The recent economic downturn revealed a real problem in the array of investment choices in most defined contribution plans. Fortunately, solutions are readily at hand.
The problem is that a major reduction in account balances just before retirement can endanger financial security. If the retiree is forced to withdraw assets when the market is down and then rely on accumulations to replace income formerly earned from employment, the portfolio can be seriously impaired.
Put another way: When accumulating for retirement, it is great to buy low. But when forced to take income to pay the bills in retirement, it is damaging to sell low.
The hit that pre-retirees took in the recent downturn is substantial. On average, investors within 5 years of retirement lost considerable sums of money, and those in 2010 target date funds did not fare better.
Large market declines cannot be unexpected. After all, since 1900, the United States has had over 30 bear markets. But most defined contribution plans make it very difficult for participants to protect themselves against these regular major declines just when they can least afford them. Participants can, of course, tilt very decidedly to fixed investments in the years prior to retirement. But that means giving up the potential for a lot of return.
Here is an alternative: The plans can offer an annuity with a guaranteed minimum accumulation benefit as an investment option for plan participants. The cost of this guarantee is lower than the cost of an annuity with guaranteed lifetime withdrawal benefits. Further, this annuity can be designed to provide cash (not just a guaranteed stream of income) at the projected date of retirement, giving the participant a high degree of flexibility.
It is true that annuities with GLWB can also play a very useful role for plan participants and should be carefully considered. But the focus here is on the annuity with GMAB.
The GMAB structure allows participants to put a significant amount of money in equities, with the chance of higher return, but removes the risk of suffering from a devastating loss of the kind that many retirees are experiencing today.
The insurance and financial services industry has devoted a great deal of discussion to the importance of making several classes of investments available to plan participants so they can design an effective asset allocation. But participants also need to have the chance to design an effective product allocation.
Annuities with the GMAB feature can allow participants to design a portfolio that more accurately provides the desired level of protection, without the “cost” of a heavy tilt toward lower-returning fixed investments.
What about the target date funds? Given that they already hold a significant amount of participant deposits, consideration should be given to having these funds incorporate annuities with GMAB.
Consider this example: A target date fund has the traditional glide path but starts the GMAB within 5 to 7 years of the target date. Assume the GMAB is 5 years before the target date. At that starting point, most target date funds have about half their assets in fixed investments. Let’s assume that is the case with our sample fund, and the other half of the fund is in equities.
If the fixed portion can earn 4% a year for the 5 years before the target date, it will earn 21.7% in the 5-year period.
Now, in order for the entire accumulation to be guaranteed not to go down over the 5-year period, the equity portion must be guaranteed not to decline by more than 21.7%. A GMAB providing this guarantee will not be very expensive, and it can bring real peace of mind and retirement protection to the participant.
In most cases, of course, the equity portion will go up and the participant will get that increase. Still, the GMAB provides the guarantee so many retirees want and need.
There are a number of ways to structure annuities with GMAB. The guarantee period can be long or short, and the annuity can be packaged with various levels of fixed investments to lower the cost of the guarantee. Further, the level of guarantee can be set at different levels.
The investment can be guaranteed to increase by a certain proportion (e.g., 1% a year) or guaranteed not to decline more than a certain proportion (e.g., no more than 5% over the guarantee period).
More work is needed to find the most effective design, but the goal should be clear: make it easier for future defined contribution plan participants to avoid major losses that force them to work longer or suffer more financial insecurity in retirement. The industry needs to expand the investment choices available to participants to allow them to attain greater protection and security.
Mathew Greenwald is president of Mathew Greenwald & Associates, Inc., Washington, D.C. His e-mail address is MathewGreenwald@greenwaldresearch.com