- This paper presents the ideas of PIMCO’s leading defined contribution experts on how plan sponsors can create a new tier that seeks to provide predictable, flexible and durable retirement income for participants who remain in-plan post retirement.
- A successful retirement tier must address three powerful retiree preferences: the ability to control assets and retain flexibility, anchor spending to income and preserve – or grow – account balances.
- PIMCO research suggests that liquid, income-oriented investment strategies may be optimal in helping to meet retirees’ preferences.
- Income-oriented strategies also may reduce sequence risk and improve asset longevity relative to fixed-spending approaches, potentially reducing the fear that often accompanies self-management of retirement assets.
- We believe “reasonably appropriate” strategies should source more than 50% of returns from income, with expected annual drawdowns of 10% or less.
- Introducing a retirement tier merits an exceptional communications strategy that ensures participant awareness, understanding and proper usage.
The Case for the Retirement Tier
The steady erosion of corporate defined benefit (DB) plans as a pillar of retirement stability in America helps explain the need for a new retirement tier in defined contribution (DC) plan menus. Gone are the days when private sector retirees could count on a consistent, lifelong stream of income from DB plans. Beginning with the first wave of baby boomers, individuals have become increasingly reliant on DC plans for retirement, as Figure 1 shows.
The retirement tier is a range of products, solutions, tools, and services, all of which allow a defined contribution plan sponsor to accommodate and support participants who are near, entering, or in retirement. – Defined Contribution Institutional Investment Association (DCIIA)
This secular trend has prompted growing support from both plan sponsors and consultants to introduce a retirement tier as an in-plan, foundational design element. Fully two-thirds of consultants we polled recommended a retirement tier, according to the 2020 PIMCO Defined Contribution Consulting Study.
There’s an urgent need for a retirement tier, but for sponsors and participants, the reasons differ.
The sponsor perspective
Plan sponsors see the retirement tier as a substantial participant benefit that may also help keep retirees in-plan – the preference of two out of three plan sponsors, according to PIMCO’s 2020 Defined Contribution Consulting Study – and sponsors have made significant progress: 2019 recordkeeping data show more than 60% of retirees remain in plan one year after retirement. Five years ago, the figure was 45%.1
Once in retirement, though, retirees may find that their DC plan has not been designed to suit their specific needs. Indeed, the majority of consultants recommend three key plan sponsor actions to address the needs of retirees, all of which are foundational elements of the retirement tier – adding distribution flexibility, employee education and retiree-focused investment options.
Importantly, no single investment option can meet the needs of all retirees. This heterogeneous group needs access to a variety of investments, ease and flexibility in monitoring and managing their account balance, and applicable guidance and tools.
The participant’s perspective
As participants near retirement, they become more engaged and show a preference to control their retirement assets and maintain flexibility rather than rely on the plan’s default investment. Indeed, data show that older participants are far less likely to invest in the most common form of default – target date funds (TDFs).2,3 Specifically, 70% of participants age 30 and under invest 100% in the target date default, a ratio that plunges to only 25% for individuals above 60.
The bottom line: The retirement tier may prove to be an essential plan design element that provides convenient access, appropriate investments and guidance to the majority of retirees who are seeking an alternative to the qualified default investment alternative (QDIA).
However, older participants face a conundrum: Although they desire control, they may lack the expertise to manage their retirement savings. This may explain why over 80% of plan participants indicated they would welcome education and advice from their employer on converting savings into income in retirement.4
The retirement tier
In our view, a retirement tier should offer a small set of investment options with varying features and risk profiles. Importantly, investments appropriate for the tier must address the needs, behaviors and preferences of retirees while addressing the key risks every retiree faces – sequence of market returns and longevity.
With this in mind, one must consider three powerful retiree preferences: 1) to control their assets and retain flexibility, 2) to anchor spending to income received and 3) to preserve or grow account balances. Having earlier touched on the preference for control, here we will focus on the remaining two preferences.
First, retirees demonstrate a preference to adapt their spending to available income in order to minimize principal drawdowns. This behavior seems entirely rational given the uncertainty one faces in managing retirement assets. When an individual’s employment paychecks stop, their retirement success depends upon their ability to convert savings to income while making those assets last a lifetime, with asset longevity largely dictated by the sequence of market returns and spending behavior. According to the Employee Benefit Research Institute (EBRI),5 over the first two decades of retirement, retirees depleted at most only 30% of their at-retirement assets. EBRI observed that “people spend the money that comes in as a regular income flow (such as a pension or Social Security income) and try to preserve their assets for uncertainties or bequests.” PIMCO research arrives at a parallel conclusion, that uncertain future spending needs lead retirees to adapt their behavior to preserve wealth.6 It is notable that this behavior appears rational and may extend the longevity of assets during the decumulation phase.
