You are on page 1of 12

Retirement plans

should target income


as the outcome

Forward-thinking plan sponsors are committed to helping their


employees reach a secure retirement, and in recent years, they
have made great strides in getting employees engaged in their
own retirement readiness. Yet too many people are still not
prepared. A number of recent surveys have found that:
W

To measure retirement
readiness, plan sponsors
should focus on
the ultimate outcome of
their plans: the income
replacement ratio,
or amount of preretirement income an
individual will need to live
comfortably in retirement.

 3% of Americans are concerned they wont have enough money


4
to live comfortably in retirement.1
 5% of workers guess how much to save for retirement, instead of
4
using estimates or calculators.2
J ust 21% are planning to receive income from annuities, which
generate retirement income that individuals cant outlive.3

Despite plan sponsors best efforts, many employees are still at a lossa problem that
may largely come down to perspective. Traditionally, the industry standard for retirement
readiness has been a large nest egg. Employees and plan sponsors alike have focused on
growing savings, and retirement planning has addressed how much to save each year, what
risks to assume in various investments, and how to avoid fees and other costs that chip
away at employees total return. This approach has resulted in little guidance on how
employees can turn their nest eggs into retirement income that may have to last for the
next 25 or 30 years.
Instead of measuring retirement readiness by looking at accumulated savings alone, plan
sponsors should focus on the ultimate outcome of their plans: the income replacement
ratio, or amount of pre-retirement income individuals will need to live comfortably in
retirement. In simpler terms, measuring retirement readiness starts with determining
employees expected monthly budget in retirement based on their existing pre-retirement
monthly budget.
With this metric in mind, plan sponsors can now take a strategic approach to plan design
that can help employees meet their income or budgeting needs in retirement. This means
considering the individual needs and circumstances of their employees in both the savings
(accumulation) and the distribution (decumulation) phases. It starts with giving employees
the tools to set the right goals for retirement. An effective plan design then helps
employees meet those goals and links to products that yield retirement income streams
that will last a lifetime.

1 Retirement plans should target income as the outcome

The savings phase


How much should employees save for retirement?
Experts have different estimates as to what level of pre-retirement income workers should
target as a savings goal, but it is important to note that one universal number may not be
appropriate for all. Income replacement rates can vary widely from one person to another:
In fact, research shows that typical replacement rates can range from as low as 58% to as
much as 82%4 (see Exhibit 1).

Exhibit 1: People with higher pre-retirement income have lower replacement rates
Replacement rates as a percentage of gross preretirement income

W Social Security W Savings


Total=82%
Total=72%
Total=62%
59%

23%
< 25th
< $25,870

38%

Total=58%

31%

21%

34%

31%

37%

25th50th
< $49,941

50th75th
< $86,882

> 75th
> $86,882

Gross Preretirement Income


Source: Marlena Lee, The Retirement Income Equation, DC Dimensions (Summer 2012).
Note: Dollar figures shown above are in 2011 dollars
The projections or other information generated by Monte Carlo analysis tools regarding the likelihood of
various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are
not guarantees of future results. Results may vary with each use and over time. These hypothetical returns
are used for discussion purposes only and are not intended to represent, and should not be construed to
represent, predictions of future rates of return.
Retirement plans should target income as the outcome 2

The reality is that each


individual may have a
different retirement
replacement rate
and thus may need to
save a different
amount for retirement.

By focusing on income replacement rates as the appropriate retirement goal, plan sponsors
can help employees determine how much they need to save based on their expected income
needs in retirement. Many factors play a role in determining the actual amount that
someone should save: income levels, portfolio returns, number of years until retirement,
and current and past savings rates, among others. The reality is that each individual may
have a different retirement replacement rate and thus may need to save a different amount.
Research indicates that workers on the lower end of the income spectrum will need a
relatively high share of their pre-retirement income, but they will require a lower rate of
savings during their pre-retirement years. A different story emerges for employees earning
more than $100,000 per year; according to this study, they will likely have to save
considerably more of their pre-retirement income, despite having a lower overall retirement
replacement rate.5 Due to regulatory savings limitations within defined contribution plans,
high-income employees may find it difficult to meet these savings goals through their plans
and may have to save outside of them. Savings options outside of the plan include individual
retirement accounts (IRAs), fixed annuities and other savings and investing accounts.
Plan sponsors should encourage their employees to maximize their retirement savings, with
an understanding that their savings rates may fluctuate over their careers. Workers may be
unemployed for a period of time, take time off to care for children or elderly parents, or
experience financial emergencies that affect their ability to maintain their target savings
rate. For this reason, employees need to save more aggressively when they can, to offset
those periods when they are forced to save less.

