Defined contribution pension plan members nearing retirement may need their employers’ help to achieve financial security during an era of low interest rates and increased inflation, according to a new report by the U.S.-based Defined Contribution Institutional Investment Association.
It found target-date funds are the dominant investment strategy in most DC plans, used by 80 per cent of members and attracting 60 per cent of plan contribution dollars. According to the data, a TDF for a plan member near or in retirement has roughly 50 to 70 per cent of its assets invested in fixed income and money market securities.
Read: 2022 DCIF: Understanding sequence of returns risk in target-date funds
The shift to TDFs over the past 15 years, in addition to the growth of DC plans, has led to more fixed income assets being held by members aged 55 and older, as interest payments that retirees can expect to receive from fixed income have decreased.
The report highlighted two key risks in fixed income investing: interest rate risk and inflation risk. Investors with a significant allocation to fixed income face two primary sources of loss during a low interest rate environment — income shortfall and price volatility. Inflation can erode purchasing power for retirees as they typically allocate a significant portion of their retirement savings to bonds. When bond yields are lower than the current level of inflation, the impact is a negative real rate of return for DC plan members.
In December 2021, the Social Security Administration announced the social security cost-of-living adjustment would increase retiree benefits by 5.9 per cent for 2022. According to the report, this COLA increase will partially offset the recent spikes in inflation affecting retirees, but if inflation continues to remain at such elevated levels, retirees’ wealth will continue to erode.
Read: Canada’s retirement system remains strong, but DC pension plans facing inflation risks: report
The research also found more DC plans are adding solutions to address members’ retirement years and plan sponsors are increasingly deciding to keep retirees in their plans as it’s in members’ best interests.
Three commonly used retirement income solutions cited in the report were fixed income annuities, bond laddering strategies and systematic withdrawal strategies. However, these options may not be optimal for retirees as stand-alone strategies considering the current environment, noted the report.
Some retirement income strategies that have been gaining traction are maximizing government-provided income, deferred fixed annuities attached to a TDF series and a guaranteed lifetime withdrawal benefit attached to a TDF series.
Read: 2021 DC Plan Summit: A look at how DC plan members value target-date funds, ESG investments