multisector bond portfolio.

Next, we modeled how well each of these four strategies perform relative to PRICE, including excess return, tracking error, and information ratio. Information ratio is basically defined as excess return divided by tracking error. (See Figure 10.8.) It is a measure of the risk-adjusted return. Given the amount of risk taken (measured by tracking error), as the information ratio climbs, so does the excess return of the portfolio. Given the amount of excess return, the higher the information ratio, the lower the tracking error of the portfolio. Between the target-date strategies, the Objective- Aligned glide path (at-retirement vintage) had a higher information ratio than the Market Average glide path (at-retirement vintage). For the diversified fixed-income strategies, the multisector bond portfolio had a higher information ratio.

To measure potential loss, we modeled risk exposure by assessing VaR at the 95 percent confidence level (VaR estimates the minimum expected loss at a desired level of significance over 12 months). As Figure 10.9 shows, among the target-date strategies, the Objective-Aligned glide path has a similar downside risk compared to the Market Average glide path. For the diversified fixed-income strategies, the multisector bond strategy has slightly more downside risk than the Barclay’s U.S. Aggregate Index.

EVALUATING PORTFOLIO LONGEVITY

How long might one’s money last? To answer this critical question, we modeled the distribution phase to evaluate the likely life of the assets. We assume participants begin retirement at age 65 with an account balance of $680,000 and withdraw 50 percent or 30 percent of a final salary of $74,500. Figures 10.10 and 10.11 illustrate the projected longevity of assets at 95 percent and median confidence for final salary withdrawal levels of 50 percent and 30 percent respectively.¹

We find that the Objective-Aligned (at-retirement vintage) Glide Path has the same asset longevity under the 95 percent confidence level and higher asset longevity under the median confidence level than the Market- Average glide path (at-retirement vintage) for both 50 percent and 30 percent of final salary annual withdrawal rates. The multisector bond portfolio has the same asset longevity as the Barclays Aggregate U.S. Index under the 95 percent confidence level and higher asset longevity at the median confidence level, for both 50 percent and 30 percent of final salary annual withdrawal rates.

As to inflation responsiveness (i.e., “inflation beta”),² we believe asset prices are much more sensitive to inflation surprises than actual levels of inflation. Asset classes with a positive beta to inflation surprises³ have historically tended to perform well, thus preserving purchasing power.

As Figure 10.12 shows, for the target-date (at-retirement vintage) strategies, the Objective-Aligned glide path had a slightly higher inflation beta than the Market Average glide path. Among the diversified fixed income strategies, the multisector bond portfolio had a higher inflation beta.

TURNING DEFINED CONTRIBUTION ASSETS INTO A LIFETIME INCOME STREAM: HOW TO EVALUATE INVESTMENT CHOICES FOR RETIREES

Retirees may benefit from building a retirement income stream from their DC plan, including access to institutional investments, fiduciary oversight, and attractive pricing. For retirees to retain assets in-plan, though, they need appropriate investment choices: that means strategies designed to keep pace with the real cost of retirement, reduce the risk of significant loss, and stay ahead of inflation. Plan fiduciaries should evaluate these strategies relative to retiree needs.

Our analysis shows that an Objective-Aligned glide path (at-retirement vintage) is superior or similar to the Market Average glide path (at-retirement vintage) across all measures analyzed, including in correlation to the cost of retirement (PRICE), risk-adjusted performance, downside risk, asset longevity in retirement, and inflation beta. In addition, our analysis demonstrates that compared to the Barclays U.S. Aggregate Index, a multisector bond strategy may provide higher return, greater asset longevity, and higher inflation protection, albeit with slightly higher downside risk.

In addition to the evaluation factors presented, and as discussed in Chapter 3, we encourage plan fiduciaries to carefully consider the use of active versus passive investment management. As noted, consultants in PIMCO’s 2016 Defined Contribution Consulting Support and Trends Survey underscored the importance of active management for all asset classes except U.S. large-cap equity. Retirees may benefit from the potential for increased return opportunity and reduced risk by selecting actively managed target-date and fixed-income strategies. Sponsors also may consider target-date strategies that embed downside hedging intended to guard retiree assets against a sudden market downturn.