3 Retirement plans should target income as the outcome

Plan design focused on outcomes


Engaging employees with an income replacement ratio is critical, but plan design is another
area where plan sponsors can use their influence to help employees reach their retirement
goals. The right elements of plan design can improve participation and savings rates,
investment performance and other plan metrics. Three practices that a plan sponsor might
consider are the use of automatic features, offering professionally structured investment
solutions, and making advice services available.
1. Automatic processes for enrollment and contribution increases: A good starting point is to
automatically enroll employees in a defined contribution plan the moment they become
eligible. Doing so can save employees from the negative consequences of inertia: Research
shows that applying automatic enrollment (as opposed to voluntary plan enrollment) can
have a big savings impact for all employees, especially those just starting out in their
careers. Workers between the ages of 25 and 29 who are automatically enrolled in their
plans could save as much as 2.39 times more of their final salary than their peers who are
left to enroll on their own.6
For those employees who are already enrolled in the plan but perhaps are not saving the
amount necessary to reach their target income replacement ratio, dynamic autoescalationwhich ties savings rates to income replacement ratioscan raise savings
rates to the appropriate level. The combination of these two automatic processes
automatic enrollment and dynamic auto-escalationcan help plan sponsors create a
more meaningful plan design. This outcome-oriented approach can help accelerate
individuals savings at critical junctures, prevent common investor-driven errors tied to
market timing and keep employees on track to meet their goals.

Retirement plans should target income as the outcome 4

We believe the goal of a


professionally structured
investment solution
should be sufficient
income to maintain a
desired standard of living
in retirement.

2. Professionally structured investment solutions: The first step in designing a professionally


structured investment solution is to determine a meaningful goal. Many comprehensive
investment solutions focus only on inputs such as risk tolerance, performance, fees,
investment style and account balances. In other words, the goal of these solutions is wealth
accumulation. By contrast, we believe the goal should be sufficient income to maintain a
desired standard of living in retirement.
Professionally structured investment solutions take into account a wide range of elements
to meet employees retirement income goals. Each of these elements is important, as even
a relatively small change in performance can have a big impact.
We believe an appropriate professionally structured investment solution should:
WW Target

income as the outcome.

WW Consider

an asset allocation strategy in which the goal is to meet future income needs.

WW Provide

broad market exposure that offers employees access to a wide range of asset
classes, in order to diversify and target higher expected returns.

WW Consider

limiting exposure to company stock (in the case of corporate plans) in order to,
among other things, potentially avoid the crowding out effect in which this option
competes for an allocation over other asset classes.

WW Use

segmentation insights based on age, account balance, earnings potential and


retirement funding status to help different employee groups reach their income goals.

WW Strive

for a low-cost all-in fee structure that is competitively priced; the goal is not
necessarily to obtain the lowest fee for each product or service, but rather to obtain the
best value for each of them.

WW Preserve

income and avoid relying too heavily on equities as an employee gets closer to
retirement and his or her earnings potential is low or depleted.

WW Provide

the opportunity to convert assets to lifetime income. This could include the use of
a low-cost, in-plan fixed annuity within the portfolio that gives employees the option to
annuitize and create a fixed income stream.

