The Real Deal: Impact of Investments on Retirement Income Adequacy

Aon’s The Real Deal: 2018 Retirement Income Adequacy at U.S. Plan Sponsors study examines retirement readiness among employees at U.S. companies. This whitepaper examines the impact of investments on retirement income adequacy. For more information, download the whitepaper above.

Examining Retirement Readiness

Aon’s The Real Deal: 2018 Retirement Income Adequacy at U.S. Plan Sponsors study examines retirement readiness among employees at U.S. companies. Over a full career, the average worker needs to accumulate retirement assets worth about 11.1 times their final pay in order to retire at age 67 and meet their expected post-retirement income needs. While the actual level of retirement needs will vary from worker to worker, the study shows that only 1 out of 5 workers (19%) is projected to meet or exceed their needs at retirement, while another 15% are close to meeting their anticipated needs. Most workers are projected to fall short, and will likely need to save more, delay retirement, adjust their standard of living, utilize non-retirement assets or some combination of the two.

Today, the majority of private-sector employer sponsored retirement assets are in defined contribution plans.¹ Many workers don’t have access to traditional pension benefits: employees with only DC benefits from their employer made up 77% of the employees represented in The Real Deal.²

The biggest driver of retirement readiness for such workers is the level of contributions, but once those contributions go into the plan, investment return on those contributions plays a significant role. The average employee without a pension benefit would need to save about 16% of pay per year (between employee and employer contributions), starting at age 25, in order to accumulate resources of 11.1 times final pay. Of that 11.1 times final pay, 3.6 comes from projected contributions, and 7.5 comes from compound returns—about two thirds the value.

Even with 16% annual contributions, poor investment performance can significantly hurt retirement readiness. A 1% reduction in the annual rate of return would lead to resources of 8.9 times final pay, falling somewhat below expected needs. A 2% reduction in return would lead to resources of 7.3 times final pay, a significant decline that would likely require major lifestyle changes in retirement.³ As the retirement plan landscape continues to shift from defined benefit to defined contribution plans, investment performance becomes an even bigger concern for workers.

Asset Allocation

Asset allocation—the choice of asset classes, such as equities or fixed income—is a very important driver of returns in an investment portfolio. However, asset allocation is not always an easy task for the average investor: what’s the “right” allocation to stocks versus bonds?

An overly conservative portfolio of bonds and cash may provide security and predictability but will likely fail to bridge the shortfall between contributions and retirement needs. On the other hand, an overly aggressive portfolio of stocks might have a higher expected return but expose the participant to the risk of a major market downturn. The example to the right shows the middle-of-the road expected career outcome (50th percentile) and the 1-in-20 downside career outcome (5th percentile) for three portfolios: all equities, all fixed income, and a balanced portfolio of 60% equities
and 40% fixed income. The balanced portfolio is expected to meet retirement needs under the
expected scenario, while still outperforming the other portfolios under the downside scenario, due to the benefits of diversification.⁴

When it comes to selecting an appropriate asset allocation, we believe most workers could benefit from professional assistance. Products like target date funds (TDFs) help workers by choosing a portfolio for them, adjusting the characteristics over time. Target date funds generally transition
from a high-growth strategy to a lower-risk strategy as a worker’s time horizon for investment declines, and the need for long-term growth evolves into a need for shorter-term security.

Investor Behavior

Participants in a defined contribution plan are subject to the biases and behaviors of all investors. Numerous firms have documented the impact of investor behavior on returns. Dalbar, a financial services firm, publishes an annual study showing the difference in average investor return and index return. In 2016, their research showed that, while the S&P 500 earned an average annualized return of 7.68% per year over 20 years, the average equity fund investor only earned 4.79% per year, for an annualized shortfall of 2.89%.⁵ Wherever it comes from, any drag on potential investment performance can hurt retirement readiness.

A variety of investor behaviors can lead to a drag on investment performance, including:

• Chasing returns: Investors frequently move money out of funds that performed poorly into funds that recently performed well, exposing them to reversals and market corrections.
• False diversification:⁶ Many investors fail to see that different investment options in their portfolio may be highly correlated. Some investors will put an equal share of their funds into each option in their menu, thinking that they are diversified, when in fact their money is concentrated in one market or sector.
• Overconfidence: Some investors overvalue their experience, information, and individual skill, and make imprudent allocation and transaction decisions as a result.

Plan design can play a role in participant investment outcomes. Many common program design decisions can exacerbate the problem, including:

• Choice proliferation: Complex program designs can overwhelm employees, which can contribute to reduced participation. Furthermore, investment menus that offer numerous similar options can contribute to false diversification by plan participants.
• Lack of diversification:⁶ While most defined contribution plans offer a plethora of equity options, fewer plans offer true diversifiers, such as direct real estate (as a component of a core fund or target date fund).
• High fees: Many defined contribution plans have high asset management fees due to the selection of high-cost active managers or poor economies of scale.