GUARDING RETIREE ASSETS AGAINST A SUDDEN MARKET DOWNTURN: SEQUENCING RISK

In December 2013, DC Dialogue interviewed (and updated at time of writing) Michael E. Drew, PhD, Professor of Finance at Griffith University and Director of Drew, Walk & Co. in Australia, about managing asset allocation and risk for preretirees and those in retirement. Professor Drew commented on sequence of return risk and how this must be a concern for retirees as follows:

When folks from age 50 to 75 have the same asset allocation, this raises concerns about the sequence of returns, as the path may have a dramatic impact on retirement outcomes. As our DC system matures, we need to think about portfolio construction with an eye on retirement income. Recent history has shown us the impact of experiencing returns that have a poor sequence, particularly towards the end of the accumulation phase and early in the distribution phase.

When asked whether he would suggest insurance solutions, and the purchase of annuities in particular, Professor Drew responded:

Yes. I think it’s a building block—one of the prudent ways to manage the risks we have in front of us and the time horizons we have. Building blocks like deferred annuities and mortality pooling are also an important part of the conversation, particularly when we’re talking about longevity risk.

For many people, it has to be a combination of these solutions. Some form of insurance (depending on the price), some sensible asset allocation and, critically, how we can frame for people the different liabilities they will face over different time horizons. And that’s the really difficult piece. In the accumulation phase, at least you have (hopefully) some idea of when someone’s going to retire. The challenging part within the income phase is the largely unknown nature and timing of health and aged-care needs and, obviously, death.

So this is a very complex problem. We need to use different building blocks to provide folks with a happy, healthy, sustainable retirement experience. The building blocks needed to meet one individual’s needs are likely to differ from those needed for the next person.

The professor goes on to encourage plan fiduciaries to help retirees and to remind us all that there is no single “right solution”:

The more work we’ve done with DC plan providers, with investment managers and policy makers, the more we’ve seen the need for fiduciaries to assist plan participants with safe passage through the retirement risk zone, I think for me that is the key takeaway.

We need to keep in mind that there is no single right solution, no silver bullet. We cannot take a deterministic, static frame to the DC challenge. Our participants face a dynamic path, one where what’s considered safe and risky changes over their lifetime. We need our DC plan design, communications, contributions and investment management working in concert to achieve a sustainable level of retirement income for our participants. And if we can have our risk management clearly informed by the outcomes we’re trying to achieve, that is a very positive step forward.

WAYS TO MANAGE MARKET AND LONGEVITY RISK . . . WITHOUT ADDING IN-PLAN INSURANCE PRODUCTS

There are many approaches and products that may help plan fiduciaries manage market and longevity risk. Some insurance products such as a variable annuity with a living benefit feature bring both market shock protection and longevity insurance into a single solution. As noted earlier, consultants raise many concerns with offering these accumulation insurance solutions in-plan; however, they are generally supportive of out-of-plan income annuities, particularly deferred annuities. We suggest that plan sponsors first consider capital market methods to manage market risk, and second consider making available out-of-plan immediate and deferred income annuities to manage longevity risk.

We have discussed the importance of asset and risk-factor diversification to minimize risk. Unfortunately, in a financial crisis, often these risk-minimization approaches aren’t sufficient to protect retiree assets. To guard against the risk of loss during a sudden market downturn, plan fiduciaries may consider target-date and other investment strategies that include “tail-risk hedging” to their basket of risk management approaches. These strategies consist primarily of selectively acquiring options on the various indices that broadly track the assets in a portfolio; these hedges, in turn, may be best purchased during noncrisis times when they are relatively inexpensive. For example, purchasing long-dated out-of-the-money put options on equity indices, such as the S&P 500, on an ongoing basis can provide investment-based hedges against equity factor risk (the risk associated with movements in the broad equity market). The intent of tail-risk hedging is not to provide protection against frequent small to medium downswings in the market, but rather to shield against the rare but catastrophic events (Figure 10.13) that can derail retirement security. In general, tail-risk hedging is a cost to the overall portfolio; the pricing of the hedges can be dynamic. It is important for plan fiduciaries to understand the potential impact of the actual pricing of the hedges on a portfolio’s return.

