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Rethinking Retirement Income

The two-fund proposal for target-date programs.

Unloved Investments Investors don't care much for immediate annuities. They won't permit changes to Social Security and would happily swap their 401(k) plans for traditional pensions, but even though immediate annuities also offer guaranteed monthly income, their sales languish.

The name doesn't help. "Annuity" is soulless. It sounds like an actuarial calculation. (Which it is, but sometimes the truth need not be told.) Nor does the product's complexity. Would you like a fixed annuity or variable? Market-value-adjusted or book? Lifetime or fixed period? Single period or multiple period? For today or deferred? "Erm, I don't know, can't I just have an annuity?"

The confusion increases when attempting to understand an immediate annuity's costs. Such expenses must exist. Those who sell annuities receive commissions, and those who manage them are also compensated. (Actuaries don't work pro bono.) But unlike with funds, annuities carry neither sales fees nor expense ratios. Their charges are implicit.

The guarantee is also a problem. The insurers that issue immediate annuities support them with their full faith and credit. That is good. On the other hand, those promises are, quite literally, for the rest of the retirees' lives. Not so good. Many retirees plan for 30-year time horizons. Over the past 30 years, 74 life insurers have declared bankruptcy. Better hope that it was not your immediate-annuity provider.

The Endowment Effect Finally comes the least-discussed deterrent, but perhaps the strongest: the endowment effect. People place more value on items that they possess than on outside items. (The grass, it turns out, is greener on one's own side of the street.) Those who stand to receive Social Security or pension payments are delighted, in part, because they have long known they will receive them. Such cash flows are their possessions. In contrast, retirees cannot acquire immediate annuities without parting with something they already hold, that being cash.

None of this would matter if guaranteed monthly income were not useful. But it is. Not only do such payments enhance the financial math by stabilizing inflows, but, for most investors, they also improve emotional health. The number of retirees who cherish the task of turning assets into cash flows roughly matches the number who refuse to take their car to the mechanic because they're happier making their own repairs.

The retirement-income marketplace is broken. The result of this dysfunction is not only a lost business opportunity for those who provide income payments, but--of greater importance to this author, at least--unnecessary aggravation for millions of retirees. There must be a better way.

A Modest Proposal I think that there is. I have a suggestion.

It concerns 401(k) plans. Retail investment accounts are important supplements to the defined-contribution system, but they are supplements nonetheless. Two thirds of American households lack an IRA account. The only realistic way to reach the masses is through 401(k)s. True, the 401(k) structure is incomplete; many smaller employers do not participate. But my suggestion addresses what exists. For the foreseeable future, the 401(k) system will remain the nation's retirement mainstay.

I invoke no new regulations. To be sure, many countries have successfully established such mandates. For example, Australia requires that employers place an amount equal to 9.5% of a worker's pay into a retirement account. The scheme has not prevented Australia's businesses from being competitive. Nor has it failed in its mission. The program has its critics, but none dispute that Australians have increased their retirement assets.

The United States, however, will not be passing such initiatives. Defined-contribution plans were created by the marketplace, not Washington, and have since been guided only gently by legislation. Corporate executives, not lawmakers, spawned the 401(k) industry. They also were responsible for adopting automatic-enrollment schemes, and for selecting target-date funds as their default investments. Changes to 401(k) plans run through corporate executives.

Double the Fun(ds) My recommendation, therefore, aims at them. This is the plan structure that they should select for their employees, to improve their retirement outcomes. I call it "the two-fund approach."

It goes like this: Rather than default new employees into a single target-date fund, divide their assets instead among two versions of target-date funds: 1) accumulation and 2) income. The accumulation fund would closely resemble today's version of target-date funds. The income fund, however, would not. It would be structured as a conventional mutual fund, with a fluctuating net asset value, but it would state its value as "projected monthly income." Upon reaching its target date, it would convert into an immediate annuity.

Effectively, this system would do more than place investors into two funds. It would place them into two accounts, each serving a distinct purpose. One would be the target-date fund, held throughout the investor's retirement--or at least a portion thereof. It would be the retiree's "growth" asset. The other would be the retirement-income fund. Two mental buckets, serving two distinct purposes.

Multiple Benefits Such a tactic would address the critical problem of the endowment effect. Expecting workers to give up their lump-sum 401(k) assets in exchange for the promise of monthly income, is asking too much. That trade is distasteful. With the two-fund approach, though, no change is required. The accumulation account of the target-date fund continues to be an accumulation account, while the income account continues to be an income account. No pain, considerable gain.

In addition to creating a new fund type, the two-fund approach would make target-date funds more consistent. Currently, their investment objectives vary. Some target-date families manage their funds for the retirement date, others for their investors' expected lives. Such inconsistency would disappear with the two-fund system, as all accumulation funds would aim for the longer time horizon.

(Presumably, accumulation funds would invest more aggressively as the retirement date nears than do today's target-date funds, while income funds would be more conservative. At least, such is my speculation.)

Throughout the process, the employee would retain complete investment freedom. He/she may alter the 401(k) plan's initial default decisions, either to buy different investments or to abdicate from the plan altogether. The same would hold on an ongoing basis. Income-fund owners could redeem or buy new shares whenever they liked, right up until the date of the first monthly check.

By my count, the two-fund proposal addresses four problems out of five. It 1) replaces "annuity" with the plain English name of "income fund"; 2) eliminates complexity (there being only one flavor of income fund); 3) makes expenses explicit (until the income fund's target date); and 4) counters the endowment effect. No additional costs or regulatory changes required.

The Catch The one remaining issue is the quality of the guarantee. No private entity's financial promises are as reliable as that of the federal government (which, after all, owns the printing presses.) It may be that 401(k) participants would accept all other aspects of the two-fund approach but ultimately balk because of fears that the insurer won't last. In which case, as with the banking system, some government support might be required to bolster consumer confidence.

But that cart is far, far ahead of the horse.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

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