In Practice December 6, 2022

Near-Retirees May Be at Risk for Retirement Income Shortfall

A DCIIA report written by industry players looks at how rising interest rates and inflation are cutting into common retirement income tactics, as well as the new tools generating interest among plan fiduciaries and sponsors.

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Near-retirees and retirees could face a retirement-income shortfall due in part to the extended period of low interest rates, according to new research by the Defined Contribution Institutional Investment Association.

A decade of low interest rates (as well as current rates, which are still historically low) and high inflation may be eroding the success of retirement income planning, with retirees at risk of turning to savings at a faster rate than expected, DCIIA members wrote in the report.

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“Retirees and near-retirees are generally more exposed to interest rate and inflation risks in their portfolios, given higher levels of fixed income holdings and a shorter investment horizon,” the DCIIA report said. “After an extended period of low interest rates, this demographic today may be more at risk of experiencing income shortfall, price depreciation and purchasing power erosion.”

People with heavy exposure to fixed-income investments, such as bonds, will likely face lower regular payments from the investment because they were purchased when rates where low, the association said. Meanwhile, inflation can cut into buying power, as the cost of everyday items increases at a higher rate than bond yields.

“If inflation continues to hold at rates higher than prevailing bond yields, retirees may suffer prolonged and possibly permanent loss of purchasing power if they are forced to withdraw larger amounts from their savings to fund their retirement expenses,” DCIIA said.

Target-date funds, which gradually shift savers into more conservative, fixed-income assets, are a key reason for this potential shortfall, the report said. Since TDFs are used by a whopping 81% of participants, according to Vanguard, many people with workplace plans who are close to or in retirement have been weighted toward fixed income investments.

“The shift into TDFs over the past 15 years, in addition to the enormous growth of DC plans, has led to more fixed-income assets being held by participants ages 55 and older just as interest payments retirees can expect to receive from fixed income have decreased.”

Contributors to the report included researchers from industry players Capital Group, Institutional Retirement Income Council (which advocates for retirement income strategies in DC plans), and PGIM, the investment management business of Prudential Financial.

The ‘Retirement Tier’

While investing in TDFs has been an effective strategy for accumulating assets, their success in providing regular income in retirement—or the decumulation phase—has not been tested, DCIIA said. That has led to an industry-wide effort by asset managers, recordkeepers and insurers to create products that can link TDFs with income-focused strategies to help retirees and near-retirees.

According to DCIIA, plan sponsors are more frequently giving “retirement-tier” participants some options. Though each has its own limitation in the current financial environment, the most popular include:

  • Fixed Income Annuities: These insurance contracts are a popular way to provide regular payments in retirement. However, they tend to mirror bond interest rates and so, if purchased in a low-interest-rate environment, will return lower yields than their historical average, DCIIA said.
  • Bond Laddering Strategies: This strategy involves buying multiple bonds with different maturity dates, then reinvesting the principal into new bonds if they are offering higher rates. This strategy can be difficult to personalize within a defined contribution plan, DCIIA said.
  • Systematic Withdrawal Strategies: This basic approach is for the retiree to withdraw a specific amount of money, adjusted for inflation, out of retirement each year. Here again, providing a solution that can withdraw the correct amount can be hard to personalize within a defined contribution retirement plan.

The limitations of these offerings, combined with the current low-rate environment, inflation and growing interest in retirement income, has kicked off increased innovation in defined contribution plans, DCIIA said. Some newer, but even less-tested strategies include:

  • Deferred fixed annuities attached to a TDF series: This strategy automatically shifts a TDF’s glidepath to a retirement income option. Instead of moving retirement savings into only fixed income as people age, it puts their money into annuities that can offer a regular paycheck when they retire.
  • Guaranteed lifetime withdrawal benefit attached to a TDF series: This strategy uses a variable annuity within a TDF, giving participants the ability to take part in growth when markets rise, while also baking in a floor to protect them at least to a certain level when markets decline. Both fixed and variable annuities have been criticized for high fees.
  • Social Security optimization through a DC bridge strategy: If a retiree delays taking Social Security, it can increase payments by about 8% every year, DCIIA noted. A bridging strategy has retirees tap their defined contribution assets as a “bridge” to get to a higher Social Security payout.

While many of these options have either been available or in discussion for years, “plan adoption has been modest,” the DCIIA report stated. The current moment may push these strategies forward as near-retirees realize their savings and income options may not be enough.

“Plan sponsors that serve retirees in-plan are in a unique position to potentially offer a higher level of retirement security than counterparts that offer only accumulation-oriented, pre-retirement solutions in-plan,” the DCIIA report said. “Plan sponsors may want to consider helping them mitigate challenges posed by persistently low interest rates and rising inflation.”

The Markets December 6, 2022

Bear Market Draws Attention to Actively Managed Funds

Active and passive funds have both found success in retirement saving plans, but recent volatility is providing further analysis for a decades-long debate.

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Can an active fund manager beat the markets in the long run, even while charging relatively higher fees? It’s a question experts have been debating for years, but with many 401(k) plans down as much as 21% in the third quarter, the answer once again feels pressing.

Recent research weighs in that active managers can beat the markets, but with a caveat: Much depends on which managers are running the funds in your plan.

