Bold, new investment strategies for near-retirees: What plan sponsors need to know

The combination of historically high inflation and fluctuating interest rates threatens to erode the income-generating strategies for retirees that have prevailed for the last two decades. But for employee benefits plan sponsors that manage direct contribution plans for members, new strategies are emerging that address and adapt to the changing economic landscape.

A report by the Defined Contribution Institutional Investment Association (DCIIA) discusses the history of defined contribution plans, focusing on income-generating, rather than asset-building, strategies. During the recent and prolonged era of low interest rates and predictable low inflation rates, several strategies emerged that plan sponsors and members favored: fixed income annuities, bond laddering, and systematic withdrawals. Now, the white paper authors suggest, plan sponsors may want to consider another option trio that are more suited to the current economic/investment environment.

Prevailing income-generating strategies

The annuities strategy is predicated on the mirroring of bond interest rates by the insurance contract negotiated between the sponsor and insurer. The insurer pays the retiree interest in line with the underlying bond rates. In a low interest climate, which favors bondholders, the insurer is protected and the retiree receives a predictable payout. But the math doesn’t work so well when rates rise, inflation increases the cost of living, and bonds are out of favor.

Bond laddering involved the systematic purchase of bonds over time so that, as some mature, others are still at work. The investor in this scheme spends the interest earned but does not touch the bonds’ principal. This strategy creates a portfolio of diversified bonds, spreading the risk of buying when rates are low to generate an income stream. Again, the combination of increasing rates plus inflation undercuts this strategy’s ability to generate sufficient income for the retiree.

Systematic withdrawal of a specified amount each year as income works well for some, in part because the amount is adjusted to match inflation over time. “Systematic withdrawal strategies can be structured in different ways,” says the report. “The most common approach is to withdraw 4% of the starting balance, increasing that amount for inflation no matter how the portfolio performs in the interim.” However, the current climate reveals its vulnerability. “Recent research suggests that in a low rate environment, a 4% withdrawal may be too high to preserve savings balances, even when investing in a balanced portfolio,” concludes the report.

New strategies to consider

The authors argue that, in the current economic environment, plan sponsors and advisors should consider alternatives to the above income-generating strategies. According to the report, “the convergence of a persistent low rate environment, a nascent inflationary environment, and the growing appeal of retirement income solutions in DC plans has kicked off an innovation phase. The DC industry’s ability to offer institutional products to plan participants at low costs provides an opportunity to deliver affordable retirement security to more Americans. Recent improvements to technology and operations are allowing exciting new elements of personalization to be integrated into plan solutions.”

Here are the Retirement Income Committee’s recommendations:

Maximizing government-provided income is a rather simple, straightforward method that involves coaching pre-retirees as the golden handshake approaches. Despite its long history with retirees, the date when one decides to take Social Security payments remains a mystery to many. Partly that’s because Social Security likes to change the rules about when one is eligible and how much one can take under certain conditions.

Related: Empower (inflation-weary) employees as they struggle to save for retirement

The authors note that platforms exist that are readily available to plan sponsors that can help pre-retirees make better choices. “If a person delays Social Security, payments will increase by about 8% for each year delayed. Participants can use their DC assets to “bridge” their income until they begin receiving Social Security benefits later. Using this type of bridge strategy is similar to purchasing a deferred income annuity.” In this scenario, the enhanced Social Security payment augments whatever base income-generating strategy is at work for the retiree. “This bridging strategy is particularly advantageous when interest rates are low because the delayed credits received from higher Social Security payments are not dependent on interest rates,” they say.

Deferred fixed annuities attached to a target date fund (TDF) series. This option would probably be best suited for the most forward-looking of plan members. The recommended strategy begins to shift investments as early as 10 to 15 years before retirement from equities to annuities–both fixed deferred and deferred income annuities. The longer “glide” to the target date allows the investor to take advantage of the economic cycles as they occur during that period. “Individuals usually are not ‘locked’ into the annuity until they retire and elect to activate the payment stream from this feature,” the authors say.

Guaranteed lifetime withdrawal benefit attached to a TDF series. Similar to the above, this strategy is designed to wring some of the risk out of interest rate fluctuation. Insurers guarantee a lifetime withdrawal benefit (income) with a variable annuity integrated into a TDF series. “These solutions give participants upside growth when markets rise, protection on their income when markets correct, and guaranteed income for life upon their retirement.” Equity exposure is greater, so to balance that risk, liquidity is provided to bridge any gap in income expectations.

Faced with low interest rates and rising inflation, plan members are becoming fearful about funding their retirement. They may decide to postpone retirement or liquidate other assets. Instead, the plan sponsor can offer alternatives to the commonly accepted income-generating strategies that can allow them to retire on schedule and have a sustainable income. “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 authors conclude.