- Demographic shifts mean more people will reach retirement in the next decade or so than ever before.
- Today’s defined contribution plans employ excellent accumulation strategies, but on reaching retirement, participants can find themselves without an adequate plan to convert their lump-sum payment into a sustainable level of income.
- While traditionally available for large defined benefit plans, we believe liability-driven investing (LDI) can be just as effective for individuals.
- By matching a participant’s desired minimum income to a portfolio of fixed-income assets and the remainder to a growth portfolio, LDI can provide a structured and consistent income for participants.
It’s a well-established fact that the developed world is growing older. In the United States, for example, the number of adults age 65 or over grew from 19 for every 100 Americans of working age in 1980 to 25 for every 100 in 2017. In the next 10 years or so, that figure is expected to grow to 35 for every 100.¹
These remarkable figures are a result of the increasing numbers of baby boomers—the term given to the generation born between 1946 and 1964—reaching retirement. Baby boomers represent nearly 20% of the American public, and every day, some 10,000 of them celebrate their 65th birthday.²
The rapid rise in the number of people reaching retirement is taking place at a time when employers are shutting down traditional defined benefit (DB) plans as a result of rising costs and onerous regulations. In their place, many employers have introduced defined contribution (DC) programs, which shift the responsibility for funding retirement from the employer to the individual worker.
The rise of target-date funds in DC plans
The majority of DC plans today use target-date funds as their investment strategy, with more than three-quarters of plan sponsors now offering them as their plan’s primary default investment vehicle.³ By streamlining what was once a complex series of investment decisions into a single yet powerful step, target-date funds have helped more participants set aside a sufficient portion of wealth for their retirement.
While target-date funds provide an effective accumulation strategy with little maintenance required from the participant, managing the decumulation of savings postretirement can be a greater challenge; depending on the type of target-date fund offered by their employer, participants can often find that their fund matures on the day they retire, requiring them to single-handedly calculate how best to manage their savings over the length of their retirement, however long that may be. And while some plans offering target-date solutions can keep a participant invested through retirement, they generally lack a specific drawdown plan to protect against longevity risk. According to a report by the U.S. Government Accountability Office, these changes are leaving an increasing number of people struggling to ensure that their accrued savings and benefits last through retirement.⁴
Source: Manulife Investment Management, for illustrative purposes only.
Traditional options for retirees amount to taking a lump-sum payment or buying an annuity, but both have drawbacks: Annuities can be expensive, while most of us are ill-equipped to invest or manage a large lump sum. Besides, cash flows from traditional asset allocation portfolios can vary depending on performance and aren’t designed to reliably match income needs for a client from year to year. For participants looking for a more structured approach to managing their retirement income, we believe liability-driven investing (LDI) represents an effective alternative.
A personal LDI plan
It’s a strategy that’s traditionally been the preserve of large DB plans, but we believe it can be just as effective for individuals.
LDI typically uses a bond’s principal and coupon payments to match a plan’s liability. For example, a 10-year bond bought at $80 and maturing at $100 can be used to fund a $100 liability due in 10 years. By allocating to both fixed-income assets and growth assets, DB pension plans are able to target cash flow consistency alongside upside potential and inflation hedging.
While the strategy may appear complex at first glance, applying such an approach to an individual’s retirement savings doesn’t need to be complicated. The first step is to determine the participant’s required minimum income level over a specific time horizon. This becomes the liability, which can be matched with a fixed-income portfolio, creating a minimum payout level. Anything above that minimum level can be invested in growth assets. Gains in the growth strategy can be automatically locked in, sold, and the proceeds converted into fixed-income assets, thereby securing a higher minimum level of income. This approach, which we call dynamic LDI, ensures participants aren’t placing their savings in a systematic, long-duration fixed-income strategy at a time when bond yields remain low.
Growth converted to income
A dynamic approach to LDI supports an increasing allocation to fixed income over time
Source: Manulife Investment Management. For illustrative purpose only. Assumptions: Decumulation period of 20 years, initial investment of U.S.$1M gross of fee results and 6% return on growth portfolio. At end portfolio date, all initial principal has been distributed.
Each payment the participant receives is a combination of gains from the equity growth portfolio, interest, and return of capital as fixed-income holdings periodically mature, thereby delivering an ongoing income stream. With each passing year, a greater proportion of the total portfolio is converted into fixed-income assets as gains in the growth assets are locked in. It’s also worth noting that as the market value of the entire portfolio experiences gains and losses, the income remains protected as the fixed-income holdings mature.
The strategy can be regarded as an extension to a participant’s DC plan that has reached maturity at retirement age. Once the existing target-date fund matures, participants are free to roll their assets into an LDI approach. Eventually, there’s no reason why plan sponsors couldn’t offer the strategy to employees prior to retirement as a listed option on their DC investment lineup, or perhaps even as the default option.
A more structured approach to retirement planning
An unprecedented number of people will reach retirement age over the next 10 to 20 years, just as generous corporate DB plans are vanishing. The outcome is likely to be a sizable proportion of the population retiring from DC plans and finding themselves in the uncomfortable position of having to transfer a lump-sum payment into an annual income that can be maintained for the balance of their lives.
We believe dynamic LDI can meet the challenges of retirement by targeting a minimum level of consistent income (derived from the participant’s fixed-income assets), while keeping up with inflation (thanks to their growth assets). Individuals should be able to benefit from what’s traditionally been available to institutional investors and, in the process, enjoy security and peace of mind in retirement.