In turning its attention from accumulation to decumulation, the 401(k) industry created new products to solve income needs, but they came with significant disadvantages, according to the presenters from Milliman during a session at Schwab Impact in November.
Ken Mungan, head of Milliman’s financial risk management practice, and Janet McCune, principal and leader of business development and communications for the Milliman Southern Employee Benefits Practice, described the strategy Milliman has developed to help advisors overcome the myriad risks clients face once they begin taking withdrawals from their retirement accounts.
First, of course, is market risk. Volatility, sequence of returns and behavior all affect market risk.
“Sequence of returns comes into play when withdrawals begin,” Mungan said. When the market is down, clients are depleting their portfolios at an accelerated rate.
Volatility forces clients’ hands when they react to market drops by jumping into cash and missing the rebound. Mungan said that in addition to losses incurred in the drop, missing that rebound reduces returns by another 2%.
He offered an example of how difficult it is to change behavior with a story of his home life. In all the years he’s been married, he began, his wife has made several suggestions for ways he could change his behavior that he has never followed. “To be fair,” he joked, “she hasn’t changed either.”
He said to the audience, “If you can’t change your behavior for your spouse, you’re not going to do it for an investment product.”
Inflation risk is another challenge retirees face when they start drawing down their portfolios. Mungan noted that the oft-touted 4% rule works when the client has a large allocation to bonds, but by changing the risk management technique used on the portfolio, an advisor can “dramatically improve” upon the 4% rule.
Milliman uses managed risk equities to address those challenges. The 4% rule isn’t based on sophisticated models; just the simple assumption that inflation will be in place forever, “usually around 2%,” Mungan explained. He called that strategy “inflation pre-funding,” claiming a large portion of clients’ portfolios will go to inflation.
A contingent growth strategy, however, uses managed risk equities to provide an alternative to inflation mitigation. Higher inflation typically comes with an increasing stock market over time; those higher equity returns will offset higher inflation.
Milliman applies a managed risk strategy that uses volatility management and capital protection techniques. “There’s no such thing as a perfect risk management strategy,” Mungan acknowledged, but these two strategies are “complementary.”
Volatility management acknowledges that when conditions are right, investors can be a little more aggressive. Mungan compared it to driving a car; a person might call himself a moderate driver, but it’s not likely that he only drives 60 miles per hour all the time, in good weather or in a blizzard. Volatility management helps advisors “modulate market exposure based on conditions.”
That strategy is “useful alone, but it’s not enough,” Mungan said. “When everything is going down together, you need capital” protection.
Providing another real world example, Mungan compared capital protection strategies to a bungee cord; the more you pull on it, the more resistance there is.
“Applied to a volatility managed strategy, [a capital protection strategy] produces a synergy,” he said.
How can that be applied to 401(k) plans, though? McCune took over to suggest four ideas for ways advisors could apply managed risk strategies to plans they advise.
First, they could incorporate managed risk equities into the fund lineup, she said. In a hypothetical glidepath with reduced bonds and between 50% and 75% risk equities, the Sharpe ratio improved and the sustainable withdrawal rate increased.
Considering investor appetite for target-date funds, managed risk “do it for me” portfolios should be a popular alternative. McCune suggested proprietary collective funds and managed accounts as options.
Keeping retirees in the plan after they stop working is another way to protect their retirement income, McCune suggested. There are benefits to the retiree. They’re still invested in a risk-managed plan and they can get regular payments from the 401(k) plan. (“We do it for defined benefit plans. Why can’t we do it for defined contribution plans?”)
There are benefits to the plan sponsor, too, as the recordkeeper maintains control over administration. Sponsors still have access to the participant website and call center, targeted education and communication, and the recordkeeper manages benefit changes and administrative matters like change of address.
Finally, clients could purchase deferred income annuities with plan withdrawals, McCune said.