“How do we bring some of the best aspects of defined benefit plans into the defined contribution world?” Timothy Pitney, managing director of institutional investment and endowment distribution at TIAA, asked on a webinar the Retirement Income Industry Association held in May, sponsored by Bank of America Merrill Lynch.
Pitney proposed using target income models as a replacement for target date funds as the default in retirement plans as a way to get more participants closer to their goals.
(Related: GMO: How to Build a Better Target Date Fund)
TIAA developed target income models with Dimensional Fund Advisors, Pitney said. Rather than the mean variance optimization strategy used in target date funds, target income models rely on liability-driven investing to protect participant income with a long-term goal of sustainable retirement income, rather than simply accumulating wealth, according to Pitney.
“Target date funds have done a terrific job for the accumulation side of the equation,” he noted, “but really are not focused on the income side once people retire.”
Target income models can be customized for plan sponsors and offer multiple glidepaths for participants.
About 70% of new participant contributions, and about 35% to 40% of overall plan flows, are invested in target date funds or the qualified default investment alternative solution from their plan provider, Pitney said. Cerulli Associates estimates that by 2019, there will be $2 trillion invested in target date funds.
Consumer education about target date funds is getting better, Pitney said, but most of the discussion around the funds is still driven by marketing. A study by the Securities and Exchange Commission found that 64% of TDF investors incorrectly believe the funds provide some guaranteed income in retirement, Pitney said.
“As an industry, we’re partly to blame,” he said.
The liability-driven approach familiar in defined benefit plans hasn’t been applied to individuals in defined contribution plans, Pitney said. Software built by Dimensional Fund Advisors lets plan sponsors use LDI at the participant level, he added.
The goal of a retirement plan is to provide participants with inflation-adjusted income in retirement, Pitney said. To do that, sponsors have to be able to define risks and “add more confidence around the desired income,” he continued.
Say a client wants an income goal of $40,000. “If the assets are not managed in the proper way, you may have significant volatility around that income. … The idea is to tighten the risk bands around that $40,000 and provide more certainty that they’ll be able to achieve that number.”
LDI strategies help reframe the retirement discussion on income rather than accumulation, Pitney said.
A $300,000 account will lose 18% of real wealth with inflation at 2%. At 4%, the loss increases to 32% of real wealth.
Interest rate risk can have a dramatic impact on annual income, too. Annual interest income from that $300,000 account falls by 71% with an interest rate of 1% versus 3.5%, Pitney explained.
Say a 64-year-old client is retiring next year and needs $3,000 a month to maintain his lifestyle. He needs to have saved $640,000 to create $36,000 a year in income. However, if interest rates change 1%, the target savings amount for the portfolio changes to between $540,000 and $730,000.
“As you get closer to retirement, interest rates have a significant impact on whether or not that participant is going to be able to buy the income they need.”
One of the more difficult aspects of retirement planning is to get participants to think about income, Pitney said. “When it came to a defined benefit plan, nobody ever asked what their balance was because they couldn’t get at it.” The focus was on monthly income rather than total balance, he said.
— Read TDFs’ Underlying Funds May Not Meet Plan Sponsors’ IPS Standards on ThinkAdvisor.