Solving America's Lifetime Income Challenge
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This document discusses challenges facing Americans in retirement planning and proposes solutions to help ensure adequate lifetime income. It notes that entitlement costs will rise significantly, replacement rates from Social Security are declining, and many lack workplace retirement plans, leaving a growing gap in assured retirement income. While defined contribution savings plans have grown substantially, risks like market volatility and inflation still threaten to erode savings. The document proposes new retirement plan designs that incorporate guaranteed lifetime income options and advice, and move beyond just asset accumulation to address distribution challenges in retirement.
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Solving America's Lifetime Income Challenge
- 1. Solving America’s Lifetime Income Challenge Robert L. Reynolds President and Chief Executive Officer Putnam Investments
- 2. Absent reform, entitlement costs will dominate federal budgets Medicare Medicaid Social Security Entitlements as percent of GDP Sources: GAO Sept. 2004 baseline extended analysis; Bruce Bartlett, Tax Reform Agenda for the 109th Congress 15 (2004). More recent data not available at the time of this presentation. Average total tax revenue as percent of GDP 18% (%)
- 3. Social Security replacement rates are declining — under current law For earners retiring at age 65. After Medicare Part B deduction (2030 includes higher normal retirement age). Sources: Alicia H. Munnell; 2004. “A Bird’s Eye View of the Social Security Debate”; Center for Retirement Research at Boston College. More recent data not available at the time of this presentation. Average replacement rate of pre-retirement income from Social Security
- 4. A gap in assured retirement income is growing Today Work income Traditional pension Social Security In 20 years Investment income Work income Traditional pension Social Security Investment income The Gap For illustrative purposes only. Other retirement income Guaranteed income
- 5. We have a huge coverage challenge to meet 75 million Americans have no workplace retirement plan Source: Office of Management and Budget, “A New Era of Responsibility: Renewing America’s Promise,” 2009.
- 6. But DC savings plans are a huge success story ― and a great base to build on American workers covered (Millions) DB plans DC plans Sources: EBRI, ICI, Bernstein Research, Empirical Research Partners, Bureau of Labor Statistics, 2008; and American Benefits Council, 2/24/2009.
- 8. The Pension Protection Act (PPA) has revitalized the DC system Source: McKinsey & Company, 2008 “Redefining Defined Contribution.” Projected asset appreciation rate of 6.1% (after fees) by asset classes is assumed to be 7.1% for equities, 4.7% for fixed income, 2.2% for money market/stable value, and 5.75% for asset allocation funds. Estimated growth in DC assets by 2015 2006 $4.1 trillion 2015 $7.5 to $8.5 trillion
- 9. But 2008 delivered a “wake up” shock on risk… Source: S&P Index, 12/31/08. Past performance is not indicative of future results. 1-year stock market declines greater than 30%
- 10. …and volatility has been severe in the new century 183 years of annual large-company stock returns Percentage total return of large-company stocks, 1825–2008 2001 2002 2008 2000 2007 2006 2004 2003 2005 50% to 60% 40% to 50% 30% to 40% 20% to 30% 10% to 20% 0% to 10% -10% to 0% -20% to -10% -30% to -20% -40% to -30% -50% to -40% 1843 1863 1830 1838 1829 1840 1825 1828 1907 1937 1931 1862 1928 1908 1846 1832 1851 1827 1831 1930 2008 1879 1935 1927 1852 1834 1856 1833 1837 1974 1885 1958 1936 1855 1836 1859 1835 1839 2002 1933 1938 1880 1842 1861 1845 1841 1954 1945 1900 1844 1865 1853 1854 1950 1901 1847 1866 1860 1857 1955 1909 1848 1867 1876 1873 1975 1915 1849 1868 1882 1884 1980 1922 1850 1869 1883 1893 1985 1924 1858 1870 1887 1910 1989 1925 1864 1871 1890 1917 1991 1942 1878 1872 1903 1920 1995 1943 1886 1874 1913 1941 1997 1951 1892 1875 1914 1957 1961 1897 1877 1929 1966 1963 1898 1881 1932 1973 1967 1904 1886 1934 2001 1976 1905 1888 1939 1982 1918 1889 1940 1983 1919 1891 1946 1996 1921 1894 1953 1998 1926 1895 1962 1999 1944 1896 1969 2003 1949 1899 1977 1952 1902 1981 1959 1906 1990 1964 1911 2000 1965 1912 1968 1916 1971 1923 1972 1926 1979 1947 1986 1948 1988 1956 2004 1960 2006 1970 1978 1984 1987 1992 1993 1994 2005 2007 Source: The Ibbotson Large Company Stock Index is based on the S&P 500 Composite Index. Prior to 1957, it consisted of 90 of the largest U.S. stocks. Prior to 1926, it is based on the New York Stock Exchange database compiled by Roger Ibbotson, William N. Goetzmann, and Liang Peng of the Yale School of Management. Past performance is not indicative of future results.