5 Retirement plans should target income as the outcome

3. Advice or other financial planning services: Advice can play an important role in workers
retirement readiness. It can provide employees with specific recommendations around
savings rates, asset allocation, investment options and other retirement planning needs.
More important, employees seeking advice tend to take action. More than half of
employees (54%) who used an online advice service between February 2012 and January
2013 saved more, changed their future allocations or rebalanced their portfolios.7
Effective advice offerings should provide actionable recommendations; be unbiased
and personalized; and should recognize the importance of lifetime income.
Retirement planning should also take into account an individuals complete financial picture,
including the rest of the household. Many advice services and offerings designed for DC
plans today dont link to other employee assets such as previous employer-sponsored
plans, DB plans, outside savings, or spouses savings. An advisor or access to a financial
planning service can help workers aggregate their holdings in order to understand their
household balance sheet. Likewise, advisors and similar services can help employees
convert accumulated assets to lifetime income. For most, the retirement phase is the most
unique and complex financial time during a persons life. Often, an advisor can help
coordinate an individuals total household assets along with other goals in order to achieve
a desired standard of living throughout retirement.
Although every employee wants to live comfortably in retirement, there is no one-size-fits-all
approach to achieve that goal. Automatic features, professionally structured investment
solutions and advice services are all important elements that if used appropriately, can help
employees improve their financial well-being.

The distribution phase


Helping employees generate lifetime income
A plan sponsors role in retirement planning doesnt end once an employee retires. In fact,
employees may need more help than previously as they face a daunting task: creating a
secure income stream to cover retirement expenses from accumulated savings. As they do
so, plan sponsors can help them navigate complex decisions: the risks theyre willing to
take with their accumulated assets, the rate at which they can withdraw their funds without
depleting their savings, the effect of inflation, the impact of health costs, and finally, the
risk that they will eventually lose the cognitive capacity to manage their financial affairs.

A combination of annuitized income from fixed annuities,


Social Security, and pension benefits, if available, can serve as the
retirement income floor to cover essential living expenses.
By providing education on safe income withdrawal rates, plan sponsors can help retirees
address one of their most common fears: outliving their savings. This is a real possibility
because many employees do not know enough about sustainable income withdrawal rates.
A recent survey found that more than 33% of retirement plan participants had no idea how
much they could safely withdraw; an additional 25% said they could withdraw 10% of their
assets per year and see their retirement savings persist.8 As a point of comparison, a 4%
withdrawal rate is often used as a rough rule of thumb for how much an individual could
withdraw from a retirement portfolio each year without depleting the retirement account.

Retirement plans should target income as the outcome 6

Exhibit 2: A single-life annuity offers consistent income throughout retirement

W Required minimum distribution W 4% withdrawal W Single-life annuity W Self-annuity

Annual retirement income

$7,000
$6,000
$5,000
$4,000
$3,000
$2,000
$1,000
$0

65

70

75

80

85

Age

90

95

100

105

110

115

This model assumes that a person has annuitized $100,000 at age 65 at a 3% interest rate. For illustration
purposes only. Actual payouts may differ. Three percent nominal interest rate return assumption for all
calculations. Single Life Annuity (SLA) based on 3% payout rate. Self-annuity payout (in which a person
takes the needed amount out of savings rather than annuitizing) set to replicate payout amount of the
SLA. Required minimum distribution payout uses Social Security unisex mortality table for remaining life
expectancy. All amounts are pretax.
Source: Richardson, David P. (2012) The Role of Guaranteed Income in Improving Retirement Security.
TIAA-CREF Institute Working Paper.

But even with a 4% withdrawal rate, retirees are still exposed to many riskssuch as
investment, longevity and cognitive risksthat could render the 4% withdrawal rule
irrelevant (see Exhibit 2).
In the face of so many risks, many employees need help in obtaining a steady income stream
that can last a lifetime, and is not affected by the highs and lows of market performance.
Fixed annuities can meet these requirements and are one of the few financial products that
can guarantee lifetime income and can only be issued by an insurance company.9
A combination of annuitized income from fixed annuities, Social Security, and pension
benefits, if available, can serve as the retirement income floor to cover essential living
expenses. But plan sponsors should communicate to their employees that annuitization from
fixed annuities is not an all-or-nothing proposition. Employees can determine whether to fund
their retirement solely with guaranteed sources of income or to maintain some flexibility and
control over their retirement assets by keeping a portion in other investment products.

