Going long: Should the DC industry reconsider participants' bond portfolios?
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By: Daniel Gardner, Defined Contribution Analyst MARCH 2011
Going long: Should the DC
industry reconsider participants’
bond portfolios?
Issue: In recent years, the defined contribution (DC) retirement plan industry has
begun to focus on lifetime income, as opposed to lump-sum distributions, for
participants. In light of this trend, should we reconsider the composition of Long bonds can
participants’ bond portfolios? help “bridge the
gap” between a nest
Response: Yes. If the switch to retirement income provision is real, increasing egg and lifetime
participants’ bond duration would target the objective better than the standard income solutions.
intermediate-duration bond portfolio does.
In particular, long bonds are better than shorter-term bonds at hedging retirement
income needs. We’ve used a fixed life annuity as a proxy for this need. It makes
sense for retirees to increase their bond durations as well. We’ve built simplified
models to help illustrate these results.
It will take time for the DC community to change its focus from wealth accumulation
to retirement income provision and to realize the implications of this change – one
being that long bonds can help “bridge the gap” between a nest egg and lifetime
income solutions. Meanwhile, we present our case here, with the hope that we can
help nudge the status quo.
Background
Providing for an income stream in retirement, in contrast to accumulating wealth for
retirement, is rightfully becoming the primary goal of the U.S. defined contribution (DC)
industry. Altering the composition of participants’ fixed income portfolios to better align
with this objective can increase the likelihood of success. By use of a simplified model,
Russell Investments // Going long: Should the DC industry reconsider participants’ bond portfolios?below, we demonstrate that careful consideration of bond duration could have a significantly positive impact on retirement outcomes. We’ll discuss the potential benefits of, as well as the barriers to, overhauling participant bond portfolios. Interest in lifetime income solutions is growing Unfortunately, DC plans have not evolved to replicate the retirement income-generating qualities of the defined benefit (DB) plans they replaced. Contribution rates are frequently too low, and workers have struggled to build investment strategies appropriate for generating adequate retirement income. According to the Employee Benefit Research Institute's Retirement Readiness Rating (RRR), 47.2% of “early boomers” and 43.7% of “late boomers” may not be able to cover basic expenditures and pay for uninsured health care costs in retirement.1 Fortunately, the government has recognized the problem. In February 2010, the Labor and Treasury departments issued a joint request for information on lifetime income and received nearly 800 responses. Russell participated in the hearing that followed, in September 2010.2 Meanwhile, retirement income products are proliferating. Many insurance companies have developed offerings for both the retail and institutional markets that give investors exposure not only to stocks and bonds, but also to diversified products designed to guarantee an income stream in retirement. Asset managers are getting into the retirement income space with distribution-oriented funds and, to a lesser extent, guaranteed products. For the right person, at the right time, an annuity purchase can increase retirement security in a big way The main tools for building the new guaranteed income solutions are annuities. In this paper, our discussion is based on the belief that annuities, in the right context, can improve retirement security. For decades, life annuities have provided retirees with arguably the best “bang for the buck” in terms of retirement income. For example, they offer retirees a higher level of income and/or a lower probability of running out of money than a systematic drawdown plan does. (See the table below, where we present “probability of sustainability” and annual income figures for a few types of drawdown strategies for a 65-year-old male with a nest egg of $500,000. The annuity income figures are derived from recently estimated quotes.3) 1 Employee Benefit Research Institute, “The EBRI Retirement Readiness Rating: Retirement Income Preparation and Future Prospects,” July 15, 2010. Available at http://www.ilretirementsecurity.org/reports?id=0027. 2 For more information, see Cohen, Collie and Gardner, “Russell’s beliefs on retirement income disclosure,” October 2010. Available at http://www.russell.com/institutional/research_commentary/PDF/Retirement_income_disclosure.pdf. 3 Estimated quote for a single life annuity, obtained at http://www.newretirement.com/services/annuity_calculator.aspx; accessed 9 February 2011. Russell Investments // Going long: Should the DC industry reconsider participants’ bond portfolios? / p2
Exhibit 1 / Comparison of basic retirement nest egg drawdown policies
Initial annual Probability of
Drawdown policy Asset allocation
income sustaining4
4% of starting nest egg, 3% annual 40% U.S. equity, $20,000 76.8%
step-up 60% U.S. bonds
5% of starting nest egg, 3% annual 40% U.S. equity, $25,000 47.8%
step-up 60% U.S. bonds
Immediate fixed life annuity, 3% N/A $27,204 Near 100%
annual step-up
Sources: Russell Investments and newretirement.com.
While life annuities do provide for more certain income than a systematic withdrawal
approach does, we recognize that they aren’t for everyone. Some examples:
Retirees in poor health should avoid them.
Those with hardly any savings should keep what they have for emergency
expenses.
Wealthy or frugal retirees who expect to spend a very small portion of their wealth
each year don’t need annuities.
But for everyone else, annuities should not be immediately dismissed as a source of
retirement income.
Of those retirees who could benefit from an annuity, many don’t like to make the liquidity
sacrifices associated with purchasing one. Allocating all of one’s nest egg to an
immediate life annuity can be a bit of a gamble. If our hypothetical 65-year-old, with a
$500,000 nest egg, follows one of the drawdown policies listed above he doesn’t face
much risk of running out of money in the near term. Why should he buy an annuity and
expose his estate to the risk of forfeiting his nest egg if he dies at age 70?
