Retirement income is in the news and several companies have responded to the increasingly visible shift from investment accumulation to income distribution by announcing new products, including:o The addition of principal protection and/or payout features to investment productso The availability of income guarantees as optional riders in variable insurance contractso The extension of traditional advice processes to include income projections, ladders and systematic withdrawal plans.
These products and enhancements are a great start. But what other products might be in our future?
Bodie, Merton and Cleeton, in their text book Financial Economics, seek to explain finance through its functions rather than its institutions, concentrating on the three pillars of finance: optimization over time, asset valuation and risk management. The transfer of risk through hedges, the pooling of risks with insurance, and the diversification of risk with investments are identified as three dimensions of risk management. Financial advisors may find it natural to add a fourth dimension, decision-making processes about risk with advice to create a framework (Chart 1) to help us understand and perhaps even forecast the evolution of retirement income products.
Ernst & Young tracks retirement income products in their Retirement Income Knowledge Bank, an online database that compares the various features, costs and benefits of retirement income products.
Traditional In-Silo AccumulationApplying this framework to the traditional in-silo accumulation and past history of the financial industry, we see that familiar products can be shown on Chart 2.
While financial advisors are not in need of definitions for mutual funds, annuities or advice processes, it may be useful to define hedges and selected types of derivatives available to retail investors in the accumulation phase.
Derivatives have been widely available for decades in the institutional markets including: options, forwards, swaps and swaptions. Derivatives have also been available in the retail markets, including call options, put options and commodity futures.
Accumulation-focused retail investors can use a derivatives strategy to protect against unexpected downturns in their investment portfolio during the accumulation phase. Two common strategies involve purchasing a put option and covered call writing.
Let’s move beyond definitions and towards observations. While traditional, retail accumulation products have tended to be in-silo developments, there are at least two examples of successful cross-silo developments in the accumulation-focused history of the financial industry: Target-date funds, also known as target- maturity funds, and separately managed accounts that both offer varied degrees of investments and advice as shown on Chart 3.
There may be an interesting lesson to be learned from the competition between target-date funds and separately managed accounts. Both are accumulation-focused, cross-silo innovations that combine investment and advice. However, the packaging of target-date funds is closer to an investment product than an advice process, whereas the packaging of separately managed accounts is closer to an advice process than an investment product. Which of these two seems to be more successful in your marketplace, the product-packaged combination or the process-packaged combination? Which of these two seems to be amplified into a greater success, in your practice or in your market, as measured by assets under management?
Cross-Silo Retirement Income GenerationSome recent retirement income-focused innovations, such as income funds, payout funds, systematic withdrawal plans and laddering processes, have been in-silo innovations as shown on Chart 4.
However, and as demonstrated by the rapid growth of the Retirement Income Industry Association (RIIA), many industry participants believe that retirement income products will require new, cross-silo developments.
Using our framework systematically, we can identify 11 potential cross-silo retirement income-focused innovations. These include six pair-wise combinations (e.g. insurance/hedges, insurance/advice, insurance/investment, etc.), four triple combinations (e.g., insurance/hedges/advice, etc.), and one combination including all categories. Which of these 11 combinations are likely to be successfully selected by the market?
Will the product-packaged vs. process-packaged distinction of the accumulation-focused target-date vs. separately managed account prove to be an important differentiator for market success in the retirement income space? Would we then be facing 22 possible combinations? To make matters even more interesting and in addition to the product vs. process packaging dimension, Sri Reddy (head of retirement income strategies, ING U.S. Financial Services) suggests that the ability to package the offering at a reasonable retail-level cost may be another key determinant for successful cross-silo combinations. For instance, combining hedging-only investment options with advice may be too expensive as a packaged option at the retail level.