Saving sufficient assets for retirement is hard. Yet allocating and distributing retirement assets may be even more formidable. In the following Q&A, Emmanuel Roman, PIMCO’s chief executive officer, and Rene Martel, head of retirement, discuss how behavioral finance and PIMCO’s Income to Outcome framework aim to address the challenge of providing income in retirement.
Q: Richard Thaler, our senior advisor on retirement and behavioral economics, commented recently that “Retirement income is the sort of problem that would be fun to think about.” How much fun has PIMCO had thinking about these issues?
Roman: Well, we have had some fun and some headaches, too. The decumulation of assets in retirement is obviously a much more complex problem than accumulating assets before retirement. Because of its complexity, decumulation is unlikely to be solved with a single solution; we’re going to need to combine a number of good ideas from different corners of the industry to solve this problem.
Such has been the case on the accumulation side in defined contribution plans. By combining a number of elements – each of which aimed to solve only a part of the problem (e.g., auto-enrollment, auto-escalation, target date strategies, and now the SECURE Act) – we’ve been able to significantly improve the landscape for workers saving for retirement.
Similarly, we’ll need multiple solutions to solve the retirement income challenge – whether it be in employer-sponsored plans, IRAs, or other vehicles in the wealth management segment of the industry. And we believe that PIMCO can play a key role in bringing some of these solutions to market.
Q: Can you discuss how investment managers like PIMCO can make a difference?
Martel: To make a significant difference, one should start with an important problem. A big one is how to protect retirees from sequence-of-returns risk, or the risk related to the timing of retirement. A substantial body of research has demonstrated the devastation that can result from poor returns in the years just before, or just after, retirement. While episodes of poor returns may be less significant in the accumulation phase, an untimely transition to the decumulation phase risks completely derailing the retirement plan and drastically reducing the longevity of assets.
We understand that most retirees will need to allocate a certain portion of their assets to higher-octane investments to achieve long-term retirement objectives – be it longevity of assets, a desired level of sustainable income, the ability to make bequests, etc. So we asked ourselves, “How can a retirement income plan accommodate the need for higher growth potential without overexposing individuals to sequence risk?”
We think the answer lies in the application of mental accounting, or segmentation, to two portfolios, one dedicated to “paycheck replacement”2 (through a low-volatility bond portfolio or “ladder”) and the other to long-term growth.5 With this framework, we believe that investors could be largely shielded from some key risks and “nudged” toward better behaviors – giving “decumulators” some of the guidance and protections that accumulators have benefited from.
Income to Outcome
PIMCO’s Income to Outcome framework can help retirees and their advisors mitigate sequence-of-returns risk. It applies concepts from behavioral finance, “mental accounting”1 in particular, and breaks down the retirement portfolio into two dedicated components:
A “paycheck replacement”2 portfolio that seeks to deliver a predictable stream of income for a certain number of years regardless of market gyrations. Think of it as a possible alternative to an annuity.3,4 It provides a runway of bond-generated cash flows (absent default) that can be extended, or shortened, at will, with no contract and full flexibility to make adjustments as circumstances change.
A growth portfolio5 with a long-term horizon. It may experience a substantial amount of volatility and be affected by market movements over time, but may not be fully exposed to sequence-of-returns risk because it is not subject to systematic withdrawals (or, at least, gives retirees more flexibility as to when they tap this portfolio for liquidity, thus avoiding locking in losses in severe market downturns).
Q: Still, is mitigating sequence-of-returns risk sufficient to move the needle for investors and retirees?
Martel: In isolation, probably not. It is just one component of the solution. But PIMCO’s Income to Outcome framework does more than that. For example, from a behavioral perspective it seeks to reduce the risk of succumbing to counterproductive yet all too human instincts. In contrast, with a traditional retirement income approach that sources income through regular withdrawals from a typical blended portfolio comprising stocks and bonds (say, 60% stocks/40% bonds), it is not rare to see panic selling set in after large market drawdowns – the latest example being the market plunge in the first quarter of 2020. Selling may exacerbate the impact of a market downturn by locking in losses and preventing investors from benefiting fully when markets rebound.
