Around this time of year, I often reflect on an annual tradition in my house. It doesn’t involve chestnut roasting, holiday turkeys, or testy debates about cranberry sauce (the stuff from the can is best, in case you’re wondering).
Rather, I’m referring to a ritual my wife and I follow every January when we grab more or less all of the gifts we purchased for each other and drive to the local mall with a bagful of returns. Despite more than 13 years of marriage, we seem perpetually unable to select the right gifts for each other. Apparently, it’s a skill that requires a greater degree of insight than we’ve accumulated so far.
This reminds me of another decision that requires knowing a lot about not only what you’re buying, but who you’re buying it for. I’m not talking about an ill-fitting sweater or a necktie that clashes with every dress shirt in your wardrobe. I’m talking about the decision behind a much more important purchase—an annuity for retirement.
The topic of annuities comes up with growing frequency in the target-date fund (TDF) industry. In the time that my wife and I have been married (we exchanged our “I do’s” just before the Pension Protection Act of 2006), target-date funds have grown from less than $50 billion in assets to more than $2 trillion. As target-date funds play an increasingly important role in the broader defined contribution (DC) landscape, many plan sponsors, regulators, and industry practitioners are asking “What’s next?” and “How can we do more to create a secure retirement for our participants?”
To some in our industry, incorporating annuities into TDFs appears, at least on paper, to be an interesting starting point for developing “next generation” TDFs. Here at Vanguard, as the industry’s largest TDF manager and a provider of annuity products to retail investors for over two decades, we’re quite close to this topic and have studied it intensely.
In fact, this past summer, I was invited to Washington to share our views before the Department of Labor’s ERISA Advisory Council. The council was studying the potential role of “lifetime income” in qualified default investment alternatives (QDIAs), and it had invited members of the industry and academia to share their perspectives.
The potential marriage of annuities and traditional investments in a TDF naturally sparks vibrant debate. The council heard testimony on the technical merits of the approach, the limited legal protections for fiduciaries selecting insurance carriers, and operational challenges in administering insurance contracts in and, perhaps more importantly, across DC plans.
However, a focus on these topics overlooks the larger question:
Is there such a thing as a one-size-fits-all spending strategy in retirement?
After all, TDFs are one-size-fits-all investment products. And while our industry has for many good reasons become more comfortable creating asset allocations based on a single input—the expected retirement date—is that really all that’s needed to inform a potentially irrevocable decision involving some or all of a participant’s retirement savings?
Our answer is an emphatic no. In fact, many factors need to be weighed and these will vary among participants. Are they married? Will they be supporting dependents in retirement? Do they own their home? What is their health status? What are their lifestyle aspirations in retirement?
These are just some of the issues that individual investors need to carefully consider before deciding to annuitize a portion of their retirement wealth. Yet, none of these factors can be accommodated in a default investment constructed as a one-size-fits-all product. Add annuities to TDFs today, and plan sponsors would need to make this decision based solely on participants’ projected retirement dates.
I know my wife’s entire story; we share a home and a life. Yet, rare is the year I purchase a successful gift for her. An annuity purchase is an infinitely more challenging decision and one that has far greater consequence and permanence.
And unlike the one-size-too-large sweater I gave my wife last year, you can’t take an annuity back to the mall the first week in January. “Undoing” an annuity is incredibly expensive and, in many cases, is not even an option.
At Vanguard, we believe the decision to use an annuity to create a more secure stream of income in retirement is a decision that requires the full awareness, knowledge, and, most importantly, affirmative consent of the participant.
That’s why we believe that an “auto-annuitize” feature in a TDF does not serve the best interest of defaulted DC plan participants. Instead, we see many opportunities to improve retirement income security using tools that largely exist today and are achievable within our current regulatory framework. These include:
- Removing age restrictions and mandatory cash-outs.
- Granting greater withdrawal flexibility for retired participants.
- Allowing for incoming rollovers.
- Offering investment options oriented to current retirees.
- Providing enhanced advice and education that may inform participants of annuitization as an option.
TDFs have been a powerful engine for good in the DC industry over the last decade-plus, but they are not without their limits, particularly when it comes to prescribing how and when participants will spend their wealth in retirement. These limits need to be fully understood and appreciated as our industry strives to deliver ever-improving financial outcomes for retirees today and tomorrow.
Thankfully, I have greater confidence in the ability of plan sponsors, regulators, and other industry professionals to make progress on this than I do in my own ability to “crack the code” on my wife’s holiday gift next year.
To read the full commentary, click here.
- All investing is subject to risk, including the possible loss of the money you invest. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Past performance is no guarantee of future returns.
- Investments in Target Retirement Funds are subject to the risks of their underlying funds. The year in the fund name refers to the approximate year (the target date) when an investor in the fund would retire and leave the workforce. The fund will gradually shift its emphasis from more aggressive investments to more conservative ones based on its target date. An investment in a Target Retirement Fund is not guaranteed at any time, including on or after the target date.