Benefits of in-plan annuitization with fixed annuities


For employees to use fixed annuity options, they must first have access to them. Some
institutions offer fixed annuity products within the plan, but if they do not, then employees
must find retail fixed annuities on their own when they retire. Both in-plan and out-ofplan fixed annuities are designed to deliver guaranteed lifetime income, but in-plan
solutions may offer employees a number of additional benefits.
WW In-plan

fixed annuities are offered in a controlled setting, with pre-screening and education
from employers. This can help employees understand how fixed annuities work and the
impact of saving on future retirement income within the context of their plan: Employees
can see, in dollars and cents, how a little more saved during their working years can
translate to a higher retirement income. Making this connection makes employees more
likely to save more effectively and regularly.10

7 Retirement plans should target income as the outcome

WW Plan

sponsors can generally negotiate lower costs for fixed annuities than individuals
using an out-of-plan option.11 This is important, because lower costs can contribute to
higher income payouts.

WW Research

shows that individuals who contribute to fixed annuities while they are saving
are more likely to annuitize a portion of their savings and receive retirement income in the
form of lifetime annuity payments. Without access to an in-plan fixed annuity, employees
may not save for retirement through an outside fixed annuity and therefore may be less
likely to annuitize their savings upon retiring.12

Meeting your fiduciary obligations with in-plan fixed annuities


When considering an in-plan fixed annuity, plan sponsors often express concerns over the
fiduciary obligations associated with selecting a fixed annuity product and provider. The reality
is that the principles and processes governing the selection of a fixed annuity product and
provider are in many ways similar to those used in the selection of mutual funds and other
investment options. And those sponsors that already offer an annuity option at the point of
distribution may not realize they may already share the same level of fiduciary obligations as
sponsors that offer an in-plan fixed annuity.
In general, the standard test for meeting that fiduciary responsibility comes down to following a
careful process in the selection and then monitoring of the fixed annuities and any insurance
companies whose fixed annuity products are made available to employees. In carrying out its
duties, a fiduciary should adhere to the so-called prudent expert standard, which calls on plan
sponsors to exercise the care, skill, prudence and diligence that would be employed by a
prudent expert acting in a like capacity and familiar with such matters and with the same goals.

The principles and


processes governing the
selection of a fixed
annuity product and
provider are in many ways
similar to those used in
the selection of mutual
funds and other
investment options.

This standard therefore calls on plan sponsors to engage in a careful assessment of


products and fixed annuity providers, guided by experts when needed and informed by a
risk-based review of a providers ability to honor its guarantee which may include a fixed
annuity providers ratings by insurance ratings services.
For those plan sponsors seeking greater assurance that they are meeting their fiduciary
obligations to a plan, they can turn to the Department of Labors safe harbor that became
effective in December 2008. This safe harbor follows the same basic principles we already
mentioned, in addition to requiring plan sponsors to consider the costs versus the available
benefits and administrative services of the fixed annuity. To be clear, plan sponsors may
choose to follow the safe harbor to meet their fiduciary obligations, but they dont have to.
Many of these issues have been tested in the courts, and the relevant rulings provide
valuable guideposts for the expectations, as well as the limits of liability, for providers.

Retirement plans should target income as the outcome 8

Fiduciary checklist
Plan sponsors may find it easier to follow an established checklist
to help guide the processes of selecting a fixed annuity provider
and conducting due diligence. This fiduciary checklist should
include a review of a fixed annuity providers:
WW Strength

and stability, which can be assessed through the insurance companys


publicly available information;

WW Ratings

and financial strength;

WW Track

record and reputation as a well-known insurance company in the fixed


annuity field;

WW Costs

that can reduce financial benefits to the participants through sales charges,
commission, surrender fees and other expenses;

WW Transparency

to determine whether the information to be reviewed is clear and


readily available; and

What matters most to


many retirees is not how
much they have saved,
but how their accumulated
savings can translate
into a lifetime of income.