Here, there’s a good argument to be made for purchasing a deferred life annuity, or
longevity insurance. At a recent industry conference, my colleague Don Ezra described
the value of allocating a portion of one’s retirement nest egg to a systematic drawdown
approach and the other portion to longevity insurance. It makes sense for retirees to
insure an income for the latter years of retirement, because the value of the protection
an annuity provides increases with age (i.e., the mortality credits become larger).5 At the
4
This is the probability of being able to follow the drawdown policy for 20 years and then buy an annuity to
provide the same income level for life. (See the appendix for capital market assumptions.) We think most
retirees don’t have much use for a metric that shows their probability of running out of money, because it
represents a completely undesirable outcome. Knowing the probability of being able to sustain an income
should be more relevant to their goals.
5
For example, imagine a group of 10 retirees, each of whom has a 10% risk of dying this year. They get
together and put $1,000 each into a single bank account that pays 5% interest annually. They agree to divide
the account balance equally among those still alive after 1 year. If at the end of the year 1 of the 10 has indeed
died, that means the other 9 would split $10,500. This amounts to $1,167 each – or a 17% return on investment.
Russell Investments // Going long: Should the DC industry reconsider participants’ bond portfolios? / p3mere cost of 10%–15% of an immediate life annuity, a retiree could buy longevity
insurance where payouts would kick in around age 85.6
Life annuities as a proxy for retirement income needs
There are several inputs to a calculation of the nest egg needed to fund one’s retirement
standard of living: cash flow (how much will I need each year?); time (how many years
until I retire?); mortality (how likely am I to reach age 85, 90 or 95?); and the discount
factor (what interest rate[s] should be applied to the cash flows? Should I use different
interest rates for short-term and long-term cash flows?). Here are some reasonable
assumptions we could make about the inputs to the nest-egg calculation.
Number of years until retirement: While this is a crucial decision, it’s not a
complicated one: retire earlier, and you’ll need more money; retire later, and you’ll
need less money. It may be worth plugging in multiple retirement ages to see which
are realistic.
Annual cash flow needed: This will be the final pre-retirement salary less Social
Security benefits and any other income derived from sources aside from the
retirement account. Its calculation takes into account the tax savings that may
accrue from moving into a lower tax bracket, from not paying into Social Security
and Medicare, and, of course, not having to save for retirement. For a typical retiree,
we expect this amount to be about 42% of final salary.7 If we want to include a
periodic step-up to meet inflation expectations, the needed cash flow will be a little
bit higher each year, and the cost of funding the cash flows will increase.
Expected mortality: This can be estimated by use of mortality tables for individual
annuitants. We’ll assume our retirement saver will survive to age 65, and then we’ll
use the mortality rates for age 65 and beyond to calculate the likelihood of survival
to any specific post-retirement age.8
Discount factor/interest rates: Interest rates can be modeled by choosing the
appropriate term rate on a spot curve. Values shown in this paper are based on a
spot curve for AA-rated corporate bonds. Using a market rate, as opposed to a
Treasury rate, is appropriate in this case, because we think retirement plan
participants should consider eventually buying an annuity. This rate better
represents the credit rating of an annuity provider.
It turns out that the retirement income need can be priced like a fixed life annuity that
begins payments at retirement.9 This annuity pays out a predetermined amount in each
of the annuitant’s remaining years. On average, it will pay out in line with the mortality
experience of all annuitants. Further, the discount rate used to price annuities is based
on an entire spot/zero-coupon interest rate curve. Anyone looking to calculate the
Similarly, if the risk of death is 20%, those alive at the end of the year could expect to see a 31% return on
investment if any other(s) among the retirees did not survive. Clearly, the higher one’s risk of dying (i.e., the
older one is), the more attractive mortality credits become.
6
Note that the relative likelihood of the retiree’s being around to collect that initial age-85 payment is factored
into the price of longevity insurance, so purchasing a deferred annuity now is cheaper than delaying until later in
retirement.
7
See the Aon Consulting/Georgia State University “Replacement Ratio Study: A Measurement Tool for
Retirement Planning,” Aon Consulting (2008), p. 2. The 42% replacement rate corresponds to a pre-retirement
income of $90,000. For someone who makes less than $90,000, the targeted replacement rate would be slightly
lower.
8
Why? Because if you die before you retire, you won’t need your retirement savings.
9
This is a reasonable assumption for essential and desired lifestyle expenses. However, medical expenses can
be unpredictable. To protect against these expenses, keep a “rainy day fund” for emergencies and consider
purchasing a long-term-care insurance policy.
Russell Investments // Going long: Should the DC industry reconsider participants’ bond portfolios? / p4present value of their retirement nest egg should use interest rates that correspond to
the number of years until the retirement cash flows are needed.
Longer bonds are better than short-term bonds for hedging the retirement
income need
A 25- to 30-year-old worker saving for retirement at age 65 or later ideally won’t be (or
shouldn’t be!) drawing funds out of the plan for quite some time. Given that relatively
long horizon, the annuity price that represents the retirement income need (described
earlier) is very sensitive to small changes in interest rates.
Here’s a simplified example:
At a 5% interest rate, an investment presently valued at $7,102 will have
increased to $50,000 40 years from now. But at a 5.5% interest rate, a lesser
present value – $5,873 – would be needed to realize $50,000 40 years from
now.