- 11. Absolute Return strategies did curb losses through 2008’s market crash Past performance is not indicative of future results. Indexes are unmanaged and used as a broad measure of market performance. It is not possible to invest directly in an index. The asset class categories are defined as follows: U.S. Bonds: Barclays Capital Aggregate Bond Index; Treasury bills: ML 3-month T-Bill Index; Absolute Return Funds: The average 2008 annual returns of 17 absolute return mutual funds as identified by Morningstar in their 7/14/09 article, “What’s so absolute about absolute return funds?”; balanced portfolio: Portfolio comprised of 60% stocks, 30% bonds, 10% cash; U.S. stocks: S&P 500 Index; international real estate: MSCI REIT Index; international stocks: MSCI EAFE Index; commodities: Goldman Sachs Commodity Index; emerging markets: MSCI Emerging Markets Index. Performance is not indicative of the performance of any specific investment. Results for longer time periods may differ from results shown for 2008. Asset class performance in 2008 (%) Emerging market stocks Comm-odities Int'l stocks Int'l real estate U.S. stocks Balanced portfolio Absolute Return Funds U.S. Treasury bills U.S. bonds
- 12. It is time to create a new generation of DC plan design Workplace Savings
- 14. Solving for a safe landing: From accumulation to distribution The lifetime financial flight path 20 40 30 50 70 60 90 80 Age Accumulation Distribution Transition ? ? ? ? 76 million Boomers
- 15. The good news/bad news risk: Longevity Source: Annuity 2000 Mortality Table, American Society of Actuaries. Figures assume you are in good health. 65-year-old couple today 50% chance of one survivor at age 92 25% chance of one survivor at age 97
- 16. Our old Nemesis: Inflation Calculated based on a hypothetical 3% rate of inflation (historical average from 1926 through 2002 was 3.06%) to show the effects of inflation over time; actual inflation rates may be more or less and will vary. Today In 10 years In 20 years In 30 years The eroding value of $1 41 ¢ 55 ¢ 74 ¢
- 17. Volatility harms wealth accumulation Growth of a $100,000 initial investment 1994 –2008 $100,000 -8% +32% -1% +16% +13% -9% +21% +4% +18% +1% +9% +8% +1% +10% +24% +5% +20% +34% -14% -36% +41% +50% -32% +32% +21% +17% +26% -15% +33% -46% * Average of yearly returns for the 15-year period. The example is for illustrative purpose only and does not reflect average annualized returns or the performance of any Putnam fund, which will fluctuate. Consistent performance is illustrative of Ibbotson U.S. Long-Term Government Bond Total Return Index. Volatile performance is illustrative of Goldman Sachs Commodities Index. You cannot invest directly in an index. Note that the reverse could be true, and a more volatile investment may result in outcomes favorable to investors. 2008 1994 Year 15 14 13 12 11 10 9 8 7 6 5 4 3 2 Year 1 $348,805 9% return* Consistent performance $192,111 9% return* Volatile performance
- 18. The price of passivity: How a purely passive portfolio would have fared in 2008 Beginning of 2008 $1,000,000 End of 2008 $751,676 Cash Bonds Stocks Stocks are represented by the S&P 500 Index, bonds by the Barclays Capital Aggregate Bond Index, and cash by the Merrill Lynch U.S. 3-month T-bill Index. Example assumes the withdrawal of $50,000 in income spread out over 12 months. Past performance is not a guarantee of future results. 10% 30% 60% 13% 40% 47% -25%
- 19. Risk in the sequence of returns: The Lucky Investor $3,074,205 Best return: 37.58% Worst return: -37.00% $1,000,000 Returns represented by the S&P 500 Index. Example assumes a $50,000 withdrawal in year 1, increased by 3% in each subsequent year to adjust for inflation. This illustration is hypothetical and not indicative of any fund or product. 1989 –2008 Returns Balance $1,343,519 Total income withdrawn 10.36% Average return
- 20. Risk in the sequence of returns: The Unlucky Investor Best return: 37.58% Worst return: -37.00% $0 $1,000,000 2008 –1989 Returns represented by the S&P 500 Index. Example assumes a $50,000 withdrawal in year 1, increased by 3% in each subsequent year to adjust for inflation. This illustration is hypothetical and not indicative of any fund or product. Returns Balance $1,196,731 Total income withdrawn 10.36% Average return
