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Generating income for retirees

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Defined contribution investment options are not designed to be "retirement ready." Efficient retirement portfolios look different than efficient accumulation portfolios, given the more focused objective of generating an income stream, and unfortunately the key building blocks for efficient retirement portfolios are often missing from DC plans. The portfolio efficiency costs of these gaps can be staggering, exceeding roughly 100 basis points on an alpha-equivalent basis.

By incorporating more extended asset classes, there is the potential to generate five or more years of additional income for retirees. Therefore, it is essential that DC plan sponsors review their core menus and investment offerings to ensure they are designed to truly optimize outcomes for plan participants, especially those nearing and in retirement.

The role of the core menu has evolved considerably over time. For example, the mass adoption of default investments, in particular target-date funds, over the last few decades has resulted in fewer participants selecting core menu funds, especially those who would generally be considered less sophisticated. While early research suggested larger core menus could negatively affect plan participation, these concerns are significantly less relevant in the age of default investments and automatic enrollment. That said, certain asset classes are still better offered through pre-packaged portfolios, whether that's target-date funds or multi-asset solutions available on the core menu.

When thinking about overall plan sponsor interest and general availability of asset classes, we can place them into three general groups, which are included in the exhibit below.

Asset Classes by Coverage Level

The Building Blocks for Better Retirement Portfolios
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The Building Blocks for Better Retirement Portfolios

Asset Class Correlations Across US Historical Market Return Environments: 2000-2022

The Building Blocks for Better Retirement Portfolios
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Source: Morningstar Direct. See Appendix 1 for asset class definitions.
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The Building Blocks for Better Retirement Portfolios
Source: Morningstar Direct. See Appendix 1 for asset class definitions.

As shown, the correlations among the risky asset classes included in the Basic group, which would include US large cap, US small cap, and non-US equity, had relatively high correlations regardless of the market return environment (positive or negative). In contrast, the correlations of the riskier asset classes in the Enhanced (e.g., emerging markets equity, REITs, and commodities) and Extended (e.g., long duration bonds, defensive equities, infrastructure, etc.) groups are notably lower and can vary across market environments.

 

Portfolio Optimizations

To demonstrate the potential benefits of increasing the opportunity set of asset classes when building portfolios, we ran a series of portfolio optimizations using PGIM Quantitative Solutions' Q4 2022 Capital Market Assumptions, including an "asset-only" optimization, which is a traditional mean variance optimization approach. The optimizations include a maximum 33.3% allocation to a single asset class, other than cash, to ensure the resulting portfolios are reasonably diversified. The efficient frontiers for the three opportunity sets are included in the exhibit below.

Asset Only Efficient Frontier Using Capital Market Assumptions

The Building Blocks for Better Retirement Portfolios
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For illustrative purposes only. Past performance is not a guarantee or reliable indicator of future results.
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The Building Blocks for Better Retirement Portfolios
For illustrative purposes only. Past performance is not a guarantee or reliable indicator of future results.

As the opportunity set moves from Basic to include Enhanced and then Extended asset classes, the expected risk-adjusted returns for the portfolio improve. For example, focusing on the asset-only optimizations for portfolios with a standard deviation of 6%, the efficient Basic + Enhanced portfolio has a return that is 0.53% higher than the efficient Basic Only, while the efficient portfolio that also includes Extended asset classes has a return that is 1.12% higher than the Basic portfolio.

We also ran a series of "surplus" optimizations, where inflation is held short as a liability in the optimization routine. This reflects the goal, for example, for a retiree to generate income for life, adjusted by inflation. Inflation protection for a portfolio is less important when someone is working because human capital (i.e., wages) are a natural inflation hedge.

Increasing the opportunity set to include the Enhanced and Extended asset classes improves portfolio efficiency; however, the improvements are even greater for the surplus optimizations, which is more relevant to retirees, compared to the asset-only optimizations. For example, if we focus on the portfolios with a 6% surplus standard deviation, the efficient Basic + Enhanced portfolio and efficient Basic + Enhanced + Extended portfolio have higher expected returns of 0.54% and 1.28%, respectively.

The larger difference for the surplus optimization is a function of the unique benefits of including inflation-sensitive assets in a retirement portfolio.

Including the additional diversifier asset classes within the Enhanced and Extended groups can be especially valuable during periods of high inflation. We demonstrate this effect focusing on the expected returns for the efficient portfolios with a 6% surplus standard deviation, but break out the returns by the annual inflation rate.

Introducing the Enhanced and Extended asset classes results in higher forecasted average portfolio returns when inflation is higher. This is when the value of the inflation protection is technically the highest because these are the periods a retiree is going to be most challenged at accomplishing his or her goals. In other words, increasing the opportunity set of asset classes has the potential to not only increase portfolio efficiency, but also increases the likelihood of a retiree accomplishing his or her income goals.

We demonstrate this effect in the exhibit below, which includes the results of Monte Carlo projection, using these same three portfolios, with an assumed 5% initial withdrawal rate, where we estimate the number of years the portfolio can sustain the income goal given varying target probabilities of success.

Years of Retirement Income by Success Rate and Asset Class Coverage

The Building Blocks for Better Retirement Portfolios
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For illustrative purposes only. Past performance is not a guarantee or reliable indicator of future results.
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The Building Blocks for Better Retirement Portfolios
For illustrative purposes only. Past performance is not a guarantee or reliable indicator of future results.

As demonstrated, increasing the asset class coverage can result in a notable improvement in years of retirement income. For example, if a retiree is targeting an 80% success rate, which our recent research suggests is an appropriate target, moving from Basic to Basic + Enhanced can result in three years of additional retirement income (27 years to 30 years), and moving from Basic to Basic + Enhanced + Extended can result in nine years of additional retirement income (27 years to 36 years). This is a significant improvement that has the potential to significantly improve outcomes for retirees.

Appendix

The Building Blocks for Better Retirement Portfolios
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The Building Blocks for Better Retirement Portfolios

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