Building Better Retirement Systems
Around the world, institutions and governments are responding to demographic changes, market uncertainty and balance sheet pressures by asking individuals to take more responsibility for their retirement outcomes.
In these systems, retirement outcomes are determined by individual decisions on saving, investing and spending – which makes the quality of those decisions the crucial factor in retirement readiness.
This makes even more urgent the development of tools and techniques to help individuals make better decisions.
BlackRock’s approach is to help financial advisors bring the insights of institutional investing to the challenge of ‘solving’ retirement for individuals, allowing your clients to see – in real-time – the potential impact on retirement success of their decisions.
Defining Retirement Success
Retirement success begins when an investor has enough assets to meet her desired income needs in retirement. To remain successfully retired, she must maintain her desired standard of living no matter how long retirement lasts, i.e., no matter how long she lives.
This means that at each point in retirement she must retain enough assets to meet her remaining retirement income needs. Understanding the relationship between assets and income needs is the key to achieving a successful retirement.
However, self-directed retirement programs currently focus almost exclusively on assets, with little or no consideration of liabilities, or retirement needs. This is a mistake and is likely to lead to unexpected and disappointing outcomes.
In place of real knowledge of their liability, investors are told to use simple rules of thumb such as ‘save 15 per cent of your salary’ or ‘spend four per cent of your assets each year in retirement.’
Compare this to other major financial goals, such as home ownership. When purchasing property, buyers know the price they paid, know what they owe, and their mortgage terms are clear. There’s no way to make retirement investing that transparent and precise.
But what if the system could move in that direction? Can investors and advisors improve their decision-making by devising ways to estimate how much retirement income will eventually cost? Which in turn could guide investors on how much to save, how to invest those savings, and how – and when – to course correct if necessary?
We believe the answer is ‘yes’ – if investors and advisors have a way to measure an individual’s retirement income needs.
A Benchmark for Retirement Needs
A sound measure, or benchmark, of retirement income needs should do the following things:
- It should be a true lifetime measure. That is, it should provide a fair estimate of an investor’s retirement liability regardless of how long the individual actually lives;
- It should incorporate some type of inflation protection, because the potential for purchasing power to erode over the length of a typical retirement is significant;
- It should be related to something investable. There should be commonly available vehicles, first, that track the changing value of the retirement liability; and second, that can provide income streams more or less equal to those indicated by our benchmark. This would allow investors the ability to “buy out” their retirement at any point they choose;
- Finally, we need our measure to be as intuitive as possible, so that advisors can use it to help clients make informed decisions.
We can already measure the performance of retirement assets (in this case accumulated savings) against well-known market indices such as the S&P 500 and ASX 200 indices. With such a benchmark for retirement needs, we could also measure the size of the liability.
In 2013 BlackRock introduced such a benchmark: the U.S. CoRI® Retirement Indexes. Each CoRI Index is designed to estimate the “cost” today, of $1 of cost-of-living adjusted (COLA) annual retirement income for someone who turns 65 in a particular year. Suppose that today the CoRI 2020 Index price is $19.39. This means that for every $1 of lifetime income that an individual would like to have in a retirement that begins in 2020, she would need $19.39 saved and invested today.
In other words, every dollar to be spent in retirement ‘costs’ the investor $19.39 to ‘buy’ today, in the form of savings. If the investor wants to spend $100,000 a year in retirement, with a COLA of 2.5 per cent, then she would need to have $1,939,000 ($100,000 x $19.39) saved and invested today.
CoRI prices generally rise as an Index approaches its maturity date, i.e., the closer the investor gets to retirement. This is primarily owing to the so-called ‘time-value of money.’
The longer we wait to purchase a series of future cash flows that begin at a fixed, future date, the more we have to pay. After retirement, CoRI prices are expected to decline because, as we age, our remaining retirement needs diminish.
U.S. CoRI Index prices are published daily and can be accessed on common websites such as Google or Yahoo. BlackRock has since added and is working to create additional CoRI indexes in other markets, where appropriate.
Getting to Retirement
Getting to retirement means growing our assets through savings and investment returns so that, at our desired retirement date, we have enough to meet our retirement goal.
Suppose an advisor has a client who is 50 years old and currently has $500,000 in retirement savings. She’d like to retire in 15 years and wants to spend $100,000 a year (with a 2.5 per cent COLA).
Our retirement benchmark indicates that she would need to have $1,000,000 invested today in order to have sufficient assets in 15 years to fund her income goal. Given today’s interest rates, she should also expect the cost of her retirement needs to increase by three per cent annually.
Taking all of this together, she needs to find a portfolio return and savings level that could allow her to catch up to the cost of her retirement needs. She has 15 years to do this.
If she chooses a portfolio with an expected return of 4.75 per cent and is willing to save $12,500 annually, then she should expect to close that gap between her current assets and the current value of her retirement needs. Chart 1 illustrates this approach.
Managing the Journey
But how can anyone be sure to earn the same return, year-in year out, for 15 years? What about volatility? What about risk?
With the benchmark, financial advisors can help clients manage those along the way. Suppose after one year, the investor realized a return of only 4 per cent when she expected a return of 4.75 per cent.
In that case, she would no longer be able to expect having enough assets at retirement to meet her income needs. She therefore needs to adjust her plan, or course-correct. She has four options.
- She can lower her retirement goal. This could allow the assets to catch up to a smaller goal in the 14 years she has left before the original retirement date;
- She could work longer. This option allows her to keep the original income goal and allow more time for the assets to catch up to her retirement needs;
- She can save more. This could increase the growth rate of the portfolio and allow her to retire at the original date with the original goal; or
- She could choose a portfolio with higher expected risk and return. This could again allow her to retire at the original date with the original goal.
These are the four levers of retirement management: goal, savings, time and return. Our investor can choose what combination of these levers adjusts the original plan so that she once again expects to have enough assets to meet her retirement needs at some future point.
At BlackRock, we call this process ‘journey management.’ In principle, it’s something any investor can do on her own. In practice, it is best accomplished with the help of a financial advisor.
With journey management, an advisor can build 15 one-year plans instead of one 15-year plan. The opportunity to regularly course correct toward a desired goal provides advisors with the means to build deeper relationships with clients over time.
Sustainable Spending in Retirement
Once our investor arrives at retirement, we can continue to use our retirement income benchmark to make investing and spending decisions.
The key task is to simultaneously manage longevity risk – the risk of outliving her money – and market risk – the risk of losing her money in a downturn. More specifically, it is to manage spending in the presence of these two risks.
As long as our investor’s spending preserves her assets’ ability to fund her lifestyle, while leaving her with the choice at any time to fully annuitize her remaining retirement needs, then she’s properly managing the two risks.
We call this approach sustainable spending.
Conclusion
As we ask individuals to assume more responsibility for their retirement outcomes, we need to help them make better, more informed investment, saving and spending decisions. Our retirement system’s current emphasis on assets and relative neglect of liabilities needs to be corrected.
A robust retirement system should take account of both assets and retirement income needs and provide tools to help individuals manage their journey toward retirement success.
Chip Castille is a managing director and chief retirement strategist at BlackRock, where he heads the Global Retirement Strategy Group.
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