Insights
Addressing Longevity Risk
- Longevity risk – or outliving one’s savings – has become a critical threat facing retirees and one that will only rise as life expectancy increases and people spend decades, not years, in retirement.
- This summary explains how our retirement income approach balances liquidity flexibility with income security in an effort to benefit both plan sponsors and the participants they serve.
- For the full whitepaper, co-authored by the Regents of University of California, contact us.
Retirement Investors and Longevity Risk
DC plans are rapidly becoming the primary source of retirement savings for many Americans. While this shift means investors have more flexibility, portability and control over their savings, it also requires more responsibility for making the right investment decisions. As medical breakthroughs and healthier living extend lifespans, regular investors have to determine how to ensure their retirement assets create a steady post-retirement income that lasts a lifetime.
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Target date funds provide a dynamic mixture of growth, income and downside protection assets that shift over time as a participant nears retirement, providing a simple yet comprehensive investing path during the working years. Features such as automatic enrollment and savings escalation have also shifted investors’ default behaviors in ways that have improved participation rates and encouraged healthier levels of savings.
These enhancements have addressed many of the investment challenges facing DC participants, including increased savings, asset allocation and rebalancing. However, we believe that DC plans and the investments employers are providing still fall short as employees transition into their retirement years.
Most importantly, longevity risk, which Defined Benefit (DB) plans cover through a guaranteed lifetime income, remains unaddressed in the standard DC plan structure. This shortcoming leaves DC participants exposed to the catastrophic risk of outliving their assets.
Balancing Income Security with Flexible Liquidity
Our research shows that many participants would benefit from using part of their balance at retirement to purchase an annuity. Not having to protect against the risk of outliving their assets may allow participants to make higher annual withdrawals from the rest of their balance (Figure 2) and may provide them with a more stable income for the rest of their lives.
The new solution that State Street has developed evolves a target date fund to include the option to purchase longevity insurance in the form of a deferred annuity.
The solution operates as a traditional target date fund until the participant reaches the target retirement age (age 65), at which point they are given the option to purchase the deferred income annuity (known as a Qualified Longevity Annuity Contract or QLAC). If selected, a portion of the participant’s balance will be used to purchase the annuity, from which future payments are scheduled to start at age 80. Because the annuity purchase is part of the solution, and incorporates pre-selected features, it provides a level of simplicity —requiring minimal additional effort from participants wishing to provide themselves with lifetime income in retirement. The remaining assets will remain in liquid form for the participant to use as they wish. Figure 3 below shows how the solution works.
*Assumed age at retirement; The information contained above is for illustrative purposes only. Participants who redeem prior to the annuity purchase will not be eligible for annuity income benefits. QLAC purchase is subject to market availability.
By using only part of the balance to purchase a deferred annuity, this solution combines the lifetime income traditionally associated with a DB plan with the flexibility of a DC plan. In addition, participants can use the guaranteed nature of the annuity to more effectively budget the remainder of their assets . The annuity helps address the risk of “living too long”, thereby potentially shortening the time horizon in which participants need to make their assets last. Because of the guarantee of the annuity, participants have greater flexibility to spend early in their retirement.
Closing Thoughts
State Street and The Regents of the University of California are committed to achieving strong retirement outcomes for participants through innovations in retirement solutions and plan design. We also share the goal of resolving remaining implementation issues through the introduction of new approaches and the engagement of stakeholders across the value chain and encourage other like-minded industry leaders to join us in helping to implement the next wave of DC innovation to shape the future of retirement.