- 21. Hedging against sequence of returns risk: The Unlucky (but smart) Investor Best return: 17.50% Worst return: -10.00% $826,714 $1,000,000 Applying a hedging strategy to limit losses 2008 –1989 Returns represented by the S&P 500 Index. Example assumes a $50,000 withdrawal in year 1, increased by 3% in each subsequent year to adjust for inflation. This illustration is hypothetical and not indicative of any fund or product. The hypothetical hedging strategy involves buying “put” options to limit the portfolio’s downside risk and financing that purchase by selling “call” options of equivalent value on the same portfolio. Returns are limited to between -10.00% and +17.50%. The option has an assumed maturity of 12 months and that the corresponding interest rate is 2%. There are risks and transaction fees associated with options strategies. Returns Balance $1,343,519 Total income withdrawn 7.69% Average return
- 22. Insuring against sequence of returns risk: The Unlucky (but secure) Investor Best return: 37.58% Worst return: -37.00% $680,218 $500,000 Annuitizing 50% of portfolio 2008 –1989 Returns represented by the S&P 500 Index. Example assumes a $50,000 withdrawal in year 1, increased by 3% in each subsequent year to adjust for inflation. This illustration is hypothetical and not indicative of any fund or product. There are fees and expenses associated with guaranteed income products. All guarantees are subject to the claims-paying ability of the issuer. Returns Balance $1,343,519 Total income withdrawn 10.36% Average return
- 23. Putnam’s RetirementReady Funds: Incorporating Absolute Return strategies Putnam RetirementReady Funds glide path Money market Absolute Return Asset Allocation 100% 50% 0%
- 24. Lifetime financial product allocation Allocation Relative Return strategies Absolute Return strategies Guaranteed income Insurance Stocks funds Bond funds Asset Allocation funds Annuity + Non-annuity solutions Health Long-term care Disability Life This illustration is hypothetical and not indicative of any fund or product. 100% 0% Age 90 65 40 20
- 25. What’s needed: Industry innovation backed by public policy Workplace Savings 3.0 Industry innovation Policy innovation
- 26. Putnam RetirementReady Funds With Putnam RetirementReady Funds, portfolio diversification and adjustments are automatic. Each fund has a different “target” date based on when the fund’s investors expect to retire and begin withdrawing assets from their accounts. The funds are generally weighted toward more aggressive, higher-risk investments when the target date is more distant, and toward more conservative, lower-risk investments when the target date is near. Simply select the fund with the target year that most closely matches your anticipated date of retirement. Your fund will automatically be rebalanced, and your risk exposure will gradually be reduced as you get closer to retirement. The Maturity Fund is designed for participants who are in or near retirement. Each fund is designed to be used as a single-choice approach to diversification and generally should not be used in combination with a retirement plan’s other fund options. RetirementReady Funds can also be used within IRA accounts and other tax-advantaged plans. The principal value of the funds is not guaranteed at any time, including the target year. Asset allocation decisions may not always be correct and may adversely affect fund performance. The use of leverage through derivatives may magnify this risk. Leverage and derivatives carry other risks that may result in losses, including the effects of unexpected market shifts and/or the potential illiquidity of certain derivatives. International investments carry risks of volatile currencies, economies, and governments, and emerging-market securities can be illiquid. Bonds are affected by changes in interest rates, credit conditions, and inflation. As interest rates rise, prices of bonds fall. Long-term bonds are more sensitive to interest-rate risk than short-term bonds, while lower-rated bonds may offer higher yields in return for more risk. Unlike bonds, bond funds have ongoing fees and expenses. Stocks of small and/or midsize companies increase the risk of greater price fluctuations. REITs involve the risks of real estate investing, including declining property values. Commodities involve the risks of changes in market, political, regulatory, and natural conditions. Additional risks are listed in the funds' prospectus.
- 27. Money market funds are not insured or guaranteed by the Federal Deposit Insurance Corporation (FDIC) or any other governmental agency. Although the fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in this fund. Investors should carefully consider the investment objectives, risks, charges, and expenses of a fund before investing. For a prospectus containing this and other information for any Putnam fund or product, call your financial representative or call Putnam at 1-800-225-1581. Please read the prospectus carefully before investing.