Second, retirees demonstrate an apparent disinterest in solutions that provide income guarantees if they require surrendering control over one’s assets. By a ratio of more than 3 to 1, retirees prefer investments that offer “control over investments and withdrawals” to ones that guarantee income for life but give ”little control over those assets.”7 A similar preference for liquidity over guarantees can be found in the market, where roughly 70% of retirees take their DB pension benefit as a lump sum rather than as an annuity, when their plan has no restrictions on lump sum distributions.8
When it comes to populating the retirement tier, liquid, income-oriented investment strategies may hold great appeal and potentially improve the probability of a successful retirement.
This suggests that when it comes to populating the retirement tier, liquid, income-oriented investment strategies may hold great appeal and potentially improve the probability of a successful retirement if they can 1) deliver a consistent and sustainable income stream (akin to a paycheck), 2) help to guard/mitigate against the crystallization of losses during down markets, thereby reducing both sequence and longevity risks, and 3) preserve retiree control over assets and flexibility to respond to unforeseen spending needs.
Retiree Spending, Sequencing and Longevity
The survey data showing retirees’ clear preference to preserve principal and anchor spending to income likely understate actual behavior. Households not only tie their expenditures to annual income, they also modify their behavior to stabilize income over time. In the 2008 financial crisis, for instance, labor income and total after-tax income fell for all age groups, with the sole exception of households headed by those aged 65 and older. For these households, despite the recession, labor income actually rose. More surprising, the rise in labor income exactly offset declining investment returns and kept total after-tax income flat.9 In short, these households reduced spending in the recession – alongside everyone else – but worked longer in an effort to keep their total income higher and preserve their assets. They wanted to avoid drawing down principal so much that they chose to defer retirement (Figure 2).
This behavior is not unique to the financial crisis. Over the 2004–2018 period, wage income had a negative correlation with total expenditures for households over 65: In years when they earn more from work, they spend less money overall.10 In fact, their adjustments to expenditures and wage income were significant enough to increase savings and rebuild some of the principal lost during the crisis
At first, this behavior seems unusual. These households have spent their entire lives saving for retirement. Why do they refuse to enjoy the assets that they have worked so hard to accumulate?
It turns out that closely linking spending to annual income leads to a longer lasting, much more resilient retirement plan. We can see this most easily in a simple simulation. Consider two retirees, both with identical amounts of wealth and identical investments, as described in Figure 3. Both retirees also target the same amount of annual spending; however, the first retiree rigidly fixes their spending each year at 4% of their beginning account balance, while the second retiree commits to spend their annual income plus a smaller fixed dollar amount.
Simply put, linking retirement spending to income helps to preserve asset balances, which can increase the flexibility and longevity of a retiree's wealth.
By committing to an adaptive income based spending strategy, the retiree will vary their consumption along with the rise and fall of markets and their overall wealth. While both strategies have the same amount of anticipated annual spending, a retiree following the adaptive income-based strategy is willing to let their annual spending rise if asset markets cooperate and fall if they do not. Upside participation is obviously appealing, while limiting withdrawals in poor markets is critical to mitigating sequence-of-returns risk. The flexibility afforded by income-based investing and spending greatly improves the longevity of assets (Figure 4) across all market environments.
The differences in longevity do not come from lower overall spending. For example, in the median case, this income-based investor will enjoy over 10 additional years of retirement spending and essentially identical lifetime expenditure as the investor following a fixed- spending strategy.11 Simply put, linking retirement spending to income helps to preserve asset balances, which can increase the flexibility and longevity of a retiree’s wealth.
Retirement tier solutions should generate the majority of their return from income rather than capital gains and have an expected drawdown appropriate for retirees.
An income-based investor’s behavior is tied to market performance. They naturally will limit withdrawals in poor markets and thus increase their ability to fund future needs. In virtually every possible outcome, the flexible, income-based investor’s assets last longer than those of a fixed-spending investor.
Building the Retirement Tier
Given both the theoretical support for an income orientation in retirement as well as the preferences of retirees for a stable level of income, the obvious question becomes, How should a plan sponsor think about designing the retirement tier? In this section, we put forth a framework to answer this question.
We believe that the retirement tier should be made up of income-oriented solutions with moderate levels of expected downside volatility. As described in the prior section, retirees demonstrate a preference for consuming largely from income and preserving wealth balances, and the evidence shows that they will adapt their labor and savings behavior to keep wealth levels constant. So given the importance of income to retirees, retirement solutions should clearly be focused on providing a high and stable level of income. However, some retirees will not have the luxury of consuming only from income and indeed may need to slowly draw down principal balances over time. Thus, retirement income solutions must have reasonable levels of volatility so as not to subject retirees to an unnecessary amount of sequence-of-returns risk. As such, we propose the following two criteria for determining appropriateness for the retirement tier:
- The majority of the portfolio’s return should come reliably from income rather than capital gains.
