Retirement Money

Shifting the Conversation: Benchmarks for Managing Income Uncertainty

Retirement Money

In order to find the right solution, you must ask the right question. Within retirement planning, particularly within the realm of target date funds, we may have been asking the wrong question for some time now.

Many investors are well aware of traditional target date fund options. Just a quick review, based on when you are expected to retire, you invest in a diversified portfolio of stocks, bonds, REITs, and sometimes asset classes like commodities and even alternative investments. This allocation automatically adjusts over time as the investor gets closer to retirement. For example, for someone who is currently 25 years old, it is reasonable to expect this person to work until they are in their mid 60s (normal retirement age according to the IRS). They would invest in a Target-Retirement 2055 Fund (approximately the year they are expecting to retire). Vanguard’s Target Retirement 2055 Fund (VFFVX) has a stock/bond split of approximately 90%/10%. Similarly, Vanguard’s Target Retirement 2015 Fund (VTXVX) has a stock/bond split of approximately 50%/50%. The fund will automatically move from riskier stocks to more stable bonds over time as the investor gets older, which is consistent with the lifecycle theory of investing.

These solutions have provided tremendous benefits to investors, especially in company sponsored defined contribution plans. We have written about them before here. The problem is that traditional target date strategies have been focusing on variability in the overall balance of retirement assets. This isn’t necessarily the question that most retirement investors are asking (even if it is subconsciously). The question that most future retirees are more concerned about is whether or not they will be able to carry their current lifestyle into retirement, which is an income question, not an aggregate account balance question. Although they may seem like they go “hand-in-hand,” from an investment perspective, there are different risks involved when trying to manage either of these goals.

Just to give you a simple example. Suppose we have two different investors who have just retired and each has $1,000,000 in aggregate retirement savings. How much in annual income can these balances produce? That depends. Mainly on current interest rates and future inflation. From an interest rate perspective we can get an idea of income production by looking at current rates for immediate fixed annuities. In a low interest rate environment, like the one we are in now, it is very expensive to turn that $1,000,000 into a lifetime stream of income. Also, if we experience rates of inflation similar to those in the 1970s, the real purchasing power of that income stream will be quickly eroded. Hence, these two investors will have much different income streams based on the same aggregate retirement savings due to interest rates and inflation. The table below shows two investors who decided to retire in different years in the past. It gives the annual income stream of $1,000,000 in aggregate retirement savings based on current immediate annuity rates at the time.

Example of Annual Income Based on $1,000,000 in Aggregate Savings

Investor

Retirement Year

Annuity Rate

Annual Income

Jill

2005

5.50%

$55,000

Jack

2013

3.50%

$35,000

This is where Dimensional has decided to focus their attention when developing their own target date retirement income strategies, which you can find here. The focus shifts from managing variability in the account balance to variability in the annual income expected in retirement. Although the overall strategy is still a balance of riskier stocks and more stable bonds, there is extra emphasis on managing interest rate and inflation risk within the strategy. The video below gives a great summary of their approach to managing these particular risks.

The spirit of these solutions is to take the ideas that are mainly associated with defined benefit plans (pension plans) and inject them into the defined contribution space. Combining these solutions with proper retirement readiness calculators can give investors the information they need to help plan for a certain level of income in retirement. Using the same example as before, for someone who is expecting to retire in 2055, they would now have an asset allocation that is comprised of 95% stocks and 5% bonds utilizing the Dimensional 2055 Target Date Retirement Income Fund (DRIKX). By the time they retire, their asset allocation will be more like 25% stocks and 75% inflation protected securities utilizing the Dimensional 2015 Target Date Retirement Income Fund (DRIQX).

On the backs of DFAs development in this space, Standard & Poor’s Dow Jones has developed benchmarks to help manager’s track the overall effectiveness of their strategy. The S&P STRIDE (Shift To Retirement Income & Decumulation) Indexes combine the elements of rebalance risk and glide path found in traditional target retirement funds, but also includes the income generating aspects of annuities. They were built in consultation from DFA to help properly benchmark their strategies.

To tackle the retirement readiness problem, we must ask the right question. In most conversations with our clients, we rarely hear, “My goal is to have $4,000,000 in accumulated retirement assets.” More often we hear, “I would like to maintain my current lifestyle in retirement.” The first response involves managing the variability of the aggregate account balance, which most traditional target date funds accomplish by utilizing the ideas of modern portfolio theory to build a well-diversified portfolio with an automatic glide path. The second response is managing the risk of being able to produce an income stream, which is driven not only by risk in the stock market, but also interest rate and inflation risk. Ignoring these last two risks can lead to many different lifestyles based on the same level of aggregate savings (as we showed with Jill and Jack). Dimensional has taken the first step to addressing the main question that most retirees are facing. We expect there to be more solutions in the future that will take this approach to trying to solve the question of “how do we achieve retirement readiness?”