- 28. Solving America’s Lifetime Income Challenge Robert L. Reynolds President and Chief Executive Officer Putnam Investments THE PUTNAM FUNDS ARE DISTRIBUTED BY PUTNAM RETAIL MANAGEMENT 258982 10/09
Hinweis der Redaktion
- Keynote Address Robert L. Reynolds Chief Executive Officer, Putnam Investments NICSA East Coast Conference, Boston, Massachusetts, October 1, 2009 “ Solving America’s Lifetime Income Challenge” Introduction My topic this morning is – “ Solving America’s Lifetime Income Challenge…” … and the emphasis will be on “ solving .” We all know America faces a very serious retirement savings challenge. It is urgent. It compounds. And last year’s market crash has raised the stakes for all of us. So if I have any bias on retirement issues, it is a bias toward action … I also know that retirement finance is much too big of a challenge to be solved by any single firm or single sector of the financial services industry. We will need to forge new alliances among plan sponsors, advisors, mutual fund companies, insurance companies, service providers and government itself. Yet my experience suggests to me that we can succeed – if we break down retirement finance into manageable elements and find ways to solve them one at a time. Core Topics So let’s take a top-down overview…starting with some systemic issues… I’ll then look at our workplace savings system and… Drill down on ways to lower volatility in DC plans and to solve for reliable lifetime income options. These are two critical goals that I believe our industry and public policy ought to really focus on. Here are some “big picture” challenges.
- Exploding Entitlement Costs As America ages, the share of future Gross National Product needed to pay for Social Security, Medicare, and Medicaid has been rising slowly but steadily. It is about to surge -- dramatically … There are roughly 76 million Baby Boomers…becoming eligible for Social Security at the rate of nearly 10,000 a day. One generation from now, this demographic tidal wave will lift the total costs of our entitlement programs up to -- and beyond -- the average annual tax bite – 18 percent -- that the entire federal government has needed…since World War II…to pay for everything it does … That includes…the Marine Corps, Yellowstone Park, “Cash for Clunkers”… everything . In other words, absent entitlement reform, the federal government is on track to become a giant ATM machine, collecting taxes from current workers and passing that revenue on to retirees… or … …we go multiple trillions of dollars deeper into debt… or … …we massively raise federal taxes. Clearly, this is an unsustainable trend. None of us here today can forecast what reforms we may see on Social Security or medical entitlements…or when we’ll see them. But one thing is very clear . No one is proposing any increase in Social Security benefits.
- Social Security Replacement Rates Declining To the contrary, due to increases in the age of eligibility and to rising costs for Medicare benefits that will be deducted from future checks… …Social Security’s capacity to replace pre-retirement income is actually programmed to decline from nearly 40% to less than 30% by 2030. I want to underline that metric – the ability to replace the income people make while working …because that is so clearly the best definition of the success – or failure – of any retirement system. And since traditional defined benefit pension plans are also dwindling and will cover only a small minority of future retirees…
- A “Gap” in assured retirement income …We can anticipate a predictable … inevitable …shrinkage of “assured” or “programmed” income for future retirees. Today’s retirees – as a group – draw roughly two thirds of their income -- from pre-programmed sources such as traditional pensions and Social Security. From now on, though…and each year going forward, future retirees will have to find ways to convert a growing share of their own savings to fill this widening “gap” in programmed income… Even if they do have the savings…converting those savings into reliable lifetime income isn’t easy. That’s why I believe that all workplace savings plans should include well-designed lifetime income options right in the plan – so participants can weigh their benefits and choose them – if they wish. But even suggesting that raises another key challenge.
