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Stable Value and the Search for the Perfect Retirement-Income Product

You know an idea has come of age when it gets its own trade industry association and its own conference. And so it is with retirement income. Never mind that in academia, chairs have been endowed and the research on the topic has been underway for a number of years. The leap to the mainstream has been made, and the issues surrounding retirement planning are now front and center.

So with the dismantling of the private pension system well underway, there is increased urgency around the question: What is the best way for baby boomers to convert defined contribution plan assets into a safe, steady, and predictable stream of income? The Search for the Perfect Retirement Income Product has begun, with investment managers, insurance companies, financial advisors, and others all prepared to tell John and Jane Boomer what to do with their 401(k) money.

If we were to design the Perfect Product, what would it look like? What attributes would be essential? Here is an initial, but by no means exhaustive, list:

• First, it would be liquid and portable. Circumstances change, and these days, no one wants to be locked into a product or a provider indefinitely.
• Second, it would be predictable. While retirees are smart enough today to know that they should not park their money in a passbook savings account, most would sacrifice at least a bit of upside return for less volatility.
• Third, it would keep pace with inflation. Again, retirees have been well warned of the corrosive effects of inflation on purchasing power, and our Perfect Product would have to speak to this issue.
• Fourth, there would be little or no chance of outliving the product. Retirees have been well warned that they are likely to live longer, and as a result their assets need to last longer.

No doubt, there are other attributes or combinations of attributes that we would look for, but for now we can focus on these: liquid/flexible/portable, predictable/non-volatile, inflation-fighting, and mortality-aware.

Next, let's examine a couple of products that are often mentioned in this search. Surprising to some but not to others, annuities are a product that have received renewed attention. On a straight-up basis, annuitization of defined contribution assets most clearly replaces the defined benefit check of the recent past, and there is nary an insurer that would not jump at the chance to annuitize a participant's 401(k) balance. The issues around annuities, however, have not changed. While it is indeed the most mortality-friendly product on the market, the standard fixed annuity comes up short on issues related to our other criteria, including its inflation-fighting abilities. To their credit, many insurers have altered their marketing approaches and now often promote a partial annuitization of assets. For at least some portion of an individual's retirement nest egg, the idea of locking in an income stream that cannot be outlived has merit and is one that we will return to.

Other retirement "decumulation" products are less products, per se, and more strategies, often involving manipulation of the individual's asset allocation. In the not-too-distant past, one approach was to execute a wholesale change of asset allocation at the exact point of retirement. Therefore, a 60 percent equity, 40 percent fixed income allocation (to use one example) on the day before retirement would switch to 100 percent fixed income on the day of retirement. In hindsight, this now looks a bit silly. At that time, however, the predominant driver was the notion that in retirement, predictable income instantaneously becomes the overriding concern. The realization that life expectancy in the United States was steadily increasing, coupled with studies of inflation, led to reassessment. We now know that the average person may live 20 years or more in retirement. (This is a far cry from the days when the average worker was dead before his Social Security benefits were set to commence!) Longer life expectancy leads naturally to a retirement asset allocation that may include a healthy percentage of equities. Of course, this reintroduces the notion of volatility and unpredictability, anathema to most retirees….just ask someone who is retired how he feels about the stock market swings of 2008-to-date.

Some prominent mutual fund families have developed probability-based asset allocation strategies for the retirement years. These strategies model expected outcomes using historical rates of returns across many broad and secondary asset classes. One phenomenon, in particular, that is of concern to these modelers is the dreaded "Year-One Bear Market Effect," which notes that a big equity market downturn in the first year of retirement is extremely difficult to recover from. An overriding objective in these approaches is to identify the optimal drawdown each year that would cover expenses, adjust for inflation, and maybe, or maybe not, leave an inheritance for the kids. Output from such an approach may then be worded along the following lines: Given this asset allocation, you can comfortably withdraw x percent of your assets each year with a y percent probability that your money will last to at least age z. The strategies allow for dynamic adjustment to preserve flexibility. Therefore, the amount of monthly drawdown and terminus date can be changed -- and probabilities then recast – to accommodate individual changes.

So where does this lead us in our search? We see that annuities are not the perfect product. Neither is a portfolio of 100 percent fixed income investments. Other approaches involve more dynamic multi-class asset allocation married to personal preference around lifestyle and risk tolerance. These presumably can be actively managed/overseen by financial advisors or be (more or less) automated through a mutual fund family, but they do run the risk of becoming too complicated for the ultimate beneficiary, the retiree. Based upon our Perfect Product wish list, gauging life expectancy is the biggest challenge here.

We may then conclude that we should set a more modest goal for ourselves. Much as insurers today advocate for partial annuitization, we can look for a partial solution by identifying products that add value, address certain issues, and are best utilized in combination with an overall asset allocation strategy. Chances are John and Jane Boomer already have such a product within their 401(k) plan, namely their stable value fund. Continued access to and investment in the stable value fund in retirement, as allowed by the retiree's former employer, has many benefits.

How can stable value add value to the retiree? For the answer, we return to our Perfect Product wish list. First, stable value is a big winner on liquidity. Typically, there are no limitations on participant withdrawals or investment transfer/reallocation within a plan. If the needs of the retiree change, money can be allocated both into and out of stable value with relative ease. Second, stable value certainly qualifies as predictable. Through the crediting rate mechanism of stable value funds, intermediate bond market results – which taken alone can evidence a degree of volatility -- are amortized into a relatively smooth pattern of returns over time. As market rates move both upward and downward, stable value follows accordingly but with much less volatility.

