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.
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.
Benefits of Default Annuity Purchases
Our calculations show that most 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 would allow participants to make higher annual withdrawals from the rest of their balance (Figure 2) and would provide them with a more stable income for the rest of their lives.
The new solution that State Street has developed alongside the Regents of the University of California expands the default component of a target date fund to include longevity insurance in the form of a deferred annuity. Because the annuity purchase is part of the default, it does not require any additional effort on the part of the participants, although they will have the ability to opt out if they wish.
The solution operates as a traditional target date fund until the participant hits age 65, at which point the fund automatically uses a portion of the accumulated balance to purchase a deferred annuity on behalf of the participant. The annuity will start to pay income once the participant reaches the age of 80.
*Assumed age at retirement; The information contained above is for illustrative purposes only. Participants who redeemprior 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 guarantee of a DB plan with the flexibility of a DC plan. In addition, participants know how long their drawdown assets must last, and can budget with more certainty than they could with traditional DC plans. By insuring against the risk of “living too long,” the participant is able to draw down the remaining assets faster, resulting in higher income in retirement.
Advantages for Participants and Plan Sponsors
While DB plans comprehensively solve the lifetime income challenge for participants, the costs and risks to sponsors are leading to their decline. Our proposed lifetime income solution solves for many of the challenges typically related to retirement income solutions, such as liquidity, cost and fiduciary risk.
Plan sponsors are uniquely placed to use their institutional knowledge to educate participants on the benefits of annuities and to use their institutional buying power to help participants obtain cost-effective longevity insurance.
Moreover, extending the default to encompass the retirement phase can be beneficial for both participants and plan sponsors. Participants benefit because they get access to a sophisticated solution at an institutional price for the retirement phase, and plans can retain greater scale by keeping the assets during retirement.
Before we are able to introduce this solution broadly to plans and participants, several implementation issues need to be addressed:
Tackling these challenges will require collaboration from many different industry stakeholders, including plan sponsors, asset managers, recordkeepers and insurers. Policymakers also have a critical role to play.
In order to build the necessary collective momentum, State Street maintains ongoing conversations with Fortune 100 employers who share an interest in advancing the adoption of income solutions in workplace savings plans. The Regents of the University of California continues to participate actively in this group dialogue.
1 An annuity contract’s financial guarantees are solely the responsibility of and are subject to the claims-paying ability of the issuing insurance company.
2 Average US life expectancy at age 80 is 9.48 years (UN population projections). The annuity described in this paper incorporates a return of premium and cash refund benefit. This means that if the participant (and spouse in the case of a J&S annuitant) dies before they have recouped their initial premium, the difference between the initial premium and the payments received will be returned to the estate.
3 Annuities are issued by third-party insurance companies, which are not affiliated with any State Street Bank and Trust Company entity, including SSGA.
Annuity: An annuity is a financial product that funds a series of fixed payments to an individual, primarily used as an income stream for retirees. Annuities are created and sold by insurance companies, which accept and invest funds from individuals. Upon annuitization, or the commencement of the payment series, funds are paid at regular intervals over time. In the case of annuities structured for retirees, payment typically spans an individual’s life.
The annuity contract’s financial guarantees are solely the responsibility of and are subject to the claims-paying ability of the issuing insurance company. Annuities are issued by third-party insurance companies, which are not affiliated with any State Street Bank and Trust Company entity, including State Street Global Advisors.
**All calculations made using mortality rates from the Society of Actuaries RP-2014 mortality tables for healthy annuitants using a 50/50 blend of male and female mortality and ISG capital market forecasts for Q4/2015. The median life-expectancy at age 65 in these tables is 85. Drawdown assumptions include a 2% cost of living adjustment (COLA) and a retirement age of 65. Self-managed drawdown: we assume the participant has all their retirement assets in a 35/65 portfolio with an expected return of 4.5% and a risk level of 7.3%. The drawdown rate is the annual rate at which a participant could draw down their assets with a 95% probability of not exhausting their assets during their lifetime. Hybrid: we assume the participant uses 25% of their retirement assets to purchase a 50% joint and survivor annuity with a return of premium benefit and a 2% COLA which starts payments at age 80 and invests the remainder of the assets in a 35/65 portfolio with an expected return of 4.5% and a risk level of 7.3%. The hybrid drawdown rate is the continuous annual rate at which the participant could draw down their assets between the ages 65 and 80 and use the remainder of their assets to supplement their annuity income after the age of 80. Annuity: the annual payment that the participant would receive if they used all their retirement assets to purchase an immediate 50% joint and survivor annuity with a 2% COLA starting payments at age 65. Calculations for the self-managed drawdown and the drawdown portion of the hybrid solution are based on simulations (simulation count = 100,000) and do not reflect the effects of unforeseen economic and market factors on decision-making. Annuity prices are based on MetLife quotes for December 2015. Expected returns are based upon estimates and reflect subjective judgments and assumptions.
The views expressed in this material are the views of SSGA Defined Contribution as at 28 January 2019, and are subject to change based on market and other conditions.
This document contains certain statements that may be deemed forward looking statements. Please note that any such statements are not guarantees of any future performance, and actual results or developments may differ materially from those projected.
The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. Investing involves risk, including the risk of loss of principal. The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA’s express written consent.
SSGA Target Date Funds are designed for investors expecting to retire around the year indicated in each fund’s name. When choosing a Fund, investors should consider whether they anticipate retiring significantly earlier or later than age 65 even if such investors retire on or near a fund’s approximate target date. There may be other considerations relevant to fund selection and investors should select the fund that best meets their individual circumstances and investment goals. The funds' asset allocation strategy becomes increasingly conservative as it approaches the target date and beyond. The investment risks of each Fund change over time as its asset allocation changes.
Diversification does not ensure a profit or guarantee against loss.
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Exp. July 31, 2020