(June 9, 2014) – Delivering sustainable retirement income requires addressing three phases in financial planning, according to a research paper: saving, investment, and spending.
However, the primary touchstone for defined contribution (DC) plan design—modern portfolio theory—only addresses the investment phase, wrote author Jeremy Cooper, retirement income chairman of investment manager Challenger.
He argued that DC schemes could learn from defined benefit (DB) plans, which cover all three. Automatic contributions from employers and employees take care of saving; asset management professionals handle the investing; and plan sponsors spends the assets by doling out regular checks.
“Not every DB plan that ever existed has failed,” Cooper noted in the paper, published recently in the Seattle University Law Review. He pointed out that many continue to effectively deliver the income promised to their members for perpetuity. “This demonstrates that it is possible for a well managed plan to prove a defined benefit outcome,” he continued—even if it is a DC scheme.
The spending phase could be addressed by third-party financial firms or insurers in the form of annuities and other lifetime income products, the paper suggested. “The use of expert managers stands in contrast to traditional corporate DB plans where every employer needs to have skills in managing assets and liabilities in order to deliver the DB outcomes.”
Of course, those third-party firms would require compensation for shouldering the risks of guaranteed income. Just how much this would cost any given retiree depends on the degree of uptake by retirees and providers.
“Like most markets, the overall supply and demand for longevity risk protection will determine a suitable price,” Cooper wrote. “The market will be cleared as long as there is sufficient available capital for a reasonable supply of the protection. A model with low premiums and consistently high returns is one that is doomed to fail.”
Cooper has been far from the first to propose such a solution to DC’s critical retirement income problem. As with other vocal advocates—State Street Global Advisor’s Head of DC Fredrik Axsater, for example—Cooper’s firm would stand to benefit from a booming market for retirement income products. Many in the Australian superannuation industry cite Sydney-based Challenger as the sector’s leading innovator, but annuity products have yet to become standard purchases for new retirees.
Still, Australia’s track record with DC has made it a leading contender to solve the retirement income issue. National law has mandated automatic contribution of between 9% and 12% of all wages to superannuation accounts, effectively solving the savings phase issue still plaguing DC systems elsewhere.
In the United States, for example, Putnam data released in April showed the average working adult was on track to replace just 61% of his or her earnings with retirement assets.
“Compulsory DC super is an effective piece of public policy because it forces people to save,” Cooper concluded. “But it is a blunt tool that does not adequately meet the retirement needs of a majority of plan contributors… Plan trustees need to do more to get members focused on the real game: targeting a replacement rate of income and a guaranteed floor of inflation-adjusted income in retirement.”
View the full text of Jeremy Cooper’s paper "Are Defined Contribution Plans Fit for Purpose in Retirement?" here.
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