Next we will look at stable value's inflation-fighting credentials. For this, we'll turn to the accompanying graph (see Figure 1).

Note: Returns for stable value are hypothetical and were calculated using historical returns of an intermediate-duration, market-value bond index and applying to those returns a standard book-value, crediting rate methodology. Return information is based upon certain assumptions, including neutral cash flow over the periods presented. Once market-value returns were calculated, the crediting rate formula CR=(MV/BV)^(1/D)*(1+YTM)-1 was applied to construct the stable value return series, pursuant to which CR = Crediting Rate, MV = Hypothetical Market Value, BV = Hypothetical Book Value, D = Duration of the bond indices and YTM = Yield to Worst of the bond indices.
The year over year Consumer Price Index (CPI) headline number from the Bureau of Labor Statistics was used as our proxy for Inflation.

As is evident, stable value has historically proved to be a largely effective tool in protecting purchasing power against inflation. There were a few years during the hyper-inflationary period of the 1970s where it did not keep pace, and other fixed income investments would have been more effective. Nonetheless, stable value, at a minimum, has protected participant wealth against inflation over the last 26 consecutive years and over the aggregate time periods shown, broadly satisfying this requirement

Finally, we should take a quick look at that most challenging of problems for retirement-income products: how to guarantee an income stream for life. Through our examination, we know that only an annuity (based upon the financial strength of the insurer) provides something close to a real guarantee. To take the extreme example, if you live to be 200 years old and your annuity provider remains solvent, you continue to get paid. In the absence of such a guarantee, stable value (and the asset allocation--based strategies that we reviewed) relies upon the quality of the modeling performed to prove their ability to provide sustainable payments.

Let's examine a hypothetical scenario where John is primarily concerned with protecting his account value. Accordingly, he decides to take out the minimum amount required by the IRS under current regulations and takes this withdrawal from the stable value fund. Figure 2 shows the account value assuming a starting balance of $1 million at age 65, with a 5 percent growth rate for the stable value fund over time and a constant 2.5 percent level of inflation. Between the age of 70 ½ and age 100, based on the current IRS minimum distribution requirements, John can withdraw an average annual distribution of $78,500. This scenario not only provides a predictable payment stream, it also preserves the account value for John's beneficiaries should he die early. By contrast, with a simple life annuity, the insurance company assumes the mortality risk but is paid handsomely if the annuitant dies early. In this scenario, the value preserved for beneficiaries is considerable, especially during the first 25 years of retirement.

Note: The account value presented above was calculated assuming a $1million investment at age 65 and an annual grow rate of 5 percent over the period of time presented. IRS minimum annual payments reflect current requirements and the impact of the 5 percent growth of the account have not been adjusted for inflation.

Let's next assume that Jane needs more to live on than simply the IRS minimum distribution. Here, we assume the same starting balance and growth and inflation rates as in the previous scenario and that 10 percent of the balance is withdrawn each year from age 66 to age 100. As Figure 3 shows, at age 100, after collecting annual payments for 35 years, Jane has over 10 percent of her initial starting balance remaining. It is interesting to note that, because the distributions start earlier than our previous example and principal is being withdrawn, the average annual distribution for this second scenario is only $47,000.

Note: The account value presented above was calculated assuming a $1 million investment at age 65 and an annual growth rate of 5 percent over the period of time presented. Distributions were assumed to start at age 65. The 10 percent annual payments reflect the 5 percent growth rate on the underlying account. The payments have not been adjusted for inflation.

It is relatively simple for John and Jane to run different scenarios to evaluate how much money they can withdraw from the fund and how long their money will last. Using the same starting balance and growth and inflation assumptions as the previous scenarios, Figure 4 shows the account value under three withdrawal scenarios: IRS minimum, $75,000 per year, and $100,000 per year. The IRS minimum payment equates to an average annual payment of $78,500 from age 70 ½ to 100. This is because the account grows from age 65 to 70 ½. As you can see, it is relatively easy to project how various annual distributions will impact account balances under different scenarios. Based on historical experience, stable value also is not generally subject to, and can even help to buffer the impact on the retiree of, equity market downturns, including the Year-One Bear Market Effect discussed above. Of course, with the caveat that past performance is informative of, though not determinative of, future performance.

Note: The account values presented above were calculated assuming a $1 million investment at age 65 and an annual growth rate of 5 percent over the period of time presented. Distributions were assumed to start at age 65, except under the IRS Minimum scenario, where distributions stared at age 70 ½. The payments have not been adjusted for inflation.

So, perhaps surprisingly, we can conclude that stable value has many attributes that make it (at least) an attractive product for use in retirement income planning. It is flexible, provides the opportunity to run various scenarios intended to predict future needs, and, based on historical information, had done a good job of fighting inflation. We can even say good things about it when it comes to protecting against the risks of living long.

A final point arguing for a place for stable value in retirement-income planning is simplicity. In the effort to create the Perfect Product, the notion of keeping it simple is sometimes unavoidably trampled upon. Practitioners would be wise to consider the desires of their audience for a readily understandable approach that, at the same time, includes a host of desirable characteristics.

Read Next: A Closer Look at Stable Value Funds Performance: A Quick Summary