- The Coverage Challenge More than 75 million of our fellow Americans have no access to any form of workplace savings. We need to find creative , cost-effective ways to cover all working Americans. It is up to public policy makers and politicians to enable – and incent – small and struggling business to offer automatic , simple , low-cost savings options to their workers. This will mean compensating companies with tax incentives to cover start-up costs and designing streamlined, low-overhead savings models – with minimal red-tape. This extension in coverage may take the form of the automatic IRAs the Obama administration has suggested…or greatly simplified 401-K offerings which were recently proposed. We should debate – and adopt – the best of these ideas when we next upgrade our retirement saving system… … Very soon, I hope. Having laid out these huge challenges… Here’s the Good news… We have a very, very strong base to build on…
- The Good News DC Plans are a Huge Success Story In fact, America’s defined contribution workplace savings plans represent one of the great success stories in investment history… DC savings plans have grown from a very small base to cover 76 million participants in less than thirty years. These workers now hold well over $3.4 trillion in their plans… Even after last year’s crash – this remains one of the largest dedicated asset pools on earth. More importantly, when we look forward, the DC system – using payroll deduction -- is the most powerful lever America has to actually raise future generations’ retirement readiness. DC plans offer the most efficient, equitable place to tackle America’s retirement savings challenge – and they have enormous untapped potential to do more. Anybody serious about raising retirement savings in America – or helping people turn those savings into lifetime incomes -- needs to harness the power of payroll deduction. And one of the great things about our workplace savings system is that it is continuously evolving and adapting. Here’s a thumbnail history…
- America’s DC System has Evolved At their inception, in the early 1980’s…DC plans were seen mainly as supplemental savings vehicles. Policy-makers in Washington viewed 401(k)-type plans as “add-ons” if you will – to a retirement system grounded on traditional defined benefit pensions and Social Security. Partly for that reason, the first generation of DC plans – Workplace Savings 1.0 -- was purely voluntary : both plan sponsors and participants had to “ opt in ”…by choosing to offer plans…or by deciding to take part. Over the 1980s and 1990s as workplace savings grew to the billions of dollars, we saw a wave of competition from mutual fund companies, insurers, and other providers… a fast-growing array of choices…continuous improvement in features and services…including online access and daily valuations…and falling costs, as well. But as the century turned…this first generation of DC plan design had clearly begun to bump up against several ceilings. Participation rates had stalled in the mid-to-high sixtieth percentile range… Despite costly education efforts, savings rates too, had stalled…at just about 7%...system-wide. As for asset allocation, far too many young workers were huddled in low-risk, low-return money funds…or stable value…while some folks right on the cusp of retiring were 100% exposed to equities. The purely voluntary, multi-choice model had reached the point of diminishing returns. Because it required participants to make the right call several times – first to participate , then to save the maximum allowed by law…then to diversify well…then to rebalance as markets moved… …this decision structure actually made it tough to succeed …and too easy to fail . Fortunately, by the turn of this century, fresh thinking -- from behavioral finance research in the academy and from live experience in the workplace -- had emerged to address those design flaws. These new solution elements included automatic enrollment and savings escalation programs – which pilot studies showed to have a dramatic, positive effect… … and dynamic lifecycle funds…balanced funds… and other forms of packaged advice…which solved for diversification, rebalancing, and risk-mitigation – automatically . All of these key “auto-features” were effectively endorsed by the Pension Protection Act of 2006…which really ushered in a second generation of plan design… Workplace Savings 2.0. By granting legal safe harbor from litigation for employers who adopted such “automatic” plan features… Congress took these cutting-edge ideas into the mainstream -- virtually overnight. I would note that the most important insight of the new thinking was the recognition that the main variables that drive results are plan design itself…”defaults” and sheer inertia. What behavioral economists call “ Framing ” or “ the architecture of choice ” heavily influences the choices that people actually make. And sheer inertia is the strongest force in participant behavior…bar none. Tapping into the power of plan design, defaults and inertia made the Pension Protection Act one of the most effective policy changes ever. Within two years of the law’s passage, the percentage of plan sponsors adopting auto-enrollment for their plans more than tripled . And the most recent studies we have show that roughly 90% of auto-enrolled employees have stayed in their plans. Last week, Watson Wyatt reported that fully 47% of the mostly large companies they surveyed have adopted auto-enrollment, and one third of those who haven’t – yet -- are considering it…while more than 6 in 10 offer now lifecycle strategies as investment defaults. Having that kind of impact, PPA was more than just a quantitative change. It was a qualitative change. With this law, Congress essentially upgraded the first generation of workplace savings from an ad-hoc, supplemental option…to something close to a fully fleshed out retirement savings system…at least through the accumulation phase. Indeed, the PPA gave a second wind to the entire DC system – which some people had thought would hit “maturity” as Boomers began to roll hundreds of billions of dollars out of their plans…
- The DC System Has Been Revitalized Here we see estimates from McKinsey and Company that project that total DC assets in America will roughly double in the decade from 2006 to 2015 – to between $7.5 and $8.5 trillion dollars. This estimate takes full account of the damage inflicted by last year’s slump… It also nets out more than $2 trillion in future rollover outflows by 2015…as DC plans become the largest source of flows to IRA’s. Clearly this is a system that is still growing…with untapped capacity to do more. Speaking of growth, I am sure all of us are pleased to see the rebound in markets we’ve experienced since this year’s lows in March. But if we want to improve our workplace savings system – and have it meet a big share of America’s overall retirement challenge… I think we also need to draw the right lessons from the “wake-up” shock we were hit with in 2008.