Since small changes in interest rates can have such a big impact on the value of
retirement income, it makes sense to somehow hedge the impact of those changes. An In the context of
appropriate hedge would need to be equally sensitive to interest rate changes. Long
duration bonds fit this description.10 In the context of funding retirement expenses, long funding retirement
bonds behave more like a risk-free asset, as seen below. On the left, we have a typical expenses, long
short-term risk and return chart. On the right, we plot the same chart, but with risk and
return relative to the retirement income need (represented by a life annuity).
bonds behave more
like a risk-free asset
Exhibit 2 / For future retirement income needs, long bonds can be a low-
risk asset
above life annuity return
Expected surplus return
Expected return
Equity
Long bond
Intermediate bond
Cash Equity
Surplus volatility
Long bond
relative to life annuity
Life Annuity Intermediate bond
Volatility
Cash
Source: Russell Investments. For illustrative purposes only.
Please note that we aren’t advocating for long bonds as a stand-alone option in a DC
plan. Rather, they should be incorporated into a holistic retirement income-focused
strategy, such as a target date fund or managed account. In fact, we argue that DC
participants can improve their retirement outcomes by holding bond portfolios with
10
In other words, long-term interest rates and annuity rates are highly correlated. Plan sponsors with a DB plan
should be familiar with this notion – it is at the root of liability-driven investing programs.
Russell Investments // Going long: Should the DC industry reconsider participants’ bond portfolios? / p5durations and credit ratings that align with the goal of funding retirement income through annuity purchase.11 We realize readers may not agree with this goal. We have two responses. First, as we’ve discussed, annuities provide an easily quantifiable answer to the question of “how much wealth does an investor need to provide adequate retirement income?” Further, the bond portfolio change we’re arguing for is robust with regard to retirement income approach – the argument holds just as well for a long-lived systematic withdrawal plan as with an annuity since both have long durations. How long should the bonds be? Very long Our research shows that the average “duration” of the retirement income need described earlier, including mortality rates by age, will be about 8.4 years at retirement. In other words, the weighted average time until cash flows are disbursed for a fixed immediate life annuity for a 65-year-old male will be about 8.4 years.12 Similarly, if we assume that all plan participants survive to retirement, the duration of the annuity for a 25-year-old will be about 48.4 years.13 Since none of the cash flows occur until retirement, we can simply add 40 years to our initial 8.4-year duration calculation. How does this insight apply to the participant’s bond portfolio? The duration of the ideal long bond depends primarily on the remaining time to retirement and on the nature of the participant’s future stream of savings, or “human capital.”14 Since human capital provides a steady return over many years, it acts like a bond. So, we want the combination of human capital and the bond portfolio to have a duration in line with the retirement income need. Yet the bond-like cash flows from human capital fall short of the ideal duration, as they all come prior to retirement. To compensate, a participant’s (especially a young participant’s) bond portfolio, which could be much smaller than the stream of future savings, would need to be of very long duration – potentially hundreds of years. We’ve included an explanation of this concept in the Appendix. (Keep in mind that the duration in the early years is highly skewed by the combination of low financial wealth and a low bond allocation.) Nonetheless, we clearly don’t expect any investor, much less a DC participant, to implement a portfolio with a bond duration hundreds of years long. We recognize that, for practical purposes, a DC participant cannot hold a bond portfolio longer than 10 to 15 years in duration. Even with this constraint, participants can improve their retirement income outlook by taking a small step: increasing the duration of the bond portfolio to a maximum of about 15 years during the accumulation phase. 11 Note that this is not an implementable strategy, but rather a simple model – duration is only one measure of interest rate sensitivity. However, it’s the most significant measure, and it’s fairly simple to model, which is good enough for this paper. 12 The weighting is according to the present value of future cash flows – in other words, the Macaulay duration. If we include an annual step-up adjustment of 2.5% to account for inflation, the duration is a bit higher (9.4 years). 13 There are two small adjustments from 48.4 to consider. One is the possibility that significant mortality improvements will occur over the 40 years until retirement, which would increase the duration slightly. The other is the term structure of interest rates. A 25-year-old attempting to hedge a 40-year deferred fixed annuity will likely face a higher discount rate than a 60-year-old attempting to hedge a 5-year deferred fixed annuity. 14 Per Morningstar: “Financial capital is defined as an investor’s current savings, such as money already saved in a retirement account. Human capital is an investor’s future potential savings, and is often the single largest asset an investor has.” http://corporate.morningstar.com/us/asp/subject.aspx?xmlfile=174.xml&filter=PR4233. Russell Investments // Going long: Should the DC industry reconsider participants’ bond portfolios? / p6
Even a small change is beneficial
In a retirement income framework, the primary goal of a DC plan should ASSUMPTIONS FOR MONTE CARLO
be for participants to afford an adequate retirement standard of living. SIMULATION
We will set up a simple Monte Carlo simulation to determine if use of Age to begin contributions: 25
long bonds can help participants achieve this goal. Specifically, we will
examine two types of zero-coupon bonds.15 They are: Retirement age: 65
1. A constant 4-year duration AA-rated bond. This bond represents the Rate of real salary growth: 1.5%.
intermediate bond portfolios used in most diversified DC investment Inflation is modeled
products. stochastically, so the nominal
rate of real salary growth is
2. A AA-rated bond that has a constant 15-year duration until a few variable, and hence the amount
years before retirement, when duration gradually decreases to our contributed each year varies.
