Innovation in defined contribution options 

There’s an interesting development in the defined contribution world: the introduction of new and attractive investment options that guarantee participants a minimum level of income for life once they retire. For advisors focused on the defined contribution space, it’s important to be knowledgeable about these investments.

These options, which I refer to as guaranteed retirement income solutions, allow participants to invest in equities while working and still lock in a level of monthly income for life in retirement, one that will not decrease. Importantly, if the account value increases due to market performance and/or new contributions, the amount of guaranteed lifetime income also increases and ratchets at that higher level. The guaranteed lifetime income can only go up; once it reaches a higher level it cannot go down. Even if the account value goes to zero the payments of guaranteed income continue as long as the participant is alive.

This investment accomplishes a number of things. First, it protects against sequence-of-returns risk. We’ve been reminded, all too well, that a market downturn just before retirement can have a devastating impact on a person’s ability to maintain their lifestyle once they retire; since 1900 there have been more than 30 stock market declines of at least 20 percent. The significant possibility of a market downturn puts older plan participants (and others about to retire) in a dangerous position. He can begin to exit from equities in the few years before retirement. But that means giving up the chance of participating in market increases that occur more often than significant downturns. It also means accepting low returns. For the great majority, who has not saved enough for retirement, investing substantially in fixed investments reduces their chance of an adequate lifestyle in retirement. Further, as we have recently learned, even reducing exposure to equities does not mean that account values are protected from severe loss.

Guaranteed retirement income solutions do, however, protect against sequence-of-returns risk. If the value of the participant’s investment decreases, the level of guaranteed lifetime income does not. This investment option provides two other advantages. First, with this type of guarantee, the plan participant can invest more in equities. After all, there is protection against downside risk. Over time, higher investments in equities tend to provide a higher return. The guarantee has a cost, but there is reason to believe that the return on the higher allocation to equities will provide a return that can, at least, pay for the cost of the guarantee, thus providing an important benefit with little or no ultimate impact to the account value.

Also, this investment lets the plan participant know exactly how much monthly income he can rely on once they retire. That helps plan participants make better decisions about when they can afford to retire. Most people do not know how much monthly income for life a set amount of assets at retirement can produce, but these investments provide that information—specifically.

If you market defined contribution plans, I suggest you look into these options. They can be quite beneficial to plan sponsors. For example, during the last economic downturn many plan participants were, understandably, unhappy with the loss of account value they suffered. For those far from retirement it’s easy to explain that they have plenty of time for the market to recover. But what about those close to retirement? The loss of account value was a significant problem and certainly affected their view of the plan the employer provided. Also, during the last downturn a number of people who lost money in the market decided to delay retirement. For an employer, this can be disruptive or worse.

If you market to individual investors exclusively, these products should act as a reminder to revise investment strategies within five years of retirement. Protection against sequence-of-returns risk becomes important and clients need clear information on how much income they can prudently expect on which to rely.