WW State

guarantees, which consider the availability of state guarantee insurance in


the states where the plan sponsor is located (and where most plan participants
reside) and the extent of guarantee coverage for fixed annuity contracts.

This checklist is not intended to define the fiduciary process for selecting a fixed
annuity provider but to provide a list of some best practices that will assist
fiduciaries in performing their duties. In this light, the checklist should be viewed as
a tool that fiduciaries may consider using in helping them fulfill their duties and
documenting that they have done so.13

Leading the way to a secure retirement


Employees face a challenging road to retirement, but plan sponsors can help them down
this road by focusing on what our research indicates is the right goal for most employees:
an income replacement rate that will meet lifetime income needs. With this goal in mind,
plan sponsors can design their plans for both the savings and distribution phases, helping
employees pave the way to a secure retirement.
Automatic features can address the need to save early and save more; professionally
structured investment solutions can set the right risk-return strategies; and low-cost
investment options can help employees make the most of their savings. However, saving
the right amount for retirement may not be enough. Retirees may also need help creating a
secure income stream that will last a lifetime. With all the risks facing retirees, the use of
guaranteed products can form the building blocks for a secure source of retirement income.
By offering fixed annuities, plan sponsors can go beyond todays requirements and set a
higher standard of fiduciary responsibility.
In the end, what matters most to many retirees is not how much they have saved, but how
their accumulated savings can translate into a lifetime of income. Plan sponsors can help
them achieve their goals by promoting active savings, smart investing, and wise choices in
products that guarantee a lifetime of income.

9 Retirement plans should target income as the outcome

T he findings come from TIAA-CREFs first Lifetime Income Survey, conducted by an independent research
firm between January 3 and 5, 2014. Polling was among a national random sample of 1,017 adults, age
18 years and older.
2
Employee Benefit Research Institute, 23rd Annual Retirement Confidence Survey, 2013.
3
The findings come from TIAA-CREFs first Lifetime Income Survey, conducted by an independent research
firm between January 3 and 5, 2014. Polling was among a national random sample of 1,017 adults, age
18 years and older. Income from an annuity is based on the claims-paying ability and strength of the
issuing company.
4
Marlena Lee, The Retirement Income Equation, DC Dimensions (Summer 2012). See Methodology
Supporting Savings Rates and Replacement Rates in the disclosures.
5
Marlena Lee, The Retirement Income Equation, DC Dimensions (Summer 2012)
6
Employee Benefit Research Institute, Issue Brief No. 341, April 2010
7
Based on 2013 TIAA-CREF proprietary research of 17,741 TIAA-CREF participants who used TIAA-CREF
Retirement Advisor (online advice) from February 2012 through January 2013 and took action within the
same time period.
8
DrinkerBiddle, Lifetime Income in Defined Contribution Plans: A Fiduciary Approach.
9
Source: American Council of Life Insurers (ACLI). Guarantees based on the financial strength of the
issuing company.
10
Paul J. Yakoboski, Retirees, Annuitization and Defined Contribution Plans, Trends and Issues, TIAA-CREF
Institute, April 2010.
11
TIAA-CREF, Investing for a Lifetime. Guaranteed.
12
Paul J. Yakoboski, Retirees, Annuitization and Defined Contribution Plans, Trends and Issues, TIAA-CREF
Institute, April 2010.
13
DrinkerBiddle, Lifetime Income in Defined Contribution Plans: A Fiduciary Approach.
Dimensional Fund Advisors LP (Dimensional) is an investment advisor registered with the U.S. Securities
and Exchange Commission. Dimensional does not issue or distribute annuities or insurance products or
provide legal or tax advice.
The information herein is for informational purposes only and is not intended to provide legal advice. Please
seek advice from appropriate counsel before taking any action.
1