aforementioned 8.4 years at retirement. This is to model a bond
portfolio that provides some hedging benefit and could realistically Initial portfolio balance: $0.
be implemented in a DC plan. Contribution rate: Start at 6%
In our simulation, it turns out that even the 15-year duration bond, which and gradually increase to around
does not come close to being an optimal hedge, can nonetheless bolster 12%, including company
participants’ chances of obtaining an adequate retirement income matches. This is a typical
stream. contribution schedule for “well-
behaved” participants
The assumptions we use in our simulation are similar to those Russell (unfortunately, even these
uses to optimize target date fund glide paths, with the goal of purchasing participants likely don’t save
a fixed life annuity at retirement that replaces 42% of final salary. (For a enough).
list of assumptions, see the sidebar on this page.)
No loans or hardship withdrawals
We model 24 hypothetical participants. Half of them invest in the 4-year from the plan. Again, we strive to
bond, and the other half in the 15-year bond. Within each group, all model how a “well-behaved”
participants invest in portfolios of U.S. equity and the bond for 40 years. participant might invest.
Eleven of the participants in each group hold static balanced funds (with
varying stock/bond mixes), and the twelfth participant holds a fund that Initial starting salary: $50,000
uses the generic Russell target date glide path. Afterward, we evaluate (although assuming a different
what percentage of final pre-retirement salary a participant can achieve salary would have no qualitative
from an annuity purchase. impact on the final result).
We generate 5,000 different outcomes for the participants using a set of Investment policy: the participant
capital markets scenarios, including annual bond returns from scenarios invests in either a balanced fund
for the AA spot curve. With that data, we calculate, for each participant: or the generic Russell glide path
strategy, starting at 90% equity
Reward – the median replacement rate (typically, how much of and 10% bonds and ending at
final salary can be replaced by purchasing the annuity) 32% equity and 68% bonds.
Risk – the 5th percentile replacement rate outcome, an intuitive
measure of the downside associated with each approach.
15
We use zeros to isolate the duration component of these bonds. Treasury STRIPS (Separate Trading of
Registered Interest and Principal Securities), are the primary zero-coupon security available in the U.S.
Russell Investments // Going long: Should the DC industry reconsider participants’ bond portfolios? / p7Here is a graph depicting our results.
Exhibit 3 / Reasonable duration lengthening can improve outcomes
60%
Median age 65+ replacement rate (% final salary)
Target Date 100%
Equity
strategies
55%
50%
45%
40%
35%
22% 21% 20% 19% 18% 17% 16%
5th percentile age 65+ replacement rate (% final salary)
ShortBond_Bal ShortBond_TD LongBond_Bal LongBond_TD
Source: Russell Investments. Hypothetical analysis using assumptions outlined in this paper.
There’s a lot to digest here, but we’ll walk through it.
First, focus on the light-blue curve. The upper-right point on the curve represents
100% equity and 0% bonds static asset allocation. The next point down the curve
represents 90% equity and 10% bonds. This pattern continues down to the lower-right
point on the curve, which represents 0% equity and 100% bonds.
Next, focus on the large blue diamond. It represents a generic target date strategy
using equities and bonds with Russell’s glide path. This strategy is less risky than the
lowest-risk balanced strategy, and yet it provides significantly higher upside. This
provides a great illustration of the benefits of a target date fund. Despite the bad publicity
they’ve received lately, target date funds remain a quality default option for participants,
particularly relative to static balanced funds.
Next, focus on the grey curve and the large brown diamond. This curve uses the
same asset allocations as the light-blue curve, and it represents what may be obtained
through the aforementioned long bond strategy. For each static asset allocation, a
participant who uses these long bonds instead of constant 4-year duration bonds can
expect a better standard of living in retirement.16
16
Although we do not present results here, long bonds provide a similar benefit when hedging an indexed
annuity (e.g., cash flow increases by 2% each year). For truly inflation-protected annuities, a real-return long
bond may be a better hedge than our nominal long bond.
Russell Investments // Going long: Should the DC industry reconsider participants’ bond portfolios? / p8Now, let’s look at the two target date outcomes. The “long bond” participant achieves
slightly higher median income replacement (53.0% vs. 50.4%) with lower risk (21.9%
replacement, vs. 20.1% replacement in the bad case). That’s an 8.9% improvement in
the bad case outcome and a 5.4% improvement in the median outcome. Further, the
probability of a successful outcome improves by 5.9% (65.2% vs. 61.6%), and the
“shortfall function” decreases by about 11.3% (8.1% shortfall vs. 9.1%).17
If we relax the bond duration cap from 15 years to 30 years, gains can be even greater.
If we perform the same “percent improvement over short-term bond” calculation, but with
a 30-year instead of a 15-year cap on duration, the improvement is 11.3% in the bad
case outcome and 7.1% in the median outcome. Likewise, the probability of success
improves by 7.5% and the shortfall function decreases by 14.9%.
Simulation discussion
In addition to the results, there are two key simulation takeaways for readers:
1. The long bond strategy does not require an annuity purchase at retirement to
be effective. Since our strategy seeks to hedge retirement income needs at all
times, a participant could stay in the strategy during retirement. The next section will
describe how the long bond strategy might look for a retiree.
