Retirement At Risk II - Challlenges for U.S. Baby Boomers Approaching Retirement
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Retirement At Risk II - Challlenges for U.S. Baby Boomers Approaching Retirement

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The U.S. retirement market faces a compound problem. A lack of savings and an often insufficient knowledge of how to manage the dissaving process are two conspicuous challenges.

The U.S. retirement market faces a compound problem. A lack of savings and an often insufficient knowledge of how to manage the dissaving process are two conspicuous challenges.

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  • 1. No. 3|2009International Pension PapersRetirement at Risk II – Challenges for U.S.Baby Boomers Approaching Retirement
  • 2. Allianz Global Investors International Pension Papers No. 3|2009 Content Executive Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 I. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 II. A rich and diverse generation – Baby boomer wealth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 III. A structural shift is underway – Retirement income sources . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 IV. Freedom of choice – Payout solutions in the U.S. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 V. Sharper focus on risk management and fiduciary duty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 VI. FOCUS: The dilemma with variable annuities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 VII. Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 Recent publications / Imprint . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 432
  • 3. Allianz Global Investors International Pension Papers No. 3|2009Challenges for Baby BoomersApproaching RetirementExecutive SummaryP lanning and saving for retirement has long been contingent on makingsufficient contributions and choosing the responsibility in the accumulation and decumulation phasesright investments. Attention in the past • Reduced pension wealth due to the global was predominantly focused on the accu- financial crisismulation of pension wealth. It is not thataccumulation has become less important. • Rising health care costsThe difference is that individuals increas-ingly are assuming more responsibility for • Increasing life expectancy, which means managing the dissaving process. In the last a person has to be financially prepared forfew years, the focus has shifted to convert- even longer.ing accumulated pension assets into aretirement income stream. The U.S. retire- This study takes a close look at thesement market faces a compound problem. challenges and provides a detailed analysisA lack of savings and an often insufficient of the retirement preparedness of babyknowledge of how to manage the dissaving boomers. We will look at different wealthprocess are two conspicuous challenges. groups and examine the effects the financial crisis has had on each. The global economic Baby boomers are in a transition phase. downturn has affected the boomers differ-Their focus is shifting from asset accumu- ently. For instance, last year’s 33%* drop in * Case-Shiller home pricelation to income generation. The share of housing prices has been especially harmful index, 20-city compositethe overall population seeking retirement for low-wealth boomer households because indexplanning strategies is increasing. Early baby they have most of their assets tied in homeboomers already may be in the process of equity. In contrast, boomers with a high netdeveloping concrete decumulation strategies; worth have been hit by having direct owner-late boomers, on the other hand, already may ship in struggling businesses and by the 40%have started deciding how to restructure their drop in the equities market in 2008. Overallportfolios to suit their retirement needs. losses were substantial last year. The sub- stantial wealth losses are highest, in relative The largest population segment in terms, for families at the lower end of theAmerican history will retire in the next two wealth spectrum. In some cases, the collapsedecades. The challenges that baby boomers of the housing market has wiped out all offace include: the wealth that a family has accumulated over the last two decades.• Decreasing Social Security benefits Furthermore, the study shows that the• Growing importance of account-type amount of income retirees get from different pension plans that require greater sources is likely to change. There will be 3
  • 4. Allianz Global Investors International Pension Papers No. 3|2009declines in both Social Security benefits and coming decumulation that will coincidethe share of income paid by defined benefit with the retirement of the baby boomerpension plans. Assets invested in defined generation.contribution plans, Individual Retirement Accounts and nonqualified accounts will The major financial events that havehave to compensate and provide boomers taken place since 2007 have had a lastingwith an increasing share of their future in- effect on the overall retirement landscapecome. As the importance of account-type and have resulted in two challenges:pension plans grows, individual investors 1) product providers will have to adapt to thewill need to assume more responsibility for new environment by adjusting their generaltheir retirement income strategies. product range to take into consideration the increased volatility, instability and uncer- Connected with the shifting responsibil- tainty of capital markets; 2) the huge wealthities for managing retirement assets in the decumulation market needs to be addressed.accumulation and decumulation phases,more emphasis will be placed on product Decumulation is not just accumulation choice and financial advice in the future. in reverse. The requirements to these prod- ucts are different. Product providers as well Pre-retirees will have to