The passing of the SECURE Act of 2019 paved the way for increased utilization of lifetime income options. The Act allows plans to include lifetime income portability provisions and to establish a fiduciary safe harbor for the selection of lifetime income providers.
A February 6, 2019 report from the Government Accountability Office (GAO) on retirement security reiterated five policy goals the GAO published in a 2017 report about reforming the U.S. retirement system.
The GAO noted that current plans did not provide sufficient tools to aid retirees in the spend-down of their savings, including the absence of lifetime income options in most defined contribution plans. Even with new Secure Act provisions, the industry has far to go to create effective income solutions for participants.
As expressed by participants, an ideal income solution will allow them to spend on a consistent, predictable basis without fear of running out of money or market losses changing their ability to spend. Solutions currently available to participants typically involve an insurance component in order to guarantee income through retirement.
Issues exist with these products, including the fact that many have features that are only supported by a small number of investment platform providers, they are expensive, and they can be complex.
Defined contribution (DC) plans place the responsibility for planning and managing retirement savings on employees. As participants in DC plans near retirement they are required to continuingly make complex financial decisions; decisions that require financial literacy and that will have significant consequences for their financial security throughout retirement.
To make early-career decisions easier, the approach for DC plans has been to put automatic feature systems in place. DC plan sponsors have encouraged participation in their plans by adopting auto-enrollment and encouraged increased deferral rates by adding auto-escalation. From an investment perspective, the default investment option is one of the most direct ways plan sponsors can impact retirement readiness for their employees.
These features will, hopefully, lead future retirees to the levels of savings necessary to fund longer retirements. Even with automatic features, it is probable that many retirees will need to consume all their retirement savings as efficiently as possible or be forced to make changes in their lifestyle.
Prior to the Pension Protection Act of 2006 (PPA), employers sought to minimize fiduciary liability for their plan’s default investment options by making the default option one that would be less likely to lose money – typically a stable value fund or a money market fund.
While money market funds offer less risk, there is a lesser chance of participant’s money growing to an appropriate amount needed by retirement. The PPA reformed policies like these by allowing safe harbor for default options that have a more balanced approach to capital preservation and capital appreciation. Thus, the balance fund, managed account, and target date funds became commonplace for the default investment option.
The stakes have never been higher to assist those nearing retirement and for DC plans to create successful retirement outcomes for their participants. This will require efforts across plan design, investment design, and education and advice.
Target date funds were introduced in the mid-1990s and introduced the “glide path,” which automatically adjusts the asset mix over time as the fund approaches its target date, making the asset allocation appropriate for every participant. This relatively simple, low-maintenance concept has been a hit with DC plan sponsors due to its one-size-fits-all structure.
Uniquely positioned
Target date funds are uniquely positioned to adopt the goal laid out by the GAO of aiding retirees in the spend-down of their savings by creating a lifetime income option. From a behavioral standpoint, participants are already familiar with target date funds, associate the target date with their retirement date and expect the fund to be a source of retirement income.
The creation of an income solution within target date funds will solve many issues. If a method for providing an income solution can be entrenched into target date funds, participants may accept it as a natural extension of the career-long investment management the funds already provide.
Inserting an income solution into a target date fund will also help the plan sponsor making it simpler to incorporate an income solution option into their existing menus and creating scale for institutionally priced income. The adoption might also address what has been an issue for current in-plan income options which is that of participant utilization. In many plans which have adopted an income solution option utilization has been quite low.
We don’t claim to know how an income solution option will be integrated into target date funds, but we believe it is consistent with the evolution of DC plans. The focus of the retirement industry has evolved to improve accumulation and has now turned its focus towards income and decumulation and the next development will likely be a change in creating retirement income.
Gordon Tewell, CFA, CPC, ERPA, QKC, is a Principal with Innovest Portfolio Solutions LLC. Kristin Lee is a Senior Analyst with the firm.