2. Bond duration, not a term premium, drives the improved outcome. A
reasonable reader, skeptical of the results, could ask, “Aren’t you just getting
Duration extension
compensated for taking on increased term risk? A 15-year bond has higher is not a gimmick; it
expected return than a 4-year bond.” In response, we set up a simulation where we
really does hedge
“flattened” the yield curve, so that any difference in outcomes between the 4-year
and 15-year bond strategies would be based on duration.18 In all the metrics the retirement
mentioned earlier, the long bond strategy still provided better outcomes than the income objective.
short bond strategy did. For example, the 5th percentile income replacement metric
for the target date strategy with long bonds fell from 21.9% to 21.1%. Yet it was still
higher than the 20.1% outcome for the short bond strategy. Duration extension is
not a gimmick; it really does hedge the retirement income objective.
It works in retirement, too
The results described above hold for a retiree. While the goal during the accumulation
phase was to purchase an annuity to replace as much income as possible, we realize
that most participants don’t buy an annuity. Instead, we’ll model the retiree’s situation by
using a common retirement rule of thumb: the retiree makes annual withdrawals of 4% of
the initial age-65 portfolio balance, plus an annual 2.5% step-up adjustment to combat
inflation. After 20 years, the retiree takes all remaining wealth and purchases an
immediate life annuity. The goal is to replace 100% of the final account withdrawal. If the
money runs out before 20 years are up, we assume the retiree borrows to meet
expenses. This way, our 5th percentile risk measure will show a “worse bad case”
outcome if the retiree runs out of money earlier on.
17
This shortfall metric translates to “if the participant does not meet the goal, by what amount would we expect
her to fall short?” If she never saves at all, this number will be 42% – the targeted income replacement goal. So,
this metric will always fall between 0% and 42%. (We think this is actually a better, more holistic way to measure
retirement risk than the 5th percentile outcome. In fact, we optimize our off-the-shelf glide path on the basis of a
similar risk metric. However, we feature the 5th percentile outcome here because it’s more intuitive.)
18
We found the average return of the 4 year bond across all scenarios was about 4.9%, while the average
return of the 15-year bond was about 5.4%. So we re-simulated the long bond strategy, but knocked 0.5% off
the bond return each year.
Russell Investments // Going long: Should the DC industry reconsider participants’ bond portfolios? / p9We use two bonds in the simulated portfolios: the 4-year bond described earlier, and a
longer, duration-matching bond. The duration of the latter corresponds to the duration of
the remaining disbursements until age 85 and the cost of the age-85 life annuity, not to
the total retirement disbursements. On average, the duration is 9.8 years at age 65,19 6.7
years at age 75 and 4.3 years at age 85.
Here are the results:
Exhibit 4 / Attention to duration pays in retirement, too
400%
100%
Equity
350%
Median age 85+ replacement rate
(% final withdrawal)
300%
40/60
Allocations
250%
200%
150%
80% 60% 40% 20% 0% -20% -40% -60% -80%
5th percentile age 85+ replacement rate (% final withdrawal)
ShortBonds_Bal LongBonds_Bal
Source: Russell Investments. Hypothetical analysis using assumptions outlined in this paper.
For a moderate 40% equity and 60% bond strategy, the matching strategy increases the
median replacement rate by about 3.3% and the bad case replacement rate by about
16.5% as compared to the 4-year bond strategy.
Notice that it’s important to have a conservative asset allocation in retirement, but with
some equity exposure. With an allocation to equities of 60% or greater, there’s a very
real chance of running out of money in 20 years – as you can see, the 5th percentile
outcome at age 85 was around $0 (or less) remaining in these cases. In retirement,
particularly the early years, one or two years of bad returns can make funding the later
years a long shot. Russell has written about this in many previous papers.20 On the other
hand, holding an equity allocation of less than 20% or so may feel safe, but by our
measure of risk it may be less safe than some more aggressive strategies.
19
This is different than the 8.4-year duration mentioned in the previous section. Why? In this case, we assume
certain payments until age 85, whereas earlier, these payments were discounted based on average life
expectancy assumptions.
20
I recommend “The date debate: Should target date fund glide paths be managed “to” or “through” retirement?”
by Josh Cohen, Yuan-An Fan, and Grant Gardner, April 2010.
Russell Investments // Going long: Should the DC industry reconsider participants’ bond portfolios? / p 10Long bonds as a bridge to fixed annuity products
Right now, many plan sponsors are interested in learning how to incorporate retirement
income options, including products with annuities, into their plans. Yet they’re
discouraged by operational complexities and a dearth of regulatory safe harbor
provisions.
Rather than deal with complex products and fiduciary concerns, we suggest that these
sponsors consider using long bonds as a bridge to annuity solutions. In other words,
sponsors could implement a long bond program now with the intention of adding an in-
plan annuity or out-of-plan rollover option later. Used appropriately, long bonds can
approximately track the price movements of fixed annuities, preparing participants for an
eventual annuity purchase. There are other reasons to consider long bonds:
Long bonds are less complex than fixed annuities. DC plans live in a world of
daily liquidity and valuation. It’s not clear that fixed annuities are adaptable to this
environment. How will record keepers, insurance providers and plan sponsors all
get on the same page? How often could the annuities be traded? And what happens
if a participant changes jobs, or if the sponsor wants to replace the annuity provider
or product?
