Changing the Conversation To Income

From Left: Robert Merton; Ed Moslander; Tim Pitney; Michael Lane

Many surveys have shown Americans’ interest in solutions that help them create a pension-like income stream from their retirement savings. These options, coupled with plan design and education that focus on retirement plan outcomes, have led the industry to an increased focus on income instead of just account balances. This is called the “DB-ification” of defined contribution plans, and while there has been much interest and discussion in the topic, it has not yet fully manifested itself as a trend across the industry.

PLANADVISER recently discussed this interest in retirement income and the complexity that such drawdown discussions bring to the industry with a group of experts including: Robert Merton, Nobel Laureate, distinguished professor of finance at the MIT Sloan School of Management and professor emeritus at Harvard University; Edward Moslander, senior managing director and head of TIAA’s institutional relationship management organization; Timothy Pitney, TIAA’s senior director and institutional investment strategist and Michael Lane, head of the Target Income Group at Dimensional Fund Advisors.

PA: Why are we seeing a trend toward income as the goal with the retirement plan process?

Merton: First, I think we underestimated what happened over the last decade, in the U.S. and elsewhere—the transition from defined benefit [DB] being the core employer retirement plan to defined contribution [DC]. DC was created primarily as a supplement to DB plans—along with Social Security. These plans were originally designed for higher-earners, whom employers expected to be able to take care of themselves in retirement. DC was envisioned as something closer to a savings plan, providing liquidity at retirement when people had a strong baseline income though their DB plan and Social Security.

Now that DC has become the core retirement savings vehicle, and not a supplement, it’s very different—particularly for working, middle-class people. As with DB plans, we have to be more focused on the benefit for participants.

A second key driver is the demographics of our society. In the U.S., approximately 77 million Baby Boomers will retire over the next 15 to 18 years. DC providers have started to realize this group will want benefits. We always knew retirement was a two-act play, accumulation and payout, but when the Boomers were in their 30s, 40s and 50s, the focus wasn’t on drawdowns. Now it is.

Third, participants are now responsible for making investment decisions about their retirement plans. That’s something they didn’t have to do with a DB plan, and they may not know how to do in the present nor be able to figure it out in the future. We have to find ways to help them make responsible decisions with respect to replacing their working income in retirement.

The endpoint to achieve a good retirement is income—and that should influence what individuals do with their money 20 or 30 years before. It can’t be about wealth accumulation and then magically switch at some age to being about income.

PA: Tim, why else is it important to have this conversation today?

Pitney: Putting relatively complex investment decisions in the hands of participants who generally have no financial experience is problematic. That’s been especially evident over the last 15 years, because we’ve had severe downturns in the market during 2000, 2003 and 2008.

Sustained, historic declining low-interest-rate environments have made it difficult to produce income through the capital markets. From 1982 to 2000, we had 18 years of a bull run; we had one down year in the market in 1991, it wasn’t too hard to pick a winner. But now it seems much more difficult. We think people want more guided solutions and more security when looking for retirement income.

Another reason we should be having deeper conversations about income, from day one when someone enters a DC program, is to overcome the recent shortcomings of solutions being used in the market. The other major trend is the growth in target-date portfolios and lifecycle investments in response to the Pension Protection Act [PPA] and the safe harbor provisions. While they may have done pretty well at accumulation, income has generally been ignored. Consultants, plan sponsors, participants and most practitioners would agree that income should be the primary goal of any good DC plan, yet we’ve seen a huge shift in assets to target-date funds, which don’t provide for any type of guaranteed sustainable income and don’t manage the risks associated with retirement income.

And we also see signs the regulators share our concerns. For example, in 2013, the DOL [Department of Labor] published tips on evaluating these funds reflecting their concern about how target-date funds were being managed and the perception among participants and plan sponsors of what target-date funds were set to accomplish. Curiously, it suggested a custom approach might work better because it could be tailored to better fit plan demographics and a plan’s ultimate goal.

“DC was envisioned as something closer to a savings plan, providing liquidity at retirement when people had a strong baseline income though their DB plan and Social Security.” —Robert Merton

In 2014, the DOL issued regulatory notices, allowing deferred income annuities in target-date funds and letting them qualify as the QDIA [qualified default investment alternative]. The Department issued a notice on QLACs [qualified longevity annuity contracts] to provide additional income in retirement, and in 2015, it clarified annuity safe harbors. So, I think they would agree that expecting participants to draw down accumulated assets, providing a sustainable income in retirement, is difficult to do.

