With the passage of the Setting Every Community Up for Retirement Enhancement Act of 2019, better known as the “SECURE Act”, and subsequent Department of Labor rules on lifetime income disclosures, the shift towards income-focused outcomes for America’s plan participants is well underway. I was reminded of the importance of this topic after watching the recent video, Closing the Retirement Gap with Indices, where Nobel Laurate Robert C. Merton and Dan Draper, CEO of S&P Dow Jones Indices, discussed the challenges facing today’s retirement system and the need for independent, transparent indices that act as a benchmark that participants can use on their journey to (and through) track their retirement investment strategies.
As highlighted by Dr. Merton’s decades work in this space, the US defined contribution (DC) system requires participants to possess investment knowledge, the time necessary to manage their asset allocation, and the ability to harmonize those allocations across the household balance sheet. Not an easy task, even for the most savvy investor. However, these challenges pale in comparison to getting the first order challenge right: identifying the correct goal for retirement.
Unlike Social Security or defined benefit plans, the DC system is focused on wealth accumulation, and unfortunately, for most, this is the wrong goal. Why? Well, most Americans today rely on their DC plan as their primary retirement funding vehicle. We use our DC savings to fund our lifestyle in retirement, from basic subsistence and health care to recreation and bequests. So, recognizing that funding retirement consumption is the goal, we must manage the unique risks that affect retirement income. In addition to the risks associated with equity investing, we also face changing interest rates and inflation in retirement: lower interest rates can reduce the income that a given balance can support, while inflation reduces the purchasing power of savings.
Now here is where getting the goal wrong may negatively impact plan participants. Most comprehensive, “do it for me” products (think target date funds) are designed with a wealth accumulation goal in mind. To mitigate the risk of not attaining that wealth goal, the allocation invests in short-term, nominal fixed income as the participant approaches retirement. This choice may work when seeking to minimize the volatility of the account balance. However, it may not be inappropriate for retirement investing, since it leaves participants exposed to inflation risk and decreasing interest rates. A more appropriate strategy – one that invests in a moderate equity allocation and an inflation-protected bond portfolio utilizing liability-driven investing – can help protect participants against market, interest rate and inflation risk. To prove this rather contrarian approach to target date fund investing, look no further than a recent SSRN paper by Mathieu Pellerin, titled Investing for Retirement Income: A Comparison of Asset Allocations and Spending Strategies. I think you will find the results compelling to say the least.
A useful resource for participants in the DC ecosystem who seek investment strategies that move from a wealth-focused mindset to the more appropriate focus on retirement income, is the benchmark or index. As an independent, transparent measurement, indices like the S&P STRIDE Index aim to provide these participants with information to benchmark the performance of their retirement goals. I applaud the application of lifecycle finance in the methodology of these indices. Further, to paraphrase Dan Draper, the S&P STRIDE Indices aim to track strategies where retirement income is sought to be the outcome. To that I say, Amen!
Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission. Dimensional Fund Advisors: (i) has collaborated with S&P Dow Jones Indices to create the S&P STRIDE Index and receives license fees with respect thereto and (ii) licenses other S&P Dow Jones Indices data and trademarks in exchange for a fee payable to S&P Dow Jones Indices.
Robert Merton provides consulting services to Dimensional Fund Advisors LP.
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