focus on the as advisers must make an effort to supportstructure of their retirement portfolios. the wealth decumulation market in the fu-They need to develop a funds-withdrawal ture. The challenge will be to develop newstrategy that is consistent with their retire- solutions and educate advisers on how toment spending goals because decumulation best incorporate these offerings into theiris not just accumulation in reverse. There clients’ portfolios. Currently, most financialare a number of risks that are specific to advisers use a basic set of financial productsthe payout phase. In the context of wealth to construct a retirement-income portfolio. Indecumulation, the important aspects rele- fact, the adviser business model is orientedvant on the product side are: toward capital accumulation; decumulation would mean a loss in fee income as advisers• The level of downside protection are usually paid a percentage of their clients’ assets or at conclusion of the contract. If the• Covering of longevity risk providers of wealth decumulation products want to be successful with pushing their prod-• Protection against inflation ucts into the distribution channel, there is no way around offering attractive fee-based• Flexibility to cover unanticipated expenses incentives to those who are supposed to sell these packages.• The option to leave an inheritance. The downturn of the housing and capital Existing products fulfill these needs markets from 2007 to 2009 has demonstrat-to varying degrees. Usually, a basic set of ed the vulnerability of retirement portfoliosfinancial products is used to construct re- that were not diversified enough to protecttirement income portfolios. However, the against the huge losses that were experi-financial industry is in a state of transition enced across almost all asset classes. Thoseas it prepares for the unprecedented up- who don’t have time to recover the losses4
  • 5. Allianz Global Investors International Pension Papers No. 3|2009will have to delay retirement or settle for lessretirement income. The crisis has chal-lenged the system in many ways. The recentmarket turmoil is likely to result in morecomprehensive regulation, a greater focusby advisers on fiduciary responsibility andchanges in product design. Especially in thecontext of wealth decumulation, solutionswill need to be sustainable in various marketenvironments. These solutions must be easyfor customers to understand so that they canpick the retirement planning strategies thatbest fit their needs. The growth in retirement assets isfaster than the overall growth in householdfinancial assets. Retirement assets are the single-largest driver of the increasing wealthof the American population.1 However,a huge decumulation market is emergingwithin the retirement market. The financialindustry is preparing to serve that market. 5
  • 6. Allianz Global Investors International Pension Papers No. 3|2009I. IntroductionT he U.S. pension system relies on a mix of public and private pension provisions.The system is based on three pillars and is mostly discussed in the context of asset accumulation and is attached to the discus- sion on sufficient contribution rates andwell known for the importance it places on appropriate investment options. Given the employer-sponsored and private pension trend toward account-type pension plans,arrangements to provide retirement income. the most important being 401(k) plans andHowever, shifts in the population structure IRAs, it is crucial that prudent decumulation and retirement landscape are affecting the strategies are developed. In order to generateretirement preparedness of many house- an income stream from accumulated retire-holds. On one hand, there is a shift from ment assets, the dissaving process must bedefined benefit (DB) pension plans, in which actively managed. Defined benefit plans pay employers assume the investment and a retirement income for life while definedlongevity risks, toward defined contribution contribution plans usually distribute lump-(DC) arrangements in which the individual sum payments upon retirement or provideusually carries those risks. On the other a phased withdrawal plan. In both cases,hand, there is this large group of 78 million income from the plans can be outlived. Thispeople who were born between 1946 and happens when life expectancy is underesti-1964 – the baby boomer generation – that mated and too much money is spent in thehas just started to retire. The early boomers early years of retirement. In addition, theseare now on the verge of retirement and need assets are subject to capital market fluctua-to prepare for their golden years. tions and inflation. The combination of these factors creates more uncertainty when trying Retirement assets predominantly come to determine one’s actual retirement income.from employer-sponsored pension plans,which is why the government has focused In the United States, supplementarya lot of attention on this area. The Pension retirement income sources play such anProtection Act of 2006 caused major changes important role because the payout rate fromto employer-sponsored pension plans Social Security is only moderate, especially(for details see Breakout Box II), however, the for middle- and high-income earners. Thelegislation is focused on the accumulation retirement of the baby boomers, however,phase. The shift in the retirement landscape has created a huge potential for the financialtoward greater individual responsibility is industry to try to address the large pools of Breakout Box I The shift toward DC pension plans In 2005, of all employees who were covered by an employer-sponsored pension plan, 64% par- ticipated in a defined contribution plan. This figure is up from 26% in 1975. The number of DC plans almost tripled over the specified period and the number of participants rose from 12 million in 1975 to more than 75 million people in 20052. This is a growth rate of more than 6% annually, which is five times higher than the growth in the overall work force.6
