31 January 2021 / RETIREMENT INSIGHTS
Evolution With Purpose
An Informed, Research-Based Approach to Better Retirement Outcomes
The role of a plan sponsor requires decision-making that has a critical impact on the retirement outcomes of their participants. These decisions require careful evaluation that is both complicated, and vital to get right. Recent T. Rowe Price research indicates that plan sponsors have a sharpened focus on delivering better retirement outcomes for participants. Last year, we published a paper called “Three Questions Today for Better Outcomes Tomorrow” to begin to distill the complex evaluation process of assessing a qualified default investment alternative (QDIA) solution into a few key questions.
- Who are you solving for?
- How do you define and prioritize risk to deliver better retirement outcomes?
- What role do you want your plan to have in your workforce’s retirement journey?
While the three questions posed in that paper go a long way toward helping sponsors focus on the fundamental elements of QDIA assessment, this paper addresses the glide path phases underlying target date solutions. In this paper, we posit that the glide path evaluation process may need a second look to ensure past processes do not leave participants vulnerable to a shortfall in retirement. We are committed to putting plan sponsor needs, and the needs of participants, first. Therefore, we encourage the plan sponsor community to ensure that their process adapts to changing retirement needs and to consider the different glide path phases in proportion to their relative impact on outcomes. This paper is designed to provide plan sponsors with key considerations to help tackle the retirement challenge today and into the future.
(Fig. 1) Risks Are Varied and Require Careful Consideration
In our survey, we asked: In your role as a defined contribution (DC) plan fiduciary, please rank the risks as outlined below that you are most concerned about for your participants.
Defining “Risk” in QDIA Assessment
The definition and interpretation of “risk” is complex. However, surprisingly, risk is often thought about in a linear way. What we mean by this is that the equity allocation in a QDIA assessment is commonly presumed to be a one-to-one relationship between higher-equity and volatility or downside risk—particularly leading up to retirement. We believe that this approach oversimplifies the complexity of the various risks retirement savers face. In fact, this approach can result in both missed opportunity and inadvertently introducing other risks without fully understanding the tradeoffs. A cornerstone of our ongoing research has been studying the way plan sponsors think about risk on behalf of their plan participants. Our findings over the last several years have revealed that longevity risk continues to surface as the primary risk of most concern by plan sponsors. Longevity risk in this study is defined as participants having a shortfall in retirement or an insufficient amount of funds to rely on through retirement. Furthermore, higher-equity allocations and corresponding growth can be key to combating longevity risk. Figure 1 shows that 40.6% of plan sponsors rank longevity risk as the source of greatest concern for their participants, and an additional 23.4% rank it as their secondary risk. Longevity risk is ranked at a higher concern than downside risk, volatility risk, participant behavioral risk, and inflation risk.
While all five of these risks matter in retirement planning and glide path evaluation and construction, this research illustrates that the various types of risks are not created equal in terms of their impact on retirement preparation. We believe a constructive way of accounting for each risk is for sponsors to develop their own hierarchy of risk prioritization in QDIA assessment. Ranking risk based on their plan’s objectives and priorities will help sponsors make informed decisions.
Longevity Risk Matters
Building on our findings that longevity risk is a #1 or #2 ranked concern by 64% of our plan sponsor respondent profile, there are many reasons why longevity risk may have their attention. We offer two likely influences below.
(Fig. 2) Actuarial Estimates of Expected Survival at Age 651
The data reveal a high probability of one person in a couple living for decades into retirement.
Retirees Face High Probability of Living Decades in Retirement
Figure 2 shows data sourced from the Society of Actuaries. The bar chart clusters represent five-year increments. The dark blue bar in each cluster shows the odds of one person in a couple living to various ages. The chart reveals a high probability of one person in a couple living up to two or two-and-a-half decades into retirement (83.1% probability of living to age 85 and 62.9% probability of living to age 90). The bottom line is that retirement assets need to sustain individuals for decades into retirement to avoid a shortfall.
(Fig. 3) Social Security Replacement Rates
Social Security replacement rates by income quintile and implied gaps at targeted 75% replacement
The Growing Funding Gap of Retirement Savers
Social Security is often presumed to have a primary role in closing the income gap for most individuals. However, we studied more carefully the role Social Security will play across income quintiles. Figure 3 illustrates Social Security replacement rates divided into earnings quintiles and is charted based on a targeted 75% income replacement. The light blue segments of the bar chart illustrate the funding gap within each quintile. Studying funding gaps in this way reveals that we can expect Social Security to provide a good portion of the targeted income for lower-income quintiles. However, it also shows that the middle- to higher-income quintiles will experience a much higher funding gap.
Furthermore, a deeper look at this data—and layering in information about individuals who are participating in the DC system (see light gray bars in Figure 4)—shows that, broadly, individuals in the DC system tend to be the middle- and higher-income quintile workers. This is important for plan sponsors overseeing DC plans because it reveals a higher funding gap for their employees. While there are certainly many more factors that may be influencing why sponsors are prioritizing longevity risk as a key concern, expected length of retirement and income funding gaps are likely foundational concerns. It should be no surprise that longevity risk ranked as a top concern by sponsors for their participants.