Long bonds are more liquid than fixed annuities. A participant should not lock a
big amount of her nest egg into an annuity without careful prior consideration,
because the decision is often irreversible. A deferred fixed annuity can lock in a Why do typical
significant portion of her nest egg at an early point in her career. To get it out, there portfolios have such
may be a high surrender fee. Long bonds can track the price movements of these
annuities without these concerns. short durations?
Long bonds may incur less fiduciary liability than fixed annuities. Another
The simple answer
common barrier to including fixed annuities in a plan is the fear that the annuity may be that we’ve
provider will experience financial hardship, or worse, go out of business. While never thought about
unlikely, the consequences could devastate participants’ retirement adequacy and
provoke litigation. In general, plan sponsors appear hesitant to adopt such products it.
in the absence of regulatory safe harbor provisions. In contrast, a well-diversified
bond portfolio puts the participants’ nest eggs into many baskets. Nonetheless, a
good way for plan sponsors to avert costly legal battles is to always document in
detail the processes they followed in reaching their decisions.
Top 5 obstacles to implementing longer bond portfolios
It’s clear that careful consideration of bond duration can benefit both DC participants and
retirees. However, we found that 15 top target date fund families hold a “moderate”-
duration fixed income portfolio, which roughly corresponds to a duration of 3 to 6 years21
Why do typical portfolios have such short durations? The simple answer may be that
we’ve never thought about it – we are stuck in old ways of thinking that are not
consistent with funding retirement income. Specifically, DC plans still focus
predominantly on assets, not on future spending needs. This may be due to the lump-
sum-distribution nature of DC plans.
21
Source: Morningstar
Russell Investments // Going long: Should the DC industry reconsider participants’ bond portfolios? / p 11WHAT ARE SOME KEY BARRIERS TO OVERCOME IN IMPLEMENTING LONG BOND
STRATEGIES IN PLANS?
Here are our top 5, in descending order of significance:
1. We want to stabilize wealth, not income. Having stable retirement income is not
our sole concern. We also value stability of wealth, and we want to avoid having to
work longer to make up for any financial losses. Holding short-duration bonds, which
are much less volatile than long bonds, would increase the stability of wealth near
retirement. On the basis of our simplified model, we found that using long bonds in a
target date strategy added about 2% to 3% incremental annualized volatility at
retirement, as compared to using an aggregate bond strategy. Yet if the plan’s
objective is to provide retirement income, long bonds are better than short-term
bonds at hedging this objective. This brings us to the next point…
2. We can’t make a rational choice between wealth and consumption. Behavioral
biases stop us from making a decision that could be in our best interests. Research
from Mathew Greenwald & Associates, Inc., indicates that retirees are hyper-
focused on the present, have a strong preference to maintain principal and have a
high need for liquidity.22 These preferences may be inconsistent with the goal of
funding a retirement income stream. Again, this leads to our next point…
3. We don’t like annuities, so there’s no point in hedging an annuity purchase.
Annuities have a mediocre reputation in this country, for reasons such as the retiree
preferences mentioned above. But the beauty of this strategy is that one need not
annuitize upon retirement for it to be effective. The change we’re arguing for could
apply to either an annuity or systematic withdrawal approach.
4. Practical/product-development issues. The long bond strategy we describe in
previous sections is based on a very simple model. DC asset managers would need
to develop a portfolio that more robustly replicates the bond portfolio held by a fixed
annuity provider. Really-long-duration instruments are not readily available, but
managers can construct these with bond futures. In addition, the strategy could
require consistent duration adjustment, particularly in the years immediately prior to
retirement. This presents a significant implementation problem for a static balanced
fund. Target date funds, however, with their dynamic asset allocation strategies, are
well equipped to implement the strategy.
5. Tactical concerns. Strategically, the long bond portfolio makes sense, but
tactically, it may not. To some investors, it is conventional wisdom that interest rates
will rise in the near future, and so bond values could decline sharply. Long bonds,
which are most sensitive to interest rate changes, would suffer the most. We have
two responses: most importantly, we aren’t encouraging plan sponsors to
dramatically alter their participants’ bond durations overnight. A disciplined,
thoughtful approach to researching and potentially implementing a duration-
extension program is best for all parties involved. By the time you complete your due
diligence, interest rates may no longer be a significant headwind. And as a
secondary issue, the conventional wisdom is not necessarily correct – for example,
market bond prices may already reflect assumptions about the future of interest
rates.
22
Greenwald, M. (2010, October). Opportunities Created by the New Retirement. Presented at the Russell
Retirement Summit, Tacoma, WA.
