approach to long-term investment have enabled target-dated funds to
become a major contender for US retirement savings. However, a
study reveals that target-dated funds’ inability to offer income
guarantees is a potential threat to retirement income.
Charles Davis reports.
Outliving their money is retirees’ most visceral fear, and
avoiding it is the financial adviser’s strongest selling point. Yet
for American retirees who rely exclusively on target-dated funds
(TDF) to provide lifetime income, the fear could prove very real,
according to a new study undertaken by professional services firm
Ernst & Young (E&Y).
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In essence, TDFs, which are also often referred to as life cycle
funds, rebalance asset allocation over a set period to take into
account changes in an investor’s risk aversion by applying
increasingly more conservative asset allocations as he or she
approaches their target retirement date. Though TDFs with target
dates of up to 40 years are available in the US, none can offer a
guarantee that at the end of the target period the capital sum that
has been accumulated will be adequate to sustain a retiree
throughout retirement.
However, in an era when life expectancy is rising, guaranteed
retirement income security is becoming increasingly important.
E&Y’s study, which it conducted on behalf of US insurer
Prudential Financial, compared the provision of retirement income
in a defined contribution 401(k) retirement plan using TDFs with
Prudential’s guaranteed withdrawal benefit solution, Prudential
Income-Flex. For the exercise, E&Y used its proprietary
Retirement Analytics model to generate thousands of simulations
into which were factored market performance, inflation and
mortality assumptions.
Possible trouble for married couples
E&Y’s research simulations show that relying on TDFs in
conjunction with systematic withdrawal programmes may exhaust
savings one-third of the time when withdrawing at an
inflation-adjusted rate of 5 percent of the initial capital. Of
even greater concern is that the study also found that married
couples could potentially run out of money in more than half the
scenarios.
In contrast, guaranteed benefit withdrawal solutions such as
IncomeFlex allow retirees to maintain income throughout their
lifetimes, even if a 5 percent withdrawal rate depletes an
individual’s account value.
“Target-dated funds are very popular right now in 401(k) and other
group retirement plans because they provide a simple, ‘set it and
forget it’ approach to saving for retirement,” said Christine
Marcks, president of Prudential Retirement.
“But systematic withdrawal programmes used with target-dated funds
don’t address the risk of running out of money in retirement. As
this important analysis reveals, that risk is still very real. On
the other hand, guaranteed solutions like Prudential’s IncomeFlex –
which use investment strategies similar to many target-dated funds
– provide income to last a lifetime, often with money left for
heirs.”
TDFs growing in popularity
TDFs have become increasingly popular and, according to US
investment industry body the Investment Company Institute,
investors put $114 billion into TDFs in 2007, up from $71 billion
in 2006 and $44 billion in 2005. Mutual fund research firm
Morningstar currently monitors 248 TDFs whose combined assets have
reached nearly $171 billion. According to Morningstar, this is up
from $2.4 billion a decade ago and $15 billion five years
ago.
An innovation that is proving popular with companies offering
defined contribution pension plans are commingled TDFs that pool
plan participants’ contributions as opposed to investing them in
individual mutual funds. Media group Time Warner, for example,
offers commingled options to participants in its $9 billion 401(k)
plan.
The latest trends in commingled TDF portfolio construction
incorporate alternative assets. In shares, this can include
companies in sectors such as real estate, commodities and emerging
markets. In bonds, managers are, for example, including US Treasury
inflation-protected securities and high-yield issues. The
underlying thread is that each type of investment tends to move in
different cycles over longer periods.
Service providers believe commingled target-dated strategies are
about to take off as well, but as the E&Y research shows,
questions persist about the ability of TDFs to enable retirees to
sustain themselves over ever-longer lifetimes.
E&Y’s research underscored the value of a guaranteed approach
to creating retirement income. For each of the three case studies
in the study, the guaranteed benefit product produced relatively
high income levels as a result of greater participation in
investment market upswings and protection from market downturns,
eliminated longevity risk, and still left a meaningful amount of
assets to pass along to heirs.
New solutions for accumulating assets and generating retirement
income that allow participants to transfer investment and longevity
risks to intermediaries, while still providing degrees of
liquidity, flexibility and control, have been introduced in the
marketplace in the form of variable annuity products with
guaranteed minimum withdrawal benefits.
One such product is IncomeFlex, a solution developed by Prudential
for use in defined contribution plans. IncomeFlex is both an
accumulation and an income solution, and product features include
both accumulation and income guarantees.
Security
Guaranteed benefit funds provide participants with security during
their accumulation years so they can plan, with certainty, on an
initial minimum retirement income level. That income will never
fall below the minimum level, regardless of market performance. In
fact, income could increase. Non-guaranteed approaches to creating
retirement income force participants to make a difficult trade-off
between income level and income sustainability that guaranteed
benefit participants do not have to make.
This is an especially important consideration for married couples,
who want to sustain income over their combined lifetime, and for
women, whose longer average life spans increase the probability of
outliving retirement assets. An increasing number of investors will
be faced with managing their own retirement plan accumulations to
maximise income but minimise longevity and investment risks.
E&Y’s study casts real doubt as to whether TDFs alone can
suffice.