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“Managing risk in this environment for potentially less-sophisticated investors— investors who are defaulted into certain strategies—is one of the most important responsibilities that plan sponsors have,” says Steve Deschenes, a senior vice president of research and development for the Capital Group, one of the country’s largest mutual fund providers as owner of American Funds.

Deschenes published research this November looking to find which active fund managers thrive in bear markets. The result showed that history matters, as managers who had done well in previous downturns did better in the next decline 12 out of 13 times.

“The resilience of those managers was pretty astounding,” Deschenes says. “There is an opportunity for plan sponsors—and an opportunity for folks who are selecting managers—who are a bit more risk-aware, risk-centric and manage to the downside more effectively.”

The common traits among these managers were the use of cash, the degree to which they relied on dividends for returns and, finally, the objective of the fund, Deschenes says. Whether focused on an area such as income security or capital preservation, adjusting for such goals is not something passive funds can do, he says.

“Passive can only have one objective, which is to replicate the market … it is mechanically linked to 100% up-capture and 100% down-capture,” Deschenes says. “Within active management, you have the opportunity at least to choose a manager who is more focused on capital preservation [or another defined objective].”

A Time to Shine

The ability to perform well consistently over the long term is what retirement plan advisers and sponsors should focus on, as opposed to shorter-term snapshots, says Michael Doshier, a senior retirement strategist at T. Rowe Price.

“Comparing the actively managed mutual fund to the passive investment is a simple side barometer that people can use, and it’s misdirected,” Doshier says. “In the pursuit of trying to find useful metrics, some people go to just cost or a short period of time.…We’re saying, ‘Look at how the funds perform over a longer period,’ which is more useful, especially in the retirement context.”

T. Rowe Price recently looked at the performance of actively managed funds as compared to passive peers over a 20-year period. The firm used rolling monthly 10-year periods and took fees into account.

The results showed that size mattered most, with the five largest active mutual fund managers at the time outperforming passive peers 62% of the time. While the rankings shifted over time depending on who had the most assets under management, the most recent five were Capital Group, Fidelity Investments, Vanguard, Dimensional Fund Advisors and J.P. Morgan, the researchers said.

Meanwhile, T. Rowe Price’s actively managed funds outperformed passive peers 73% of the time. The investment firm looked at 124 of its own active funds, representing 71% of its total mutual fund AUM.

The story changed when comparing all 10,700 active funds in the research to the 3,109 passive peers. In that case, T. Rowe found that passive funds outperformed active 53% of the time. That broader view, Doshier says, is partly why the role of the retirement plan adviser is so crucial in steering plan sponsors.

“You’ve got to look at the providers,” Doshier says. “That’s why [retirement plan advisers] exist: to guide plan sponsors in areas of financial wellness and what goes into their investment lineup in their 401(k) … That’s why most of our assets are sold via the adviser community.”

People also tend to notice the successes of active management, he says, during times of volatility.

“Even in the bull run, where everything is going up, active can still outperform passive,” Doshier says. “But we do find that choppy waters, in general, are where good active managers shine.”

Passive Works, Too

S&P Dow Jones Indices have been contrasting active and passive investing for the past 20 years, and their findings—though based on different measures than T. Rowe Price and Capital Group’s Deschenes—show passive outperforms active. In the most recent report through June 30, the S&P 500 outperformed actively managed large-cap U.S. equity funds for 17 of the past 20 years, according to the S&P Indices Versus Active scorecard, or SPIVA.

“There are periods when the environment is potentially beneficial to active managers,” Anu Ganti, senior director of index investment strategy at S&P Dow Jones Indices, said in an email. “However, what our unbiased data shows is that most active managers have historically underperformed their benchmarks most of the time. As you extend the time horizon, historically, underperformance tends to worsen.”

S&P’s research shows that larger actively managed funds outperform smaller ones, but still not as much as the S&P 500. The larger actively managed funds performed a bit better, with 7.8% annualized returns as compared to 7.4%, according to the firm. The overall S&P 500, however, returned 9.1%.

A T. Rowe Price spokesperson noted that their data focused on the most “like comparisons” to actively managed funds that would go into retirement plans, not the closest corresponding indexes.

No matter the strategy plan advisers favor, the long-term commitment of retirement savers to their portfolios was reiterated by further data released last week by the Investment Company Institute. The ICI said that through the first three quarters of 2022, investors stuck with their defined contribution plans despite market volatility.

“Most DC plan participants kept their asset allocations steady as stock values generally fell during the first nine months of the year,” the institute said in a press release. “In the first three quarters of 2022, 7.4% of DC plan participants changed the asset allocation of their account balances, slightly lower than 8.3% in the first three quarters of 2021 and 9.5% in the first three quarters of 2020.”

Even fewer DC plan participants changed the asset allocation of their contributions, ICI said, on the basis of its research into more than 40 million participant accounts. In the first three quarters of 2022, 3.8% of participants changed how their contributions were allocated.

“ICI’s research is showing that 401(k) investors save for the long term and prioritize keeping their retirement nest eggs intact,” Sarah Holden, senior director of retirement and investor research, said in a press release.

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