LIVING BEYOND 100: PLANNING FOR LONGEVITY

PIMCO’s November/December 2015 DC Dialogue focused specifically on the issue of longevity, as we interviewed Professor Joshua Grill, PhD; Associate Professor, Department of Psychiatry and Human Behavior; Director of Education, Institute for Memory Impairments and Neurological Disorders; and Associate Director, Alzheimer’s Disease Research Center, University of California–Irvine, on the issue of living beyond 100 years of age. Professor Grill comments that:

Unlike any other time in history, people are living longer, healthier lives. Medical science has made incredible strides toward reducing major causes of death, such as stroke and heart disease as well as some cancers. As a result, the human lifespan continues to increase. If the pace continues, we expect that over half of the children born this century will celebrate their 100th birthday. We anticipate that by 2050, the number of Americans age 85 or older will quadruple to 21 million.

The biggest challenge for retirement income planning posed by an aging population, according to Dr. Grill, is that of dementia, which he defined for us as “a clinical phenomenology whereby a person has cognitive impairment—problems with the way they think—that prevents them from living life the way they once did.” The issues posed by dementia are wide-ranging and carry significant risk for the success of retirement income planning through the life span, particularly in the later years for the population who reaches an advanced age:

People over 65 years of age control a growing percentage of defined contribution assets and significant additional wealth. As you can imagine, cognitive decline can inhibit sound financial decision-making. Unfortunately, the elderly are often unaware of diminishing cognition, which may place them at greater risk of making financial errors or, worse, may open them to fraud risk. Retirement professionals can help reduce these risks.

Health care costs are also a significant factor for retirees’ retirement planning as well as for employers. [Alzheimer’s Disease International] reports that the worldwide cost of dementia exceeds $600 billion annually. Covering this escalating expense may further increase health and long-term care insurance premiums. Plus, in most countries, an increasing burden is falling on the younger working-age populations, as fewer workers support the growing retired population. Providing care for elder loved ones certainly will add to the retirement savings challenge for the younger populations. There are many issues.

Dr. Grill also provided some closing words of advice for how retirees and their loved ones can plan for the potential of diminished mental capacity, including the possibility of dementia, in and through retirement:

Early in retirement or even prior to retirement, when cognitive abilities are intact, is the best time to plan for managing both medical and financial decisions. Financial and legal professionals can help with writing a power of attorney and an advance health care directive, along with other important documents that capture the retiree’s wishes. Again, the earlier these concerns are addressed, the more the individual can be involved in making sound decisions for their future.

For retirement income professionals, including DC plan sponsors and employers, Dr. Grill advises that “An ounce of prevention is worth a pound of cure”:

Professionals can urge or incentivize employees and clients to put plans in place for old age while they are still cognitively healthy. It’s best to plan for the worst and hope for the best. If the unthinkable happens, you want everything in place. As people near retirement, we should ask, “Do you have a durable power of attorney? Do you have an advance health care directive? Do you have a living will and trust? Do you have long-term care insurance?”

Employers and insurers can also offer incentives to stay active and healthy. For instance, people can be offered reduced insurance costs if they walk 10,000 steps a day and keep up routine wellness visits. These incentives are expected to cost less than the cost of caring for those who become diseased. Preventive medicine is the way of the future.

MANAGING LONGEVITY RISK: CONSIDERATIONS FOR BUYING AN ANNUITY

Employers also may consider making an institutionally priced annuity purchase program available to retirees. This could enable retirees to access immediate and deferred income annuities. Retirees may gain greater comfort in managing longevity risk by purchasing a deferred annuity that begins paying income, for example, when the retiree reaches age 85. A deferred annuity may allow the retiree to shorten their investment horizon and possibly increase installment payouts. Combining an objective-aligned target-date strategy or a multisector fixed-income strategy with a deferred annuity may create a more secure lifelong retirement income stream.