Finally, we’ve seen a confluence of 403(b) plans and 401(k) plans since the 403(b) regulations in 2009. We believe the goal of 403(b) has always been to deliver sustainable lifetime income in retirement. 403(b)s have learned much from 401(k)s over the last five to 10 years, on governance, fiduciary practices, menu design, etc. But the 401(k) industry has much to learn about providing sustainable income using solutions that target income replacement.

PA: How is the industry responding to this focus on income?

Lane: The industry is focusing on income replacement calculators that show what participants’ accumulated savings may provide in today’s income terms. I believe that’s a good first step. And, from the industry perspective, I see many improvements where account values are starting to be reported in income terms.

However, I haven’t seen where many providers are incorporating many of the best features of DB plans into a DC plan, not just reporting expected income but actually managing the risk and volatility of that income number.

The downside of calculators not being aligned with an investment strategy that manages income risk is that the distribution of outcomes can be quite wide. For example, assume a 65-year-old is a few years or months away from retirement and sees his income number jumping around from day to day. One day he’s on track and the next day he’s off track by 10% to 20%. He may have to rethink whether he can afford to retire. That scenario can be unnerving to someone planning to retire in the near term or someone trying to plan five, 10, or even 15 years away from retirement.

We believe providing meaningful information to participants about the income they could expect is important and we know that they are looking for a turnkey professionally designed investment solutions. But it goes beyond just reporting income. We also think it’s important to provide plan fiduciaries with information and tools to ensure that participant portfolios are managed to an income goal, seeking to decrease volatility by managing risks relevant to retirement income, which may help decrease anxiety for participants. The ultimate goal is to give them a higher degree of confidence that they’re on track for their targeted retirement date.

“Plan sponsors need to include income-generating products inside the plan. If a sponsor includes an income option solution, such as an annuity, retiring participants will be more likely to use it.” —Edward Moslander 

PA: Ed, how can plan sponsors then help address the shift to income and income-oriented positioning?

Moslander: Plan sponsors need to acknowledge, and then explicitly communicate to employees, that the plan’s objective is to provide retirement income. Employees haven’t necessarily viewed it that way because employers aren’t strong enough about what they’re trying to accomplish.

Then, structurally, because most money will flow into QDIAs, they need to use one with income as its goal. In this situation, even unengaged participants will have the potential to replace an appropriate amount of their working income.

Finally, plan sponsors need to include income-generating products inside the plan. If a sponsor includes an income option solution, such as an annuity, retiring participants will be more likely to use it.

Pitney: In facilitating the shift to income, a plan sponsor also needs an adviser or consultant aligned with that goal. Advisers’ first task, over the last decade, was to get the plans in order from a governance and fiduciary perspective, looking at fees or funds or their investment policy statement [IPS]. Now that work is in maintenance mode, they need explicit direction to focus on their plans providing income. Many don’t do this, so, it will be increasingly important for plan sponsors to re-evaluate their adviser and make sure they choose one able to effectively deliver on income oriented goals.

“Advisers’ first task, over the last decade, was to get the plans in order from a governance and fiduciary perspective, looking at fees or funds or their investment policy statement. Now that work is in maintenance mode, they need explicit direction to focus on their plans providing income.” —Timothy Pitney

PA: What prevents participants from achieving the sustainable income they need for retirement?

Lane: In the future, not being able to achieve the income needed may likely be a result of the pace of change within the DC market. For example, I was recently at a consultant’s office, and he said, “For 15, 20 years, we’ve been trying to get people to focus on the account balance in their DC plan. Now you’re saying we should go back to what we tried to get them to focus on in DB, the income and their funding status.” A big impediment is that people have been going down a path for so long, it’s tough for them to reverse gears and change course.

In addition, we’re saying, “Participants shouldn’t worry so much about their account balance because, even if it drops, they might have the same exact buying power.” That’s counterintuitive to what most advisers have developed in terms of marketing materials and advertising for the last 20 years.

So, it’s changing the mindset and getting everybody comfortable with the fact that DC is no longer a top-up plan or a DB supplement. It needs to replace income like a pension and be thought of in a similar way.

Merton: Another problem for participants is what does risk mean to them? Most often, it depends on their objectives. Ten years ago, if someone had $1 million and told an adviser they were unsophisticated and wanted to keep their money safe, the adviser might have suggested a certificate of deposit [CD] at a fully insured bank. And $1 million would have earned 4% or 5%—$40,000 to $50,000 a year. Today, making that same type of investment may pay one-tenth of 1%, or $1,000 a year. I don’t think many people could live on that.

