By Jodie Gunzberg
"You Keep Livin', We'll Keep Payin'" - lottery spokeswoman, Christy Calicchia. Most people, while they only dream of winning a lottery, understand the concept between a big lump sum payout and an annuity that says something like "either win $1 million today or win $1,000 a week for life." Though the concept is clear, and in many cases the annuity is worth more, lottery winners almost always choose the lump sum.
Although paying for retirement is not quite like winning the lottery, of course, since working and saving are part of the retirement equation, there is a similar concept. It is difficult for retirement savers to reframe their thinking from "How much do I need at retirement?" to "How much monthly income do I need to replace in order to comfortably live through retirement?"
To answer the question of how much it costs to retire, Marlena Lee, co-head of research at Dimensional Fund Advisors, joined S&P Dow Jones Indices to discuss the pillars of retirement income choices and how to manage the risks to secure better outcomes.
According to Ms. Lee, the key element in plan design to improve retirement outcomes is to set up the right goal for retirement to provide income through retirement. For example, a goal should be achieving a level of annual income that supports a desired standard of living in retirement. Once that goal is defined, then there are two additional things to do in order to line up both the communication as well as the investment. It's really important to communicate to participants in income terms, since it might be different to say, "You need to save a million dollars by the time you retire," as opposed to, "You need to replace five thousand dollars of monthly income throughout your retirement."
Secondly, but just as important, the investments need to be designed to reduce the risks that can impact retirement income, such as market risk, inflation, and interest rates. These matter to provide income in real terms and understand how much people can withdraw from their portfolios in retirement.
An effective solution should enable plan sponsors to provide meaningful estimates to participants on how they are doing relative to their income goal, empowering them to make better decisions toward achieving desired retirement outcomes. To help plan sponsors evaluate success, S&P STRIDE (Shift To Retirement Income & Decumulation) indices work in two major ways. The first is by the allocations and the second is by the constituent selection. The family of indices publishes weights according to glidepaths in the methodology and uses indices for corresponding asset class betas to fill in the positions. The attribution can be done to measure the impact from weights or security (fund) selection.
Despite the external forces on retirement income, there are three main variables a plan participant can control: how much to save, when to retire, and how much income will be needed in retirement. More income in retirement means either saving more or saving for longer, but understanding how those variables interact requires income-based information. For example, these questions may help participants consider the levers and require detailed information in income terms:
- If I increase my savings by 1%, how will that impact my income in retirement?
- If I want to retire one year earlier, how will that impact my lifestyle in retirement?
Precise information in income terms is vital as participants near retirement. For example, it's not enough to tell a participant that they can expect to have income ranging from $30-70K. That is probably not going to be useful for that participant to determine whether they can afford to retire next year. On the other hand, if the estimate ranged from $45-55K, this may be much more informative and useful for decision making. This requires not only information in income terms, but having an investment solution that is managing income uncertainty.
The key difference for an income-focused approach is that the risks that must be considered are related to the uncertainty of future income rather than the volatility of wealth. Traditional target date funds typically increase fixed-income exposure nearing retirement to reduce overall volatility. However, the appropriate risk management asset for an income-focused solution is one that hedges against inflation and interest rate risk and reduces the uncertainty about how much income can be expected in retirement. The innovation uses inflation-linked bonds matched to the duration of future retirement income liabilities to manage risk of assets for an income-focused solution.
Therefore, a solution focused on income in retirement as the goal should be designed to offer greater exposure to growth assets when an investor is early in their accumulation phase to accelerate wealth accumulation, and then, over time, trade off growth potential for assets that hedge against inflation and changes in interest rates to reduce the uncertainty around the level of consumption one's savings will be able to afford.