Russell Investments // Going long: Should the DC industry reconsider participants’ bond portfolios? / p 12Concluding thoughts We’ve explained how DC plan sponsors have become aware of the retirement income problem and how the duration of the DC participant’s bond portfolio can be altered to more effectively target retirement income. We model a small change to current practice that reduces retirement income risk and describe how and why it might help to “bridge the gap” between a nest egg and a lifetime income stream. Finally, we discuss potential behavioral and practical barriers we’d need to overcome to widely adopt this change. Clearly, there’s room for improvement for the typical DC participant. The duration- extending bond strategy is one way to improve outcomes. For implementation purposes, it’s not a quantum leap, particularly in target date funds. The bigger problem will be convincing participants that this strategy, while potentially increasing the volatility of their account balances, actually may improve their odds of enjoying comfortable retirement. A retirement income framework lends itself to a rethinking of the construction of participants’ portfolios. In particular, it suggests a shift away from a strictly capital growth or capital preservation mind-set. Instead, we believe, we should adopt an asset growth or liability hedging model similar to those used in DB plans. The asset growth portfolio, which could include any asset, would be built to maximize return within a given risk tolerance. The liability hedging portfolio, on the other hand, would track the retirement income liability. It would most likely consist of long bonds, Treasury STRIPS, Treasury Inflation-Protected Securities (TIPS), and perhaps annuities. Our hope is that this paper will nudge the DC industry toward thinking not just about longer bond portfolios, but about outcome-driven solutions in general. Russell Investments // Going long: Should the DC industry reconsider participants’ bond portfolios? / p 13
Appendix
A. Bond duration and the life cycle investment problem
To help illustrate this concept, let’s examine a hypothetical DC participant’s experience.
This participant shares many attributes with the model participant Russell uses to
optimize its target date glide path, including age at beginning contributions (25);
retirement age (65); rate of real salary growth (1.5%); initial portfolio balance ($0); and
contribution level (starting at 6% and gradually increasing to near 12%, including
company matches). We make many simplifying assumptions for ease of understanding:
1. The initial starting salary is $50,000 (but assuming a different salary would have no
qualitative impact on the final result).
2. The participant invests in an equity asset with constant 8% annual return and a bond
asset with constant 5% annual return (similar to the capital market assumptions
used for the other graphs and outlined later in this appendix).
3. The participant invests according to the generic Russell glide path, starting at 90%
equity and 10% bonds and ending at 32% equity and 68% bonds.
4. Inflation is 2% annually and constant.
5. For present value/duration calculation purposes, we assume a discount rate of 5%,
in line with the return on the bond asset.
On the basis of these assumptions, we calculated the value of future portfolio
contributions (i.e., human capital) and the size of the bond portfolio over the participant’s
career. This information appears on the chart below.
Exhibit 5 / Evolution of bond wealth and human capital
$1,000,000
$750,000
Present value at a particular age
$500,000
$250,000
$0
25 30 35 40 45 50 55 60
Age
HumCap BondWealth NetBondWealth
Source: Russell Investments. Hypothetical analysis using assumptions outlined in this paper.
Russell Investments // Going long: Should the DC industry reconsider participants’ bond portfolios? / p 14“HumCap,” or human capital, refers to the present value of future contributions to the portfolio at a
particular age. “BondWealth” is simply the value of the bond portfolio, and “NetBondWealth” adds the
two.
According to our calculations, the duration of HumCap is about 20.5 years at the start of
the 40-year career. Ideally, we’d like the net bond portfolio to have about a 48.4-year
(8.4 years plus 40) duration, decreasing by 1 each year. To achieve this, we’d need to
hold a bond portfolio with duration near the “bond wealth duration” given below:
Net bond duration = human capital duration * human capital / net bond wealth + bond
wealth duration * bond wealth / net bond wealth. (In other words, the net bond duration
is a present value-weighted average of the human capital duration and bond portfolio
duration.)
Based on our simple model assumptions, which include the participant allocating nearly
all contributions to equities, we calculated the duration for human capital, the bond
portfolio, and “net bond wealth” (starting at 48.4 years and gradually declining to 8.4
years) for each year until retirement.
Exhibit 6 / Appropriate bond duration by age, duration less than 100 years
100
80
60
Duration (years)
40
20
0
25 30 35 40 45 50 55 60 65
Age
HumCapDur BondDur NetDur
Source: Russell Investments. Hypothetical analysis using assumptions outlined in this paper.
As mentioned earlier, human capital duration (“HumCapDur”) starts at around 20.5 years
and gradually declines to zero. On the other hand, the bond portfolio duration
(“BondDur”) is quite startling – it doesn’t fall below 100 years until age 46. In fact, at age
25, it’s over 10,000 years!
With the information provided here, we think readers could reconstruct this simple model
for themselves in a spreadsheet.
Russell Investments // Going long: Should the DC industry reconsider participants’ bond portfolios? / p 15B. Notes
I. CALCULATION OF PRICE AND DURATION OF RETIREMENT INCOME NEED
This paper frequently refers to “the retirement income need.” To calculate this, we used
a simplified model that mimicked the price of an annuity. We assumed that the annuity
would be paid out in annual installments. We then determined how many years
remained until the first annuity payout,23 the second annuity payout, …, the 50th annuity
payout. We then take this time and map it to one of 11 key term rates in a spot curve
scenario file.
From there, we can find the present value of each $1 annual payment on the basis of the
appropriate spot rate given by our scenario files and by the probability of the retiree’s
surviving to receive that particular payout. The present value of a particular $1 payout is:
Lk
Pk ,n , y
(1 sn ,t , y ) k y
Where Lk is the probability of surviving to the kth payout24 and sn,t,y is an appropriate spot
rate for that payment, pulled from the nth scenario of the tth term length with y years to
the target annuitization date. Note that if k = 1 and y = 0, then Pk,n,y will trivially be 1; we
assume the participant survives to age 65.
