Today, most participants don’t have a company pension to pool risk and pay out a steady stream of income after they retire. Instead, they’re relying on their individual investment portfolio to fund their retirement needs. This shifts the responsibility to the participant to accumulate sufficient savings during working years, and spend down assets sustainably in retirement years.
Traditional investment approaches have provided guidance to workers saving for retirement, but what about when it comes to taking income? Let’s first explore how these theories apply to the accumulation phase.
Modern Portfolio Theory (MPT) is a mathematical framework that financial professionals have used to build investment portfolios that maximize expected returns for a given level of risk for the past seven decades. In fact, the creator of MPT, Harry Markowitz, won the Nobel Prize in 1990 for his work on it.
When a client is accumulating assets, risk is commonly defined as volatility or standard deviation, and reward is defined as expected return. For a given level of volatility, you want to get as much return as you can, or conversely you want to take as little risk as possible to achieve a given level of return. The optimized risk and reward portfolios make up the Efficient Frontier, which is the most return you can get for a given level of risk or the least risk you can get for a given level of return.
Efficient Frontier. Each dot is an investment portfolio. Those closest to the Efficient Frontier may provide the greatest returns with the least risk.
For many years, retirement planning was all about setting a savings goal and hitting that number. However, when it comes time to retire, many participants aren’t comfortable spending down those assets. In fact, a recent study found that most current retirees still had 80% of their pre-retirement savings after two decades of retirement.¹
While guidance like the four percent rule exists to help people determine a safe withdrawal rate, it doesn’t come with any guarantees. At the same time, there are a number of unknown retirement risks, which could upend the rules, such as:
Personal spending shocks can also happen. A medical diagnosis could lead to costly health or long-term care bills. A divorce could disrupt financial planning as a person transitions from a dual-income to a single source of income. With all of these risks in mind, it is no wonder that participants are hesitant about funding essential retirement needs with income that is solely reliant on market returns.
Generating secure income to meet our retirement goals while navigating uncertainty is a challenge. To help participants looking for some level of protection in their retirement income to meet at least their basic expenses such as housing, health care, utility bills, and groceries, we need to shift from an accumulation to a decumulation mindset.
Let’s start by “redrawing” the risk-reward spectrum for income. We would put income on the y-axis as the reward, and we need to find a way to define risk that quantifies the retirement unknowns.
This is where Monte Carlo analysis and the Probability of Success metric comes into play. We can make a bunch of assumptions about longevity, equity returns, and inflation, and then calculate how much income a portfolio can generate for a given level of risk or Probability of Success.
So we are going to use Probability of Success as our definition of risk, and we are going to graph it on the x-axis. When we take less income, the Probability of Success is higher (there is less risk). When we take more income, the risk that we run out of money increases, so the Probability of Success decreases.
The goal is to be on the “Efficient Income Frontier.” We want to get the most income for a given probability of success, or the highest probability of success (lowest risk) for a given level of income.
Efficient “Income” Frontier. Each dot is a retirement portfolio. Those closest to the Efficient Income Frontier may provide the highest level of income for a given amount of risk.
To help participants take more income for a given probability of success (level of risk), we need to first consider how to help them secure a baseline of income to meet their essential expenses. One such strategy is to recommend an in-plan annuity with increasing income potential. These products can help improve topline Probability of Success and make the portfolio less sensitive to uncontrollable retirement risks.
For example, the Allianz Lifetime Income+® Fixed Index Annuity has a number of features to help address longevity, market, and inflation risks, including guaranteed lifetime income, protection from market downturns, and increasing income potential.
Intended to be part of an overall solution, an in-plan annuity provides a predictable, dependable level of income that participants can count on. Knowing that they’ll receive a reliable payment each month from their annuity can help participants budget and feel more confident about meeting certain essential living expenses.
Read our latest white paper to see how an in-plan annuity can help improve a diverse range of clients’ chances of a successful retirement portfolio. The scenarios outlined in this white paper were run by our Portfolio Impact Report engine – a tool developed by Allianz Investment Management U.S. LLC (AIM US) to demonstrate the probability of achieving retirement goals by using model hypothetical portfolios and 20,000 Monte Carlo simulations.
Plus, learn more about AIM US and how our approach to hedging helps us deliver more value to participants.
Mark Paulson is Vice President of Hedging Business Development at Allianz Investment Management, LLC. With over 15 years of risk management experience, he helps integrate the hedging team’s capabilities into Allianz Group initiatives, helps educate distribution partners on the benefits of dynamic hedging, and is passionate about quantifying the value of guaranteed lifetime income in a retirement plan.
For more insights and perspectives including technology, legal, and demographic perspectives in the defined contribution space, see our Insights and Education.
Ready to go more in-depth? Email our team.
¹ To spend or not to spend, Blackrock, January 2023
Fixed index annuities are designed to meet long-term needs for retirement income. They provide guarantees against the loss of principal and credited interest, tax-deferred accumulation potential, and the reassurance of a death benefit for beneficiaries.
Products are issued by Allianz Life Insurance Company of North America, PO Box 59060, Minneapolis, MN 55459-0060.
Increasing income potential is provided through either a built-in or optional rider at an additional cost.
Guarantees are backed by the financial strength and claims-paying ability of Allianz Life Insurance Company of North America.
Product and feature availability may vary by state and plan.
This content does not apply in the state of New York.
AllianzIM, a wholly owned subsidiary of Allianz Life Insurance Company of North America, is a registered investment adviser. AllianzIM provides hedging and other derivatives-based risk management solutions through its proprietary platform.