  • 7. Allianz Global Investors International Pension Papers No. 3|2009assets that have been accumulated overthe past decades. The value of total financialassets of private households in the UnitedStates at the end of 2008 amounted to USD 40.8 trillion of which USD 14 trillion were held in retirement accounts.3 Another impor-tant asset class for private households is realestate, in which they had invested USD 18.3 trillion at the end of 2008.4 A major share ofU.S. private household wealth is held by babyboomers. Because this large group is on theverge of retirement, the market for decumu-lation products is poised to evolve into a massmarket that attracts attention from bothproduct providers and professional advisers. Breakout Box II The Pension Protection Act of 2006 Signed into law in August 2006, the Pension Protection Act (PPA) of 2006 is the most far-reaching regulation introduced in the United States since ERISA (Employee Retirement Income Security Act) in 1974. New regulations apply to both defined benefit and defined contribution plans. The most important regulations affecting defined benefit plans are: new funding standards; rules governing the valuation of plan assets and liabilities with at-market rates; and special rules for at-risk plans. For defined contribution plans, the PPA aims to govern investments in default options and gives guidance on contribution schedules. What is more, the automatic enrollment into employer pen- sion plans has been facilitated. The shift in occupational pension plans toward DC plans necessitated action on the part of the government. The PPA tries to guide employers and employees in their investment decisions and stimulate participation in occupational pension plans. 7
  • 8. Allianz Global Investors International Pension Papers No. 3|2009II. A rich and diverse generation – Baby boomer wealthT he United States is experiencing a shift in its population structure. By 2050, peo-ple age 65 and older will account for 20% of An analysis of data from the Survey of Con- sumer Finances 2007 shows that 65% of the baby boomer generation’s investable assetsthe population compared with 13% today. are held by just 4% of boomer households.The share of elderly people will grow because This group, known as the ultra high net worthof the size of the baby boomer generation, population, has investable assets of at leastwhich will have reached retirement age by USD 30 million. In contrast, only 2.6% of baby 2030 (see Figure 1).5 This segment of the U.S. boomers’ investable assets are allotted topopulation includes 78 million people who 70% of boomer households. Figure 2 showswere born between 1946 and 1964. Despite the distribution of investable assets amonglow savings and heavy debt, the baby boomer baby boomer households.generation is considered to be the wealthiestever in American history. However, wealth isnot distributed equally among this group sogreat disparities exist.Figure 1: Population structure in the U.S., 1950* – 2050 Period when baby boomers Period when baby boomers were born will retire100% 65+90%80% 15–6470%60%50%40%30%20% 0–14 10% 0% 1950 1975 2000 2025 2050 Source: United Nations, Population Database; *Earliest data available as of 19508
  • 9. Allianz Global Investors International Pension Papers No. 3|2009Baby boomer financial wealthAn analysis of the data from the recent Survey and becomes less and less significant for theof Consumer Finances (SCF 2007) shows that wealthiest groups. One explanation for this isalmost half of private household financial and that there is a cap on the amount that can benonfinancial assets are held by baby boomers. invested at a favorable tax rate. The second im-Total financial assets of private households portant asset class for those with total wealthamounted to USD 41.2 trillion in 2008, down of up to USD 1 million is liquid assets that by more than 17% from USD 49.8 trillion in are held in all types of transaction accounts.2007.6 By implication, total baby boomer Directly held stocks, mutual fund investments financial wealth amounted to approximately and bonds take on more weight for peopleUSD 19 trillion in 2008. This huge amount with high levels of wealth (see Figure 3).of wealth will be available for consumption,reinvestment and bequest over the next few Over time, the relative importance of retire-decades. ment assets measured against total financial assets has steadily increased compared with Financial assets account for 36% of baby 10 years ago. When asked what is their pri-boomers’ total assets. The way assets are in- mary reason to save money, half of the re-vested, however, varies among wealth groups. spondents to the SCF 2007 age 45 to 64 saidThe SCF 2007 data shows that retirement as- retirement. Surprisingly, saving for retire-sets such as Individual Retirement Accounts ment is just as important to people who have(IRAs) and account-type pension plans make accumulated large of amounts of wealth asup the largest portion of the portfolios for it is to those who have not. One differencemost of the population. However, their per- is that households with low levels of wealthcentage is decreasing with increasing wealth manage their assets with the intent to coverFigure 2: Distribution of financial wealth among baby boomer wealth groups BB households BB assets UHNW 4% 65.3% (> $30m) HNW 25% 32.1% ($1m < x < $30m) Mass affluent 31% 2.4%($100k < x < $1m) Less affluent 39% 0.2% (< $100k ) Source: Survey of Consumer Finances 2007, 2009, own calculations 9
