Delivering more: can guaranteed investment strategies help?
Transitioning from “employee” to “retiree” is a complex process and the result of countless decisions employers and employees make over the course of many years. The employee’s decisions include how much to contribute, how to allocate contributions, avoiding loans and staying the course. The employer’s decisions largely center on plan design, which include matching contributions, auto features and investment selection. As the employee-to-retiree transition begins, there is a new series of interdependent decisions between employee and employer: mainly what options do employees have to transition their retirement savings into income?
The majority of 401(k) plans offer limited support at this transition point, unlike their defined benefit and 403(b) cousins that were designed to provide guaranteed income in retirement. The recent passing of the SECURE Act (Setting Every Community Up for Retirement Enhancement Act) acknowledged this. In an attempt to encourage the inclusion of lifetime income options on plan menus, the law expands the fiduciary safe harbor for the selection of an annuity provider if certain conditions are met.1 This is a critical step aimed at helping 401(k)s evolve.
The benefits of an in-plan guaranteed income solution are often attributed to retirees who are focusing on the simplicity of a consistent stream of income.2 However, there are potential benefits of including guaranteed income solutions in a plan menu for employees who are still in the process of growing their retirement savings. Annuities have the potential not only to provide income for life at retirement, but may also help employees save more, guarantee growth and protect retirement savings.
Most corporate defined contribution plans use target date funds as their default investment option. While target date funds remain an important and popular retirement savings tool, there may be opportunities to improve asset allocation strategies. Nearly 7 in 10 Americans say guaranteed retirement income is the most important thing their retirement plan should provide, but at the same time, 63% of employees incorrectly believe they’ll get that from their target date funds.2
One way 401(k) plans can advance is by enhancing the default option. Target date funds and other asset allocation strategies, such as managed accounts, will continue to develop and evolve into vehicles with the portfolio strength, investment diversity and performance that will help support employees to and through retirement.
Rigorous modeling can demonstrate how adding a guaranteed investment component, such as a deferred fixed annuity, to target date funds may improve the overall portfolio. A guaranteed investment component helps manage the downside risk of fixed income markets, while protecting potential returns. In fact, modeling examples have shown improvement in fund returns and a noticeable reduction in standard deviation of returns, particularly during fixed-income bear markets, providing investors with the assurance of principal safety and guaranteed interest even in the most volatile markets. To demonstrate this, we modeled two different strategies:
Strategy A: hypothetical mixed-asset portfolio returns without a guaranteed investment component
Strategy B: hypothetical mixed-asset portfolio returns with a guaranteed investment component
Asset mix modeling
Strategy A: This modeling example simulates the one-year return of a hypothetical retirement income target date fund and considers a variety of equity and fixed income return scenarios. The one-year return is shown in the row/column intersections in the table below:
Strategy B: Like Strategy A, this model uses the same simulated one-year returns of a hypothetical retirement income target date fund and considers a variety of equity and fixed income return scenarios. However, Strategy B substitutes 75% of the fixed income sleeve with a guaranteed investment that pays 2.5% interest. The result shows the potential for an increase in overall returns of the target date fund/account in markets where the fixed income sleeve returns less than the guaranteed investment, such as in a rising interest-rate environment.
The scenario below demonstrates how the guaranteed investment component in Strategy B offers downside protection and can stabilize overall fund returns. The scenario shows a 1.32% average return improvement across a range of fixed income returns (-4% to 4%). The improvement in one-year returns with the guaranteed investment component is most pronounced when the traditional fixed income sleeve experiences poor performance (e.g., during a rising interest rate environment). When traditional fixed income returns are 2.5% — i.e., equal to the returns from the guaranteed investment component — overall returns remain unchanged between the two strategies.
Incorporating a guaranteed investment option into target date funds and other asset allocation arrangements, such as managed accounts, can enhance and protect overall portfolio returns. Modeling illustrates how a guaranteed investment strategy can help stabilize fund returns and reduce downside performance in a multi-asset portfolio, helping plan participants minimize market risk and sequence of returns while they prepare for, and live in, retirement. If the guaranteed investment also provides the option for lifetime income, the approach can also help participants generate income in retirement that they can never outlive.