IMMEDIATE AND DEFERRED ANNUITIES: WHY OUT-OF-PLAN MAKES SENSE

In PIMCO’s 2016 DC Consulting Support and Trends Survey, respondents placed “out-of-plan annuities” as most desirable among the insurance-related retirement income choices. Such programs allow employees and retirees to receive competitive bids from multiple insurance companies for immediate or deferred income annuities (DIAs) or longevity insurance (more information on these types of annuities below). Employers may be able to make such programs available through their DC plan record keeper, but without adding the annuity income products as a plan distribution option. Rather, the employer makes available the program benefits, including competitive institutional pricing, and does so without taking on the fiduciary oversight required for insurer selection.

These platforms may offer access to two or more types of annuities, as defined by Hueler Income Solutions^®:

Immediate Income Annuity. A long-term contract between an annuitant and an insurance company for which the annuitant pays a lump sum premium to the insurance company. The insurance company converts the assets into a stream of guaranteed monthly income payments for life or a specified fixed period of time. An Immediate Income Annuity provides income immediately after the premium is received, typically, within 30 days from the date of deposit; however, the annuitant can choose to defer payments for up to 12 months after the date of purchase.

Deferred Income Annuity with Death Benefit. A long-term contract between an annuitant and an insurance company for which the annuitant pays a lump sum premium payment to the insurance company and the insurance company converts the assets into a stream of guaranteed monthly income payments for life or a specified fixed period of time. A Deferred Income Annuity enables the annuitant to defer income payments for as little as 13 months or up to 40 years. Prior to the income start date, the Death Benefit would be a return of premium. After the income start date, the Death Benefit is determined by the annuity type selected at the time of purchase.

Deferred Income Annuity with no Death Benefit (“Pure Longevity Insurance”). A long-term contract between an annuitant and an insurance company for which the annuitant pays a lump sum premium payment to the insurance company and the insurance company converts the assets into a stream of guaranteed monthly income payments for life. Currently, the only start date available for a Deferred Income Annuity without a Death Benefit through the Income Solutions^® platform is on the annuitant’s 85th birthday (Pure Longevity Insurance). There is no return of premium to beneficiaries should the annuitant(s) pass away before the income start date.

Insurance providers may offer participants a range of features, such as a cash refund, joint and survivor benefits at specific percentages, fixed period, and CPI-linked adjustments. The participating companies are often willing to competitively bid based on the desired contract type and features. Prior to 2014, buying longevity insurance or a Deferred Income Annuity within a tax-deferred IRA or DC plan posed a problem given the required minimum distribution rules that compel payments to begin at age 70 years and 6 months. (Required Minimum Distributions, or RMDs, are amounts that the U.S. federal government requires one to withdraw annually from traditional IRAs and employer-sponsored retirement plans.) To address this problem, the Treasury issued regulations under the Code of Federal Regulations (CFR) 1.401(a)(9)-6, declaring that as long as a longevity annuity meets certain requirements, it will be deemed a “Qualified Longevity Annuity Contract” (QLAC) and the contract value will be automatically exempt from the RMD calculations (beginning at age 70 years and 6 months). Hueler Income Solutions defines a QLAC and requirements as follows:

Qualified Longevity Annuity Contract (QLAC). A Deferred Income Annuity (DIA) with or without a Death Benefit can be designated as a Qualified Longevity Annuity Contract (QLAC). The income start date for a DIA QLAC with a Death Benefit must be after the age of 70 years and 6 months, no later than the first day of the month following the annuitant’s 85th birthday. The only available income start date for a DIA without a Death Benefit is on the annuitant’s 85th birthday.