- The expected drawdown of the portfolio should be tolerable for most retirees – no more than 10% per year.12
With respect to sources of return, there can be stark differences between the share coming from income versus price appreciation among various investments. This is particularly true along the broad dimension of fixed income versus equities. Figure 5 shows historical returns decomposed into income and capital gains for an array of fixed income and equity sectors. Among five fixed income sectors – Treasuries, investment grade (IG) and high yield (HY) corporate bonds, agency mortgage-backed securities (MBS) and emerging markets (with debt denominated in U.S. dollars) – all derived at least 74% of their returns from income over the 19-year period ended last February. High yield, in fact, earned more than 100% of its return from income over the past two decades.
Equities tell a very different story, however. During the period, U.S. equities earned only 29.7% of their return from dividends. Real estate investment trusts (REITs), while providing higher income returns than U.S. equities (2.8% versus 2.0%), still provided the majority of returns from capital gains. Interestingly, international equities earned 72.6% of their returns from dividends, but this was more a reflection of their lackluster total returns than their yield orientation.
The major fixed income sectors have historically generated most of their returns from income while equities have generated the majority of their returns from capital gains
Of course, income is only half the story. Retirees need to be particularly concerned about the risk level in their retirement income portfolios – sequence-of-returns risk is a main factor affecting the portfolio’s ability to sustain a long retirement. Additionally, consultants have indicated in our annual DC Consultants Survey that drawdowns up to 10% are generally tolerable for most retirees.
Figure 6 shows the percentage of returns from income versus capital gains for the asset classes shown in Figure 5, but overlays the realized forward value-at-risk (VaR) onto the graph. We present VaR because, in general, we believe tail risk measures are better than volatility metrics in representing the potential drawdown risk of a strategy or asset class. Fixed income sectors – in particular Treasuries, investment grade corporates and MBS exhibit relatively low levels of VaR. Moving to higher-yielding credit increases tail risk fairly significantly; the VaRs are 12.3% and 11.6% for high yield and emerging markets (EM), respectively. Such risk levels are likely too high for these investment sectors to be considered for stand-alone options on the retirement tier.
Equities, on the other hand, are unambiguously too volatile as a stand-alone option. U.S. equities, international equities and REITs have forward VaRs of 19.1%, 20.5% and 31.3%, respectively, far higher than the 10% tail risk limit that we believe is reasonable. In our view, these risk levels are too high for all but the least risk-averse retirees. And while, as we will show, some amount of equity exposure may be appropriate in retirement, our view is that those retirees who wish to gain higher levels of equity exposure should do so through the primary investment menu rather than directly through the retirement tier.
Despite their high volatilities, equities can still play a constructive role in an integrated retirement solution. Because equities generally have higher estimated returns (due to residing lower in the capital structure) and can help manage long-term inflation risk, as dividends generally rise with inflation, they may help both with respect to maintaining purchasing power and improving asset longevity. As such, while equities do not meet the stand-alone criteria for the retirement tier, either in terms of income orientation or volatility, we believe equities can still be an important component of a retirement income solution so long as the equity allocation is consistent with our criteria for retirement tier investments. An obvious question, therefore, is, How much equity risk is reasonable in a retirement income solution?
While there isn’t necessarily a definitive answer, Figure 7 sheds light on the issue. We began with a simplistic income-oriented fixed income solution that equally combines investment grade, MBS, high yield and EM exposures. We then combine the fixed income portfolio with various amounts of U.S. equity exposure (S&P 500) and show the impact on income levels, as well as VaR. The left side shows that a hypothetical 100% fixed income solution easily meets the income requirement, with 92% of historical returns coming from income. Additionally, the risk requirement is satisfied with a VaR level of 6.5% Thus, we view well-constructed 100% fixed income solutions – although not eligible as QDIAs – as highly appropriate as an integrated solution on the retirement tier.
The rightmost part of Figure 7, on the other hand, shows that a 100% hypothetical equity portfolio clearly does not satisfy either criteria, with only 30% of historical returns coming from income and a VaR level of 19%. However, between these two extremes, a portfolio composed of up to 40% equities potentially satisfies both objectives. For example, the 40/60 portfolio (40% equities/60% fixed income) has historically produced 65% of returns from income, with a VaR of 10%. Portfolios with equity risk in excess of 40% begin to produce risk levels likely too high for an integrated retirement tier solution. We would generally advocate for slightly lower equity allocations than 40% in retirement, however, particularly when combined with more yield-oriented fixed income portfolios. A yield orientation within bonds generally implies an increase in equity beta (vis-à-vis higher credit exposure) relative to a core bond allocation, implying that the equity allocation may need to be lowered to some degree to compensate.
