We have all heard this in one form or another: you should progressively invest more conservatively as you approach retirement (my personal favourite is the dictum that the equity portion of retirement savings should equal 100 minus your age). But does this make sense? Where does it come from? Should defined contribution (DC) plan members adopt it? Should sponsors encourage it? Let’s take a look.
That was then…
Some 20 years ago, when DC plans were getting off the ground, interest rates were at their peak and there were few options other than purchasing a life annuity at retirement. In fact, most plans automatically called for a life annuity purchase (or at least offered this as the default option)—the plan administrator would survey the market and buy from the insurer that offered the best annuity rate under the option chosen by the member. Little had to be done regarding investments, as most members were either invested in (then) high-interest paying GICs, or in a single balanced fund with a fairly high (e.g., 60%) bond content.
…this is now
Today, it is rare that members purchase a life annuity at retirement. With low interest rates, the advent of more flexible retirement income vehicles such as LIFs or RRIFs, an increased desire for control and the wish to leave potentially large sums of money to the kids (retirement savings are larger today than they used to be), annuities have largely gone out of style (too much so if you want my opinion).
Still, the industry as a whole appears to forget this and continues to suggest that you should be ever more conservative with your investments as you near retirement. This is true of educational material from the vast majority of providers (including their risk-tolerance questionnaires), and most of the new lifecycle (a.k.a. target date) funds, which shift plan members to a very large portion (typically more than 65%) of fixed income—and cash!—in their asset mix by the time they are a few years from retirement.
In theory, this works fine. If they were to purchase annuities, plan sponsors—and plan members as well, assuming they understand these dynamics—would want to immunize against market risk as retirement approaches. Normally, the best way to do this is to progressively increase bond content so that the portfolio value fluctuates as much as possible in tandem with annuity purchase rates. This way, if bond rates go down, annuity rates go up (annuity rates are strongly—but oppositely—related to long-term bond rates), but so does portfolio value. On the other hand, if bond rates go up, then portfolio value goes down—but that’s alright because annuity rates also fall. The member is then protected (at least partly) against annuity purchase rate fluctuations.
Sooooo?
It has been shown many times over that equities offer better long-term growth and inflation protection, which would reduce the risk of running out of money during retirement. Even when considering a member who retires at age 65, the remaining life expectancy is still around 20 years (more, if you consider the last survivor in a couple). So, in effect, a large part of the savings will remain invested for a good 10 to 12 years.…Is it reasonable to have over two-thirds of the portfolio in fixed income? I say no.
Given that most DC money is not going to be used to purchase an annuity today, the current generalized approach actually does a huge disservice to most DC (and other CAP) members—a disservice which could represent potential fiduciary liability for sponsors, particularly in regards of default investment options such as lifecycle funds.
Sponsors should therefore require from their providers to offer better education, adapt their decision-making tools, and clarify the best use of the available investment options to ensure the best possible long-term retirement outlook for their plan members, in accordance with their preferred retirement income vehicles.