The premiums per individual are limited to the lesser of $125,000 (lifetime) or 25 percent of your total IRA balances (excluding Roth IRAs and inherited IRAs) as of December 31st of the year prior to purchase. Dollars from either IRAs (excluding Roth IRAs and inherited IRAs) or qualified accounts can be used to fund a QLAC. It is the annuitant’s responsibility to ensure QLAC premium limitations are met.

Today, longevity insurance can be purchased as a qualified plan distribution option (QPDA) or through an IRA rollover. In order to qualify for an IRA rollover, the regulations currently require participants to have opened the IRA in the preceding year and have the appropriate balance to meet the purchase requirements. These requirements have the unfortunate unintended consequence of subjecting the remaining balance (e.g., $375,000 if purchasing a $125,000 QLAC) to retail investment fees—thus we encourage Treasury to amend its ruling so that an IRA QLAC may be purchased directly from the plan.

In our view, offering plan participants the opportunity to purchase income annuities (whether deferred or immediate) allows them to benefit from transparency and competitive bidding while minimizing the fiduciary oversight of such offerings. Keep in mind that although the purchase is made out-of-plan and thus out of the fiduciary oversight⁴ of the plan, the participant still benefits from the institutional pricing and the ability to tap DC assets. Given that the annuities pay directly to the participant from the insurance company, holding the contract as an individual outside the plan may make sense, as this direct payment is the simplest option. As shown in Figure 10.14, employees or retirees may gain many of the same benefits of access to an in-plan accumulation annuity program as they would by being offered access to an out-of-plan annuity purchase platform; notably, the latter requires the employer, not the ERISA plan fiduciary, to select and offer the program.

Another consideration for employers is to make annuity purchase programs available within their voluntary health and welfare benefits offerings. As employees make decisions about health, life, disability, and long-term care insurance, that may also be the time to consider whether to purchase longevity insurance.

In the March 2007 DC Dialogue “Where’s the Beef?” we interviewed Professor Zvi Bodie of Boston University and Kelli Hueler, CEO of Hueler Companies, about building sustainable retirement income using a combination of TIPS, target-date strategies, and annuities. Professor Bodie shares his “big beef” with target-date retirement funds: the marketing of the funds as having a “target date,” yet no guarantee of a specific payout. Hueler suggests that participants can add a guaranteed insurance product to their retirement income plans by coupling an annuity purchase with their target-date funds. She shares her views on deferred annuities:

A new generation of products is coming that allows participants to gain this guarantee. We believe in offering a strategy that allows individuals to begin the process of building retirement income while they’re still employed. For instance, while they’re still active in their plans, employees can purchase target-deferred annuities. Ideally, this is accomplished by purchasing from multiple providers at different times at current competitive institutional rates. This reduces exposure to provider and interest-rate risks.

Bodie and Hueler are not alone in suggesting the complement of target-date strategies and deferred annuities. By purchasing a deferred annuity to start paying out at age 85 (or earlier), the retiree shortens the investment horizon for the at-retirement target-date strategies and may more confidently set up installment payouts, or periodically withdraw assets to fund retirement income. This is one strategy that a financial advisor should help a preretiree consider. An advisor should also help clients understand the pricing differences that may be available when annuities are offered within a company plan as a distribution choice from that plan or via an institutionally priced platform; in some employer-offered programs, women may benefit from unisex pricing (i.e., their gender cannot be taken into account despite their expected longer lives relative to men). Annuities may or may not be attractive for the participant, depending on other income sources, annuity rates, bequest intentions, and other personal factors.

As participants work to create a sustainable retirement income stream, they may express the wish that they had a traditional defined benefit payout. In response, academic thought leaders and retirement experts may tell the participants, “You can create your own income stream using a combination of DC assets and insurance solutions.” PIMCO’s August/September 2014 DC Dialogue is an interview with Jeffrey R. Brown, the Josef and Margot Lakonishok Professor of Business and Dean of the College of Business at the University of Illinois in Urbana-Champaign, Illinois, about creating a lifetime income stream, including how traditional DB plans measure up to the retirement income needs of the workforce. Dr. Brown explains that in his 15 years of studying the U.S. retirement system, he’s observed that “the system works extremely well for part of the population and not very well at all for other parts of the population:”

Full-time workers who have access to and participate in an employer-provided retirement plan—most commonly a defined contribution plan—should be on a very good path to a financially sound retirement. Fortunately, over the last decade, a lot of DC improvements have been made, including automatic enrollment and contribution escalation, improved investment defaults, less reliance on employer stock, and so forth. People who participate in a DC plan should, in theory, be very well set for retirement, with one main caveat—that they successfully transition from accumulation to retirement income.