- But 2008 Delivered a Wake-up Shock Last year one of the three worst years for stocks in a century… Millions of participants in workplace savings plans were painfully hit. The S&P 500 stock index dropped 37%...total assets in 401(k) plans fell 22% -- to just over $2.3 trillion. And some plan participants, specifically people just entering or very close to retirement -- who actually needed to draw income from shrinking nest eggs – were especially impacted. The whole 401(k) system was exposed to a barrage of political, academic and media criticism. We all know the line about “my 401(k) turned into a 201(k)” Now I don’t buy in -- at all -- to the blanket criticism we’ve heard of 401(k)’s… But I do believe that as our workplace savings system matures – and takes a central role – as the prime source of future retirement income… Then those of us who believe in it most passionately…should also be the most determined to keep on improving and refining it. And when we do see flaws revealed under stress…as we clearly have …we should be the first to want to fix them.
- Volatility Has Been Severe in the 2000’s First off, maybe we should note that while the crash of ’08 was stunning… We’ve seen a lot of volatility – just since the turn of the millennium. Hundred-year floods seem to come more often that every century! This is a chart of 183 years of stock returns – with positive years shown in green and down years in red… It strikes me that half the years since 2000 have been down…including two of the worst nine years since 1830. No wonder so many people are still shell-shocked…holding cash on the sidelines. No wonder we find such a lively interest in strategies that offer the possibility of curbing volatility. After all, 2008 was not just bad because stocks dropped across the developed world… The worst thing was the correlation across a host of asset classes…including real estate and commodities…
- Absolute Return strategies did curb losses in 2008 Though not yet an official fund category, the 17 absolute return funds tracked by Morningstar did manage to limit losses to just over 10% last year, based on average return. That may have disappointed those who expect absolute return strategies to deliver positive returns even in seasons when most global asset classes are plunging. But on the whole, they succeeded in limiting losses in 2008 to less than that generated by a wide variety of asset classes. Beyond that, last year’s experience certainly suggests to me that…
- We Need a New Generation of DC Plan Design -- Workplace 3.0 It is time to think about a new generation of DC plan design…one that is more robust to market extremes. Let’s call it Workplace 3.0… Let me sketch some ideas on what this next generation DC system should include.
- Core Elements of Workplace Savings 3.0 For starters, we should build it on the PPA’s strong base of auto-features and defaults. Those ideas have demonstrated their effectiveness at getting workers to save consistently in broadly diversified portfolios. The only issue is whether auto-features should be made mandatory…or should we just let peer pressure…and fear of being sued…drive adoption? I believe we do need to build in much stronger protection against market volatility… like that we saw last year. And I believe we ought to offer built-in options for assured lifetime income. All workplace savers need access to advice and guidance…especially as they near retirement… And employers who offer these benefits should have strong legal safe-harbor protections against litigation. Without it, people hesitate to adopt even the best ideas. Basically, what we need to do is finish the job that the PPA did so well for the accumulation phase…and apply those same principles to distribution. The challenge now is to offer guidelines, even guardrails for the distribution phase and find ways to encourage workers to choose reliable lifetime income options.
- Solving for a Safe Landing…from Accumulation to Distribution As David Blake of the UK Pension Institute put it… What we’ve done with retirement plans is to get the plane to take off…We even have a flight path…but we’re not sure about how to come in for a safe landing… That’s the unmet challenge – embedding qualified lifetime income options – whether they be annuities or non-annuity income solutions – directly into workplace plans. Over the next 20 years or so… We will be transitioning millions of Boomers – the first “mass” generation of workplace savers – into full retirement for many years to come – and far too many of them are flying blind. Mistakes can be very damaging…and retirees don’t have time on their side to make them up. Some distribution risks – are familiar – like longevity and inflation… Some are less well known…like the impact of volatility on wealth accumulation… And then there’s “sequence of returns” risk – a hazard that is little known, except to professional financial planners. I want to look at these risks – and then sketch some possible solutions.
- Longevity Risk The good news is that a healthy couple, aged 65 today, has a long time to enjoy retirement. There’s a 50% chance of one member of the couple living to 92 – and a one in four chance that one of them will live to 97. The bad news is that they need to plan to finance a retirement that may extend well beyond average life expectancy…and could run 30 to 40 years.