The point is: If someone is measuring everything wrong, they can’t possibly manage it correctly. Measuring income first should be the lead item, because it’s a retirement account, not a savings account. Until we get that right, it will be hard to get people in the right place.

For the same reason, if we were reporting how much income an individual could buy, people would see how much money they would need to get a decent retirement. They might look at $1 million and say, “I’m rich,” until they see how little income that will supply. Beyond that, we need solutions that draw more retirement income benefit from the assets people do have.

One item that can really move that needle for the working middle class around the world is the annuity. For DC plans to help create proper income, they may need: 1) very good annuity products, and 2) education to help people see the value of giving up their money when they don’t need it to create an income when they do.

PA: For plan sponsors and advisers, what paradigm shifts need to occur within retirement plans to make income key in the planning process?

Moslander: Advisers and consultants talk about income being the goal but don’t necessarily practice that. So this needs to change.

For plan sponsors, participant engagement should be about what risk to manage when the goal is income, which is different than when the objective is wealth. Additionally, plan sponsors and providers could define the success of a plan by how well it helps replace pre-retirement income. Communicate that standard, versus others the plan may have used.

“It’s changing the mindset and getting everybody comfortable with the fact that DC is no longer a top-up plan or a DB supplement. It needs to replace income like a pension and be thought of in a similar way.” —Michael Lane

Finally, make this a win-win. Both employers and employees have an interest in people retiring on time. That’s a win for everybody. Viewing income replacement as a means to a win-win is a way to shift the paradigm.

And it would help to stop calling them defined contribution plans; they’re actually “target benefit solutions”. Someone is making a defined contribution—big deal. What is the benefit the plan is trying to achieve? If we can concentrate on the right goal, and put that front and center on statements and online tools, the focus will change. Account balance, instead of being the first thing a participant sees, should go in the back of the statement. If we want this to be like a pension program we need to focus on the income.

Ultimately, we can bring people to retirement, but we also have to bring them through it. Here, the final fiduciary regulations will be critical in directing the market. Who will be able to help the participants with their completion strategy and make sure the critical decisions they make are in their best interest and made by the right provider? Participants have a strong loyalty and trust in their plan sponsor and in the providers and advisers they choose. Plan sponsors and providers will need to be able to advise people through that completion strategy.

PA: What are the takeaways that retirement plan advisers should receive from this, and what’s the best action they can bring to their clients?

Pitney: Reaffirm with the plan sponsor the goal of the plan. If they say the goal is to help people accumulate wealth, that sets a certain strategy. Most plan sponsors, though, I think would say that income is the primary goal. Then structure the plan—including working with a provider that has the services and products—to deliver on that goal.

Advisers may need to adjust their services, becoming more conversant in how to deliver income to the retirees and manage to that income goal. The defined contribution industry has been largely about picking funds and building menus, and Dr. Merton mentioned the importance of annuities in this equation. Many advisers are unequipped to evaluate and deliver recommendations on annuities. They would serve themselves well by changing that.

To shift this paradigm, advisers will need to keep the client focused on income all the time. This will require the advisers and the plan sponsors to take a look at how to best integrate all these factors into a reasonably turnkey solution that’s easily accessible for the plan’s participants. Providers like TIAA are well-equipped to help navigate the shift in focus from wealth to income.

Dimensional Fund Advisors LP (“Dimensional”) is an investment advisor with the Securities & Exchange Commission. Robert Merton provides consulting services to Dimensional. TIAA and Dimensional work together to deliver a goals based retirement plan solution to the 403(b) and 457 marketplace. The solution helps plan sponsors create portfolios that seek to address income risks (market, interest rate, and inflation) leading up to and throughout retirement. It is fully integrated within the TIAA Recordkeeping platform and utilizes new custom model technology. Dimensional does not provide advisory services in connection with the solution.

Michael Lane and Robert Merton are not affiliated with TIAA. The views presented in here are their own. The material is for informational purposes only and should not be regarded as a recommendation or an offer to buy or sell any product or service to which this information may relate. Certain products and services may not be available to all entities or persons.

TIAA-CREF Individual & Institutional Services, LLC, Teachers Personal Investors Services, Inc., and Nuveen Securities, LLC, Members FINRA and SIPC, distribute securities products.

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