We believe the Income to Outcome framework can reduce the potential for such behaviors. Because several years of future income needs can be pre-funded through the “paycheck replacement”2 portfolio and will not be affected by market downturns (provided the retiree holds the bonds until maturity and absent default), we think investors will be less likely to react harmfully to market adversity. They can let the growth portfolio take advantage of its longer-term horizon while feeling confident that the paycheck portfolio should satisfy their spending needs over the coming years.
Ultimately, it’s by combining many different elements – such as mitigating sequence-of-returns risk, limiting the potential for behavioral mistakes, and nudging retirees toward optimizing Social Security benefits – that this retirement framework will move the needle even more significantly.
Q: What about annuities, or guaranteed solutions? How do they fit within PIMCO’s Income to Outcome approach?
Martel: The vast majority of retirees have access to an excellent guaranteed solution with Social Security. It is the only source for an inflation-protected annuity, guaranteed by the U.S. government, at a cost that excludes private sector profit objectives and the impact of capital requirements. In general, retirees should absolutely seek to maximize the value of that benefit. And maximizing its value for most people would likely mean claiming benefits as late as they’re able – if possible, at 70, the age when benefits max out.
Unfortunately, very few retirees opt – or are able – to wait until that age. Many reasons may prompt this, but we believe one is the strong desire among retirees for a stable and reliable source of income to replace their paycheck when they retire. And because a Social Security pension achieves this better than most other decumulation strategies, many newly retired individuals instinctively claim Social Security benefits as soon as they can, usually well before 70.6
The Income to Outcome framework could be of great help here. Because the “paycheck replacement”2 portfolio seeks to provide a predictable source of income for at least the first several years of the retirement journey, retirees may feel more inclined to claim Social Security benefits later, closer to the value-maximizing age of 70 (for most).
Deferred annuities can offer another way to combine guaranteed solutions with the Income to Outcome approach.5 They may help investors stretch the longevity of their assets and meaningfully reduce the risk of “running out of money.”
For investors seeking maximum longevity protection, combining the Income to Outcome framework with a deferred annuity can be a solution. PIMCO’s framework seeks to solve for predictable income streams in both the short term and the long term, giving investors control and flexibility to fine tune their longevity protection objectives. For instance, “paycheck replacement”2 at the beginning and middle stages of retirement could be complemented by an annuity with a start date “deferred” far into the future. An insurance policy of this sort could begin paying out at, say, 85 or 90, and be offered with a significantly lower premium (due to discounting a shorter payment stream) than an immediate annuity that starts paying out earlier in the journey. In other words, the framework seeks to provide investors an option to pay for a longevity guarantee only for the years when there may be a legitimate risk of running out of money (i.e., the later retirement years).
Q: Manny, the Income to Outcome approach seeks to bring personalized and customizable retirement income solutions to the masses. How can PIMCO make this effort scalable from a business perspective?
Roman: In other lines of business, customization has been an important driver in helping investors achieve their objectives. PIMCO’s liability-driven investing (LDI) business, for instance, provides a great degree of customization that has supported defined benefit plans greatly over the last decade. Now, to contribute credibly to the retirement income challenge, we’ll need to customize on a mass scale, both for individual investors and their advisors. We’re dealing with a much larger number of end users, whether they are financial professionals or retirees. Technology will be a key to success. It’s the only way to make such an effort scalable, and we will deploy it on several levels.
For example, we are working on a digital solution that will enable financial professionals to confidently build an intuitive and personalized retirement income plan, based on the Income to Outcome framework. We are also working to automate “paycheck replacement”2 in easily scalable bond portfolios, and optimize the sequence of withdrawals and their tax implications through technology. This soup-to-nuts solution is aimed at scaling and simplifying the full decumulation problem for financial professionals and their clients.
We believe this will benefit retirees directly through simplified retirement planning. It should also help their financial professionals concentrate on other value-adding activities, including managing the growth portfolio to potentially deliver “surplus” wealth for the retiree to either enjoy or pass on to their heirs. So in the end, the goal is for the investor to win on multiple fronts.