- Inflation Over that kind of time frame, our old nemesis – inflation – can gnaw away at the purchasing power of a nest egg – so that you need $24,000 thirty years out to buy what $10,000 buys today. So retirees need assets that can counter inflation – classically, that means equities.
- Volatility Harms Wealth Accumulation A less known risk is the impact that market volatility can have on the process of accumulating those assets in the first place. In this example, we compare 15 years of historical returns on U.S. government bonds – with a well-known commodity index – from 1994 through last year. Both assets averaged 9% returns per year over that time…but the bonds were much less volatile than commodities…and never had gains anywhere near 50% in one year. But since the bonds had mainly positive years…and never had to make up for devastating plunges – the net result after 15 years was to produce total returns nearly twice as large as commodities – with a much lower ratio of sleepless nights, too. A 50% loss, after all, is not only unnerving…it requires a 100% gain just to get back to even! Any investor, advisor, or policymaker who believes that a buy-and-hold index strategy is the answer should consider what happened to index strategies in 2008.
- Purely Passive Portfolios were Crushed in 2008 Here is a totally indexed $1 million retirement portfolio – balanced at the start of last year 60% equity, 30% bonds, and 10% cash. This investor plans on drawing $50,000 – 5% -- in monthly increments…and holds on as the markets tank. By year-end, his portfolio has been reduced by nearly $249,000. Thank God he has the consolation of paying low fees… I offer this example up to any investor, advisor, or policy-maker who thinks that index funds or ETFs offer some kind of magic bullet in retirement investing. To the contrary, the closer one is to retirement…the more dangerous a excessive reliance on passive investing becomes. Preserving wealth is an active endeavor. It doesn’t mean that active funds will always outperform index funds. They won’t. But at least they have the possibility of offsetting losses in a market downturn. Let’s turn now – in some detail -- to the more arcane risk posed by the sequence of investment returns a retiree realizes right after pulling the rip cord. We’ll use a hypothetical all-equity portfolio – and 20 years of historical returns for the S&P 500 – from the years 1989 to 2008 inclusive.
- Sequence of Returns Risk – 1 – lucky If the investor retires in 1989 – then his timing is wonderfully lucky… Starting with $1 million, withdrawing 5% a year…stepping up at 3% annually to cover inflation… This portfolio returns more than $1.3 million in income over 20 years…and rides positive early-year returns to create a total balance of more than $3 million at the end. But suppose we “flipped” just the sequence of these returns – so that they ran from 2008 to 1989? The average yearly return over the period would be the same: 10.36%... But…
- Sequence of Returns Risk – 2 -- unlucky In this case, making the same initial withdrawals and inflation adjustments… … the unlucky – or ill-timed -- investor is flat broke after just 19 years…and manages to draw only $1.1. million in income from the original $1 million portfolio. That’s sequence of returns risk – in a nutshell. It’s the chronological equivalent of a lottery ticket. How can we mitigate this risk? Many ways…but let’s look at two.
- Hedging Sequence of Returns Risk – 3 – unlucky (but smart) Here, the investor has the same unlucky sequence of returns we just saw… But he has a very smart advisor who systematically creates a “collar” or two-way hedge around his $1 million portfolio – using puts and calls to limit both the highs and lows…capping the upside at 17% and limiting losses to 10%. This has the effect…even with the unlucky sequence…of allowing this investor to draw just as much income as the lucky man two slides back…over $1.3 million… … but also to sustain a sizeable portfolio after twenty years…$826,000 more than in the unhedged example. There are risks and transaction fees associated with options strategies. In general, these strategies are not appropriate for individual investors, particularly those in a qualified retirement plan. But in the hands of an experienced financial advisor or portfolio manager, options can be an effective tool at reducing volatility. Here’s another strategy that could mitigate the unlucky sequence – using the same assets and withdrawal assumptions.
