Human Capital Briefs

New Ideas for Evaluating Lifetime Income Options

June 28, 2017

As Defined Contribution (DC) plans have become the primary retirement vehicle in more organizations, there is a growing recognition that the method of payout and the options during the payout periods are an important part of making these plans real retirement vehicles rather than just asset accumulation plans. 

Over more than 50 years, actuaries, economists and investment experts have developed a variety of tools and approaches to help plan sponsors evaluate investment options and use quantitative approaches to make choices. The efficient frontier has been an important part of that investment theory. However, plan sponsors seeking to apply the same general types of analytical approaches to a range of payout options have found the tools available to them to be limited. There are a number of options and big trade-offs, but it has not been easy to understand the trade-offs.

A new research study, “Optimizing Retirement Income Solutions in Defined Contribution Plans: A Framework for Building Retirement Income Portfolios” jointly sponsored by the Society of Actuaries and the Stanford Center on Longevity develops the concept of the efficient frontier for retirement income payouts, and provides an analysis of a wide variety of payout options – using two different definitions of efficient frontiers. The two efficient frontiers look at the trade-off between more expected income vs. more liquidity, and the trade-off between level of income and risk.

The analysis offers a new quantitative method of evaluating the trade-offs. The research includes a large number of options evaluated for three hypothetical retirees. It should help plan sponsors analyze the types of options available and choose which types of options to offer. It should also improve due diligence in choosing options, and provide the potential for a much more robust analysis of options. While this is a research study, it is hoped that these ideas will be incorporated into the analysis of specific options for different plans and service providers who offer a range of payout options. The study also provides evidence of how large the differences can be between options.

The research also documents the value of investing in equities once a base, lifetime guaranteed income has been established to cover regular expenses. This runs counter to much conventional wisdom and is worth careful consideration.

Four broad sets of strategies are studied in this project. The first (Phase 1 in the study) looks at a portfolio approach to retirement income using options that are available to employer sponsored plans in today’s market. Phase 2 uses savings to support and enable delayed claiming of Social Security.  Phase 3 combines systematic withdrawal strategies with qualified longevity annuity contracts (QLACs). Phase 4 looks at strategies that protect retirement income in the period leading up to retirement. The study includes extensive analysis of many options in each of these phases. The final report is supported by four interim reports including detailed modeling.

Here is a sample of the findings:

With regard to the postretirement portfolio:

• There are a variety of viable Retirement Income Generators (RIGs) that can be provided in DC plans today.

• The modeling indicates that RIGs that pool longevity risk (such as lifetime annuities) provide higher expected lifetime income than investing approaches that gradually pay out plan funds and self insure longevity risk.

• RIGs that invest savings provide access to unused savings throughout retirement, whereas many annuities do not generally provide such access. There is a trade-off for the higher income provided by annuities in the loss of liquidity and loss of a potential bequest. 

• A payout plan based on the IRS required minimum distribution rules (the minimum amount which must be paid from a tax-advantaged plan such as a 401(k) or IRA) produces a more level pattern of real (inflation adjusted) retirement income than some other commonly recommended payout systems.

• Effective solutions may combine different types of RIGs to provide some of the advantages of different approaches.

(Note that the modeling provides quantitative results for sample individuals studied.)

With regard to using savings to delay Social Security benefits:

• The modeling shows that using retirement savings to enable delaying Social Security benefits increases projected average retirement incomes for all of the solutions studied.  The increase in retirement income on the efficient frontier was 2% to 6% compared to claiming Social Security at age 65 in the portfolio solutions tested.

• Increases in income from delaying Social Security are greater for solutions not on the efficient frontier. This implies that retirees who plan to deploy retirement income strategies with a significant reliance on fixed income investments or products may instead want to consider using savings to enable a delay strategy.

With regard to coming qualified longevity annuity contracts with systematic withdrawals:

• These solutions get the benefits of diverse types of strategies, and combine better guaranteed income with better liquidity than a solution focused on either. 

• These solutions may be able to increase income for the same amount of risk, but with increased complexity.

• Integrated solutions are somewhat complex to implement and may require the involvement of a skilled adviser to implement such a strategy and monitor it through retirement, while making adjustments as needed.

• Integrated solutions can be used in various ways and layering additional income at a high age using a qualified longevity annuity can generate funds to help pay for medical, living support, and long-term care costs. 

The report concludes that a combination of secure income to cover essential expenses with investment of other assets and systematic withdrawals will often be a good strategy. For example, Social Security and annuities can become the “bond” part of a retirement income portfolio, with remaining assets invested significantly in equities using a prudent systematic withdrawal strategy. This analysis substantially increases the methods that plan sponsors can use to evaluate the structure of their offerings to give employees a range of choices for generating income in retirement.

 

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