We believe portfolios up to 40% equity are generally reasonable, with income and risk levels appropriate for retirees.
Figure 8 shows all of the asset classes and portfolios discussed in this section and compares their historical returns from income versus VaR. We view those residing in the northwest quadrant as most appropriate for the retirement tier.
Figure 9 shows a schematic of how a plan sponsor might think about building out the retirement tier. Options include 1) mapping existing retirement-appropriate options from the plan sponsor’s core menu, 2) creating new integrated solutions that blend both new and existing options, and 3) adding new opt-in choices appropriate for retirement. Naturally, there are often certain items on a plan sponsor’s core menu that are broadly appropriate for retirees. Examples would include the at-retirement final vintage of the sponsor’s target date fund, a diversified multi-sector bond portfolio and stable value. Additionally, new integrated retirement solutions can be created by combining asset class and sector exposures often found on core menus with off-menu exposures to create portfolios that seek to deliver a consistent level of income. In general, our income and risk criteria for retirement tier investments would lean toward building such integrated solutions rather than a direct mapping of specific items such as equities or high yield strategies. Finally, to the extent a plan sponsor wishes to add new opt-in strategies such as managed accounts or annuities, we believe such investments may have a place on the retirement tier.
The rightmost section of Figure 9 shows which potential retirement tier investments meet certain key criteria. As described in detail in this paper, an income orientation is key, in our view, for retirement success, but not all solutions are income oriented. For example, the at-retirement vintage of most target date funds is often geared more toward total return, and therefore its income level and consistency can vary considerably across asset manager strategies.
Additionally, retirees have indicated a strong preference for liquid, market-based solutions that can be easily redeemed if needed. Most retirement tier investments meet the liquidity criteria, though certain annuities offer more limited or no liquidity features (e.g., single premium immediate annuities, deferred income annuities). Lastly, QDIA eligibility is important for those plan sponsors who wish to default their employees into particular solutions. And while we have argued that a 100% fixed income solution generally meets our criteria for inclusion in the retirement tier, because it is not multi-asset, plan sponsors are unable to default participants into such a structure. Interestingly, the concept of the retirement tier has prompted interest in a “dual QDIA” approach, in which the sponsor retains its primary target date fund as its accumulation QDIA but designates a second investment as the retirement QDIA. Plan sponsors can define a catalyst – reaching a certain age, say – that triggers the transition from the accumulation to the retirement QDIA.
The onset of retirement – and the cessation of a steady paycheck – create a new sense of vulnerability for most DC participants. This partly explains DC participant retirement preferences to control their assets, anchor spending to income and preserve or grow account balances. They also look to their employer for financial advice and guidance.
To better serve participants, we believe plan sponsors could usefully establish a retirement tier that offers a small set of investment options with varying features and risk profiles. These must align with participant preferences and have appropriate levels of risk, including the ability to mitigate two big ones – sequence-of-returns and longevity risks. Based on our modeling, we believe the retirement tier should be composed of income-oriented solutions with moderate levels of expected downside volatility.
Creating a new retirement tier is a big step. Sponsors must ready new investment options, plan for a growing population of participants and prepare a significant participant communications campaign. Done right, though, the result could be a larger, more confident and better prepared group of participants, both active and retired.
Employees look to their employers first when it comes to education around financial decisions, including investing for retirement. In fact, over half of employees feel that their employer has a responsibility for their own financial well-being.1 This includes helping participants make the pivotal transition from saving for retirement to creating retirement income. According to EBRI, four out of five employees would find workplace guidance on converting their savings to income helpful.2 Similar to the unique investment solutions that retiring participants need, they also need tailored communication and education resources as they embark on a new part of their journey to retirement.
A communication strategy to support the retirement tier generally consists of two distinct components: awareness and education. In the past, we’ve seen plan sponsors combine both elements in communications to be more cost effective, but participants can easily get overwhelmed by the massive amount of information they must digest.
An awareness campaign has several goals – to inform a target audience, increase interest, create a positive image and ultimately influence behavior in the short term. Messaging should be concise, action-oriented and occasionally even punchy. An educational campaign has one goal – to convey the key details in a structured manner. Messaging can be situational, precise and easily accessible at any time. These components are critical to successful adoption of a new retirement tier. 1
2020 MetLife Employee Benefit Trends Study; www.metlife.com/ebts 2
2020 Retirement Confidence Survey, EBRI. www.ebri.org