- Insuring Against Sequence of Returns Risk – 4 – unlucky (but secure) In this case, the investor converts 50% of his initial $1 million portfolio into a guaranteed income product and draws the remainder of his income from the remaining portfolio. The total 20-year income matches the hedge strategy – and the initial $500,000 in equity assets actually grows to over $680,000 – because committing assets to guaranteed income helps this investor avoid half of the huge initial loss in this sequence…and allow the portfolio time to recover. That’s a smaller balance at the end than with the hedging strategy…but bear this in mind…this investor’s assets have risen, not fallen…AND…he still owns a guaranteed income contract…and with it, a high degree of security. To be clear, there are fees and expenses associated with guaranteed income products, just as with hedging strategies. And all guarantees are subject to the claims-paying ability of the insurance issuer. However, I believe guaranteed income is an important piece of the retirement income puzzle, one that will require asset managers and insurers to work together for the benefit of their mutual clients. Let me now draw together some implications of this data… … to sketch what we at Putnam believe to be the key building blocks for creating lifetime income solutions in DC savings plans.
- The Putnam RetirementReady Funds Glidepath First of all, we believe that workplace plans should make much more use of absolute return strategies…as a new category of qualified defaults…as investment options...and as a key element in lifecycle strategies. And we’re acting on that belief. Just last week, we introduced the industry’s first suite of lifecycle funds that integrate Absolute Return strategies – and we’re using them as the default in our own 401(k) plan. You can see that RetirementReady glidepath on this slide…with Absolute Return strategies – shown here in orange -- rising to become a growing share of the lifecycle portfolio as the retirement date approaches. By the way, we have a clear definition of what the target date for these funds means: it is the date by which accumulation ends…withdrawals begin…and the assets are allocated to help provide long-term income at a withdrawal rate of 5% or less. Obviously, absolute return strategies cannot guarantee that they will achieve the positive results they aim for over an investment cycle…in our case…a rolling three-year target…However, they do have a lower risk profile and should help limit losses in a market downturn. What’s more, Putnam Absolute Return Funds are specifically designed to limit risk – and therefore won’t necessarily capture the upside in raging bull phases. But think about this. Relative-return funds or strategies, which track closely with their benchmarks, will lose value when the markets they track plummet – as we saw happen to so many relative-return only lifecycle funds last year. Absolute return strategies have at least the possibility of earning positive returns – no matter what markets do because they target a T-Bill index. We believe these strategies will earn a central role in lifecycle investing and in retirement portfolios generally – where wealth preservation and volatility dampening are so vital. Let me now share with you a conceptual slide…showing the way Putnam sees financial products and services being allocated strategically over an investor’s lifetime.
- Lifetime Product Allocation Here we see what you might think of as a lifetime “glide-path.” It shows not precise numbers…but the changing weights or roles of asset management and insurance in an investor’s financial life. We don’t include banking or real estate assets…mainly because they have little or no role in workplace savings… But in our view, there is – or should be – a natural alliance and synergy between investments and insurance elements over an investor’s lifetime. There is a place for insurance even at a very early age…and also for relative-return, market-benchmarked investments…well into a person’s 90s. We believe that there should also be a growing element of absolute return strategies in a person’s lifetime product portfolio… …and a very substantial role for guaranteed lifetime income to form a secure base in retirement. Relative Return, Absolute Strategies, and Guaranteed Income are responses, respectively, to the risks of inflation, volatility and longevity…the three major threats to retirement success. We recognize that there will – and should be – debate about the percentages of these solution elements that should be “allocated” in the next generation of workplace savings plan design. But we think that a debate on ways to lower volatility and secure reliable lifetime income from these plans is healthy…and long overdue – and will help shape the legislation we need to finish the job that PPA has so far advanced. We mean to engage that debate…and we encourage all of our colleagues in financial services to put their own best ideas forward. In particular, we think there should be a natural alliance and collaboration between asset managers and insurance companies in shaping a national retirement savings policy.
- Needed: Industry Innovation and Public Policy Support Even under current law, I believe, we already have it in our power to create a new generation of workplace plans that would provide millions of Americans with less volatile workplace plans that can offer higher replacement rates and lifelong income options. It is possible – right now – to dampen volatility in workplace plans…introduce Absolute Return strategies into these offerings…and offer plan participants access to lifetime income options. Some of this is already happening. But…If we want to fully realize the potential of a new generation of workplace savings… We will need new legislation…to ratify best practices…and assure plan sponsors of legal safe harbors as we extend best practices across the whole workplace savings world. America is moving – as we speak – from a long era of leverage, consumption, and reckless excess…to a new respect for thrift, prudence, hard work – as well as reasonable risk-taking and entrepreneurship. I can’t think of anything we could do that would contribute more to that change…than re-booting our workplace savings system…and better linking secure, lifelong income to a lifetime’s labor. Ladies and Gentlemen, we can do this… Let’s get to work. Thanks for listening…and thanks very much for having me.