All investors are subject to behavior-related drag, even the professionals, but average workers without professional experience or expertise are especially susceptible. Plan sponsors can help mitigate these sources of drag through program design, investment menu selection, and participant communication.

Population Dynamics

When making decisions about a defined contribution plan investment program, it’s important to understand who the employees are. Are they financially savvy? Do they like to have the freedom to make decisions, or do they prefer predefined solutions? What levels of benefits do they have, and how exposed are they to market risk?

Target date funds are great tools for helping plan participants with asset allocations, but not all target date funds are alike. In their 2013 publication, Target Date Retirement Funds - Tips for ERISA Fiduciaries, the Department of Labor outlined some considerations for selecting TDFs. Key considerations included establishing processes for comparing and periodically reviewing TDFs, understanding the underlying asset allocations, and considering custom or non-proprietary TDFs.

Most off-the-shelf proprietary TDFs are aimed at an average population, but a population that is
sufficiently different from average may merit a TDF that reflects its unique characteristics. For example, populations with higher-than-average levels of pension benefits (e.g., government, utilities, education sectors) already have a built-in allocation to low risk “assets” in the form of defined benefit plans. Such populations would benefit from having a higher allocation to return-seeking assets (like equities) in the defined contribution plan.

Otherwise, they may be too conservatively invested, and defined contribution accumulations might not be enough to close the gap between resources and needs. Conversely, populations without pension benefits should consider compensating for the lack of low-risk pension benefits by having more low-risk assets (like fixed income) in the defined contribution plan. A plan demographic analysis can help identify these factors when selecting an off-the-shelf TDF, or when choosing to customize.

A retirement adequacy study can also help determine which employee groups need more assistance. A study of projected retirement needs and resources can identify those employee groups that are saving less, that are invested too aggressively or conservatively, and that are
participating in the plan at different rates, and connect these to other characteristics like age, service, pay level, job category, and location. This can provide invaluable data for making plan design changes, supporting investment menu selection, and directing participant communication campaigns aimed at improving financial wellbeing. To paraphrase Lord Kelvin, if you can’t measure it, you can’t improve it—and a retirement adequacy study can be a valuable first step toward truly understanding and improving employees’ retirement readiness.

Conclusion

Improving retirement readiness for workers may seem like a daunting process, but it can be made tractable by following a few key steps:

1. Get to know your employee population. Reports from the plan recordkeeper and investment advisor can help identify participant circumstances and behaviors that are impacting retirement readiness. A retirement adequacy study can put it all together, showing which employee groups may need the most help.
2. Consider solutions that address the key challenges. There are many tools in the plan management toolkit, including plan design, investment selection, and participant communications. Many investment-oriented solutions, such as simplifying the menu, reviewing the default investment option, and managing fees, can help to improve participant outcomes without affecting employer costs. 
3. Implement changes and monitor results. Put the solutions into practice and review the performance of the program periodically to ensure that participant outcomes are moving in the right direction, course-correcting when needed.

The transition from defined benefit plans to defined contribution plans has transformed the nature of retirement risk for employees and employers, bringing individual investment performance to the forefront. This gives plan sponsors and plan participants the opportunity— and responsibility—to make informed investment program decisions, with the ultimate goal of ensuring a secure retirement for workers.

^{1 Source: Investment Company Institute, Retirement Assets Total $27.1 Trillion in Fourth Quarter 2018}

^{2, 3 Source: Aon, The Real Deal: 2018 Retirement Income Adequacy at U.S. Plan Sponsors}

^{4 Diversification does not ensure a profit nor does it protect against loss of principal. Diversification among investment options and asset classes may help to reduce overall volatility.}

^{Source: Aon simulated performance; period for the top exhibit is the full career, and the period for the exhibit labeled “potential 1-year downside return” is one year. The hypothetical performance calculations are shown for illustrative purposes only and are not meant to be representative of actual results. The hypothetical performance calculations for the respective strategies gross of fees. If fees were included returns would be lower. Hypothetical performance returns reflect the reinvestment of all dividends. The hypothetical performance period is one year. The hypothetical performance results have certain inherent limitations. Unlike an actual performance record, they do not reflect actual trading, liquidity constraints, fees and other costs. Also, since the trades have not actually been executed, the results may have under-or- over compensated for the impact of certain market factors such as lack of liquidity. Simulated trading programs in general are also subject to the fact that they are designed with the benefit of hindsight. These hypothetical performance results do not take into consideration the ongoing implementation of the manager’s proprietary investment strategies. No representation is being made that any portfolio will or is likelyto achieve profits or losses similar to those shown. Returns will fluctuate and an investment upon redemption may be
worth more or less than its original value.}

^{5 Source: Dalbar 2017: Investors Suck At Investing & Tips For Advisors, Seeking Alpha, September 26th}

^{6 Diversification does not ensure a profit nor does it protect against loss of principal. Diversification among investment options and asset classes may help to reduce overall volatility.}

^{7 Source: Aon, The Real Deal: 2018 Retirement Income Adequacy at U.S. Plan Sponsors}

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