  • 10. Allianz Global Investors International Pension Papers No. 3|2009required spending needs in retirement while general wealth management thanhigh net worth individuals focus more on retirement.Baby boomer non-financial wealthIn general, nonfinancial assets such as real left a large number of baby boomer home-estate, vehicles and businesses make up the owners with a net liability.7 This means thatlargest portion of total assets among baby the proceeds from the sale of their homesboomer households. While the wealthiest would not cover their mortgages so additionalgroups in the survey – those with total assets savings would be required to pay off the loans.of more then USD 50 million – have more invested in their businesses, people in the low- Projections show that homeowners areest wealth groups – those with assets of less worse off than nonhomeowners. The dropthan USD 250,000 – have portfolios in which in housing values has eliminated large por-housing equity dominates (see Figure 4). tions of homeowners’ wealth, in some casesThis made lower wealth groups particularly all of their wealth.8 Hit hardest are people whovulnerable to the bursting of the housing have accumulated only little wealth besidesbubble because they have so little invested their home and planned to use their homein a diverse mixture of other assets. Studies equity to finance retirement. These peopleshow that the plunge in housing prices has presumably will have to cut down on theirFigure 3: Split between financial assets among baby boomer wealth groups, [%]100% 90% Other financial assets 80% Liquid 70% assets Bonds 60% Stocks 50% Retirement accounts 40% Other managed 30% assets 20% Mutual funds 10% 0 <$250K >$250K–$1m >$1m–$5m >$5m–$10m >$10m–$25m >$25m–$50m >$50m Groups are separated by total assets Source: The Federal Reserve Board, Survey of Consumer Finances 2007, own calculations10
  • 11. Allianz Global Investors International Pension Papers No. 3|2009retirement spending and will find it difficult dependent on Social Security benefits, whichto maintain their standard of living. These are not exceptionally generous.retirees and near retirees are now even moreFinancial crisis impact on baby boomer wealthThe downturn of global capital markets in es in 401(k) plans were hit particularly hard2008 that followed the bursting of the U.S. by the downturn in 2008.housing bubble resulted in substantial fi-nancial losses for many people in the United Employees with the most years on the jobStates. Employer-sponsored and individual and large account balances* had the largest * of more thanpension arrangements play a large and losses among U.S. pension portfolio holders. USD 200,000growing role in providing retirement income. Hit hardest were workers age 45 and older.Retirement savings accounts, which repre- These people saw their account balances dropsent about 34% of overall household assets9, by more than 25%. High equity exposuressuffered huge losses across-the-board. In made them vulnerable to the increased vola-2008, overall retirement assets shrank by more tility on the equity markets. Research shows than USD 4 trillion10 from their peak of USD that 43% of 401(k) participants age 56 to 6518 trillion in mid-2007. Unlike defined bene- had more than 70% of their portfolios allocat-fit plans, defined contribution plans pass on ed to equity funds, company stock and thethe investment risk to the employee. Due to equity portion of balanced and target datethe shift toward DC pension plans, employ- funds in 2007. In fact, 22% of this group hadees increasingly suffer the consequences of an equity share of more than 90%. In con-adverse capital market movements. Balanc- trast, people with account balances of lessFigure 4: Split between financial and nonfinancial assets* between baby boomer wealth groups**, [%] Assets of low wealth households Assets of ultra high wealth households Non Financial Non 81% Homes Financial Other 77.8% 65% 94.6% Financial Financial 19% 36% Other Homes 22.2% 5.4% * Nonfinancial assets include: vehicles, residential property, nonresidential real estate, businesses and other ** Low-wealth households have wealth up to USD 250,000; ultra high wealth households have wealth of more than USD 50 million Source: The Federal Reserve Board, Survey of Consumer Finances 2007, own calculations 11
  • 12. Allianz Global Investors International Pension Papers No. 3|2009than USD 10,000 saw positive growth in 2008 as new contributions more than offset the Breakout Box IIIdecline in asset values. Although U.S. 401(k)plans across all age groups continue to have U.S. pension assets experiencedhigh exposure to equity markets, the share the 3rd largest loss globallydropped notably in 2008. This decline, how-ever, was not the result of transfers between According to the OECD’s recently released “Pensions at a Glance,”investment options; it was due to declining the United States had the third-largest decline among all OECDequity prices.11 countries. Only Ireland and Australia experienced larger losses. Pension fund assets dropped by about 26% in the United States. Nevertheless, there is a general trend to- Irish pension funds had an investment return of -38% while theward greater diversification. Compared with value for Australia was -27%. The main cause of the steep declines2000, the number of plan participants hold- is that the pension fund portfolios in all three countries have beening 100% equities dropped from 37% to 16% dominated by equity investments.at the end of 2008.12 There is evidence that pension plan spon-sors continue to adopt automatic enrollment of lifecycle funds for people age 56 to 65 wasand that they mostly offer lifecycle funds as 51.2% at the end of 2007. A research paperthe Qualified Default Investment Alternative from the Employee Benefit Research Insti-(QDIA). An analysis by Fidelity Investments tute (EBRI) shows that had plan participants shows that by the end of 2008 more than 60% in that age group been 100% invested in life-of pension plans were using lifecycle funds cycle funds more than 43% would have hadas the default option, that is up from 38% a 20% reduction in equities. That meansin 2007.13 Lifecycle funds automatically re- they