Without an employer who provides a workplace retirement plan, which he tells us may represent up to half of the U.S. workforce at any given point in time, individuals are potentially left with Social Security plus whatever retirement savings they amass individually. This may mean retirement income is insufficient. Comments Dr. Brown:

A complete do-it-yourself system is just not going to work for lots of people. To help address the coverage issue, we need to make it easier for smaller employers to offer DC plans to their workers. The employer plays a huge role in the success of the retirement system.

Most importantly, employers are trusted intermediaries. As plan sponsors, they act in a fiduciary capacity to design and deliver retirement plans. Designing plans with automatic enrollment and contribution escalation, as well as thoughtful match formulas, is clearly helping people participate and increase their contribution rates. Plan sponsor selection and oversight of the investment default is also helping participants by improving diversification—reducing market risk—and simplifying communication. And we know that plan design can positively leverage human behavior.

Interestingly, Dr. Brown also comments that “While DC plans are not perfect, the DB system also was far from perfect.” He points out that when DB plans were the norm, total pension coverage rates were no higher than what we now have in a DC-dominated world. Going forward, Dr. Brown says he encourages plan sponsors, policy makers, and participants “to continue to work on improving the existing DC system” by ensuring DC plans better address, in addition to higher participation and contribution rates (with automatic enrollment and contribution escalation), investment, inflation, and longevity risk:

Our current DC system has never really been focused on the ultimate objective of providing guaranteed income in retirement. An advantage of the DB system was the default to receive a monthly check for as long as you live. There’s absolutely no reason why we couldn’t create a monthly income stream within the DC system.

Overall, DC plans can better manage investment and longevity risk. I’d start on the investment side with two suggestions: first, improving the investment default’s alignment to the DC plan objective, and second, increasing asset diversification. Then, we need to address longevity risk for participants.

Ultimately, Dr. Brown says he believes we’re “at the beginning of an explosion in innovation that will help improve defaults. This may include a combination of financial products and insurance solutions, which may be brought together in simple packages that do not exist today.”

IN CLOSING

In this chapter, we’ve explored the idea that retirees may be best off creating a retirement income stream from their DC plan. Plan sponsors can help retirees by confirming they have appropriate access to their money, together with investment choices that offer attractive risk-adjusted returns. We suggest considering the investment options within the PRICE retirement-income liability framework—that is, confirm, as you plan for retirement, that assets keep pace with retirement cost. We also suggest considering risk of loss, asset longevity, and other factors. Finally, we encourage employers to consider whether it makes sense to make available an institutionally priced annuity purchase program; combining a longevity annuity with an at-retirement target-date strategy or multiasset income fund may offer retirees an attractive lifetime income stream.

QUESTIONS FOR PLAN FIDUCIARIES

1. Do we want to retain retiree assets in the DC plan?
2. Does your record keeper support retiree asset retention or work to pull retirees out of your plan?
3. Will the retiree assets help bring down costs for all participants (active and retired)?
4. Do we offer sufficient access to retiree assets: partial and installment payments?
5. Does our plan offer sufficient and appropriate investment choices for retirees: at-retirement target-date strategies, multiasset fixed income, and capital preservation?
6. Can retirees consolidate DC and IRA assets within the DC plan?
7. Do we have a communication program to help retirees understand the benefit of retaining assets in the plans?
8. Do we offer access to objective financial planning?
9. Do we offer access to an out-of-plan annuity purchasing program?