Many defined contribution pension plans contain a built-in contradiction. During accumulation, they offer an array of investment choices — sometimes too many. In decumulation, by contrast, the choices are very limited — perhaps to a conservative balanced fund and an annuity.
Many plan sponsors don’t pay enough attention to decumulation because they’re focused on removing the retiree as a liability. However, employees expect reliable income replacement in retirement that few DC plans can provide. Plans can gain a competitive advantage by offering a payout similar to a defined benefit — one that targets not running out of money without the restrictions of an annuity.
As a reminder of the importance of meeting employees’ needs before and in retirement, this table from the Callan Institute’s 2020 Defined Contribution Trends Survey tracks the “ability to attract/retain employees” as an emerging measure of DC plan success.
Table 1: Criteria to measure plan success
Source: Callan 2020 Trends Survey
There’s no question decumulation is a challenge for DC plan members. In fact, the crippling complexity of the drawdown phase is the “nastiest, hardest problem in finance,” according to Nobel Laureate William Sharpe.
During decumulation, challenges involving actuarial, capital market, inflation and social security payment variables unique to every individual are compounded by an array of health and personal circumstances that require multi-stage stochastic programming to solve.
My colleague Ioulia Tretiakova and I have done extensive research on dynamic accumulation into, and through, retirement. In particular, we researched a solution that replicates the navigation functions of an autonomous automobile by selecting a target destination, extending the life of capital within acceptable risk ranges, and systematically working towards that destination. This goal-seeking algorithm, like a global positioning system, automatically adjusts asset allocation to find the path offering the highest probability of success.
We engineered a way to navigate individual member portfolios to minimize the risk of running out of money before dying, and found an approach that dynamically manages risk and could offer over 50 per cent more income to spend or leave as a legacy over a range of withdrawal rates without increasing the probability of running out of savings.
To plan for the income security of a couple, the algorithm establishes the investing time horizon as the life expectancy of the last survivor using mortality tables, recalculated monthly. Then it selects the best combination of assets, with an increasingly conservative ceiling for risky assets such as stocks. Targeting a specific income replacement ratio — for example, 70 per cent — significantly increases the probability of achieving it over target date funds: 96 per cent versus 23 per cent in a low to rising interest rate environment, and 95 per cent versus 57 per cent in overall historical testing.
Let’s assume a retiree chooses four per cent of accumulated capital as the withdrawal amount, with funds invested in a through-retirement target-date fund or conservative balanced fund comprising 35 per cent stocks and 65 per cent bonds. Our calculations show the retiree has a 26 per cent chance of running out of money before dying in a low to rising interest rate environment. Of course, a one in four chance of going broke is unacceptably high for most people. In contrast, a dynamic algorithm with the same four per cent withdrawal rate reduces the chance of running out of savings to seven per cent. Further, skipping cost-of-living increases not earned in the preceding year reduces the chance of running out of money before dying to just two per cent.
The same retirement portfolio saw over 50 per cent more income through management of risk compared to holding a static mix of assets. In my opinion, this is a manageable balance with which to employ an immediate or deferred annuity to protect against extended longevity risk.
Many decumulation strategies focus on offsetting inflation risk using treasury inflation-protected securities in the U.S. or real return bonds in Canada. While inflation indeed erodes purchasing power, today’s combined low-rate and low-inflation environment presents more important problems.
Our research found a total return approach that manages risk is more effective at replacing income than allocation portfolios such as lifestyle and lifecycle funds. As a prospective employee, imagine weighing job offers from one company offering a pension plan dedicated to replacing income and minimizing the chance you’ll run out of money before dying and from another company offering a target date fund with no decumulation strategy and a one in four chance of ruin. More focus on targeting risk and less focus on asset allocation can yield better choices in decumulation and expanded options in retirement spending. With the range of possible personal circumstances and uncertainty, this is the kind of choice employees can use and appreciate — and that employers can use to attract and retain the best employees.
Mark Yamada is president and chief executive officer of PUR Investing Inc. These views are those of the author and not necessarily those of the Canadian Investment Review.