Using this calculation, the price of a $1/year deferred annuity for the nth scenario with y
years to annuitization will be:
An , y 50
k 1 Pk ,n , y
,
the price of a $1/year immediate annuity on the day of retirement will be:
An 50
k 1 Pk ,n ,
the “duration” of any particular annuity25 will be:
50
k 1 Pk , n , y ( k 1)
Dn , y y
An , y
,
and the duration of the immediate annuity on the day of retirement will be:
50 P ( k 1)
Dn k 1 k ,n
An , since y = 0.
23
The income needed for the first year of retirement. This would be paid on the day of retirement.
24
We use the Society of Actuaries 1996 U.S. Annuity 2000, Male #887 table for mortality expectations. We
assume that the likelihood of surviving to retirement is one. This table describes a single male annuitant. Lk
would be higher for a single female annuitant, and higher still for a joint life annuity.
25
We multiply the present value of each payment by k – 1 instead of k, since the kth payment will be received at
time t = k – 1, where t is the number of years after the retirement date. Further, the first payment is received in y
years, which is why the duration formula for the deferred annuity starts with y.
Russell Investments // Going long: Should the DC industry reconsider participants’ bond portfolios? / p 16II. EXPLANATION OF CAPITAL MARKETS ASSUMPTIONS
We used 5,000 simulations to construct Exhibits 3 and 4. In these simulations, the
annual equity returns are calculated using Monte Carlo scenarios. The annual bond
returns are calculated using AA corporate bond spot curve Monte Carlo scenarios, which
include 11 key term interest rates. We present a statistical summary of these scenarios
in the matrix below. While we used 11 interest rates in all, we feel that the 5, 15 and 30
year term rates provide a fair representation of the larger group.
Exhibit 7 / Capital market assumptions
Correlation
5-year 15-year 30-year
Mean SD Equities spot/zero spot/zero spot/zero Inflation
Equities 7.88% 18.28% 1.00
5-year
4.93% 2.71% 0.09 1.00
spot/zero
15-year
5.49% 2.09% 0.08 0.96 1.00
spot/zero
30-year
5.72% 1.38% 0.08 0.93 0.99 1.00
spot/zero
Inflation 2.27% 3.68% 0.06 0.46 0.40 0.38 1.00
Source: Russell Investments. Assumptions are as of September 2010.
III. EXPLANATION OF BOND RETURN CALCULATION
The AA-rated interest rates form the basis for the bond returns. We select the longest
term that is less than or equal to the bond duration. We then pull the spot rate for that
term in the current year and the next year – since we calculate yields only on an annual
basis, we use a simplified formula for the bond return:
Rn , y Sˆ n , y D n , y ( Sˆ n , y 1 Sˆ n , y )
Where Ŝn,y is the interest rate in the nth scenario with y years to retirement, and Dn,y is
the Macauley duration of the bond. (Technically, we should use modified duration, but it
doesn’t make a significant difference in the results.)
IV. EXPLANATION OF REPLACEMENT RATIO CALCULATION
After calculating the final accumulated wealth for each of our 5,000 capital markets
scenarios, we determine the ending salary “replacement ratio” for that wealth, where RR
is the replacement ratio, W is the ending wealth, C is the final salary before retirement,
and A is the price of a $1 immediate annuity on the day of retirement:
Wn
RR n
C n An .
To calculate the reward component of Exhibits 3 and 4, we calculate the median RRs
for each asset allocation strategy. For the risk component, we use the 5th-percentile RR.
Russell Investments // Going long: Should the DC industry reconsider participants’ bond portfolios? / p 17Acknowledgments The author would like to acknowledge the contributions of the many colleagues who devoted their time to this paper. In particular, he thanks Josh Cohen, his boss, who gave him the time and encouragement needed to complete it; Tim Furlan, for helping with the investment model; and Grant Gardner, his father, for offering guidance along the way. For more information: Call Russell at 800-426-8506 or visit www.russell.com/institutional Important information Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional. These views are subject to change at any time based upon market or other conditions and are current as of the date at the beginning of the document. The opinions expressed in this material are not necessarily those held by Russell Investments, its affiliates or subsidiaries. While all material is deemed to be reliable, accuracy and completeness cannot be guaranteed. The information, analysis and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity. Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment. There are no guarantees that any stated results will occur. Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns. Target date fund investing involves risk, principal loss is possible. The principal value of the fund is not guaranteed at any time, including the target date. The target date is the approximate date when investors plan to retire and would likely stop making new investments in the fund. Target date funds are not intended to be a complete solution to investors retirement income needs. Investors must weigh many factors when considering to invest in these funds, including how much an investor will need, how long will the investor need it for, what other sources the investor will have and, if the investor is purchasing shares in an IRA account, whether the fund's target distributions will meet IRS minimum distribution requirements once age 70 1/2 is reached. Although stocks have historically outperformed bonds, they also have historically been more volatile. Investors should carefully consider their ability to invest during volatile periods in the market. Copyright © Russell Investments 2011. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an "as is" basis without warranty. Russell Investment Group, a Washington USA corporation, operates through subsidiaries worldwide, including Russell Investments, and is a subsidiary of The Northwestern Mutual Life Insurance Company. The Russell logo is a trademark and service mark of Russell Investments. First used: March 2011 USI-8878-02-13 Russell Investments // Going long: Should the DC industry reconsider participants’ bond portfolios? / p 18
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