Retirement plans should target income as the outcome 10

This material is solely for informational purposes and shall not constitute an offer to sell or the solicitation
to buy securities or investment services. The opinions expressed herein represent the current, good faith
views of [Dimensional] at the time of publication and are provided for limited purposes, are not definitive
investment advice, and should not be relied on as such. The information presented in this article has been
developed internally and/or obtained from sources believed to be reliable; however, [Dimensional] does not
guarantee the accuracy, adequacy or completeness of such information. Predictions, opinions, and other
information contained in this article are subject to change continually and without notice of any kind and
may no longer be true after the date indicated. Any forward-looking statements speak only as of the date
they are made, and [Dimensional] assumes no duty to and does not undertake to update forward-looking
statements. Forward-looking statements are subject to numerous assumptions, risks and uncertainties,
which change over time. Actual results could differ materially from those anticipated in forward-looking
statements. This material is directed exclusively at investment professionals. Any investments to which this
material relates are available only to or will be engaged in only with investment professionals.
The material is for informational purposes only and should not be regarded as a recommendation or an offer
to buy or sell any product or service to which this information may relate. Certain products and services may
not be available to all entities or persons. Past performance does not guarantee future results.
TIAA-CREF products may be subject to market and other risk factors. See the applicable product literature,
or visit tiaa-cref.org for details.
Annuity account options are available through contracts issued by TIAA or CREF. These contracts are
designed for retirement or other long-term goals, and offer a variety of income options, including lifetime
income. Payments from the variable annuity accounts [and mutual funds] are not guaranteed and will rise or
fall based on investment performance.
Annuity contracts and certificates are issued by Teachers Insurance and Annuity Association (TIAA) and
College Retirement Equities Fund (CREF), New York, NY.
2014 Teachers Insurance and Annuity Association of America-College Retirement Equities Fund, New York,
NY 10017

Methodology Supporting Savings Rates and Replacement Rates

Dimensional simulated income and portfolio paths of 10,000 households. The working years are age
25 to 65, and full retirement occurs at age 66. Final pre-retirement income matches the actual income
distribution of households age 60 to 64 in 2009.i Pay raises and portfolio outcomes are jointly drawn
from historical distributions of changes in real per-capita income and real stock and bond returns over
the period from 19302010.ii Each year, the households save a fixed fraction of their gross income in a
Roth retirement vehicle. The portfolio is invested in stocks and bonds, with the percent invested in stocks
equaling 100% age.
We assume households with below (above) median final income want to replace 100% (90%) of preretirement spending, where pre-retirement spending equals gross incomeless savings, federal income
taxes, and FICA taxesestimated using current tax laws and standard deductions.
A households spending is partially funded by Social Security, but any shortfall is financed using personal
savings. The table below shows the savings rates needed to achieve this spending level (or more) with
7590% probability, assuming the price of a $1 real annuity is $20. Even with a Social Security replacement
rate of 59% for the lowest income quartile, savings must be about 10% to maintain at least the same level
of pre-retirement spending in about 85% of the simulations. For households with annual income exceeding
$25,870, a savings rate in the low teens is required to maintain spending levels with high probability.

Percentage of pre-retirement income


Pre-retirement income range
Median effective tax rate
Savings rate
Spending adjustment
Replacement Rate
Total
Social Security

< $25th

25th50th

50th75th

> 75th

< $25,870

< $49,941

< $86,882

more than $86,882

8%

14%

18%

21%

9%11%

13%15%

12%14%

13%16%

0%

0%

10%

10%

8183%
59%

7173%
38%

6163%
31%

5759%
21%

Notes

i. Source: US Census Bureau. 2010 Current Population Survey. Annual Social and Economic Supplement.
ii. Real changes in per-capita income obtained from Bureau of Economic Analysis. National Income and
Product Accounts tables. The assumption that the household does not defer taxes allows me to complete
the analysis without having to make predictions about future tax rates.
The projections or other information generated by Monte Carlo analysis tools regarding the likelihood of
various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are
not guarantees of future results. Results may vary with each use and over time. These hypothetical returns
are used for discussion purposes only and are not intended to represent, and should not be construed to
represent, predictions of future rates of return.
Circumstances can cause substantial deviation from the estimates. This could result in declines in an
accounts value over short or even extended periods of time. Results may vary with each use and over time.
C17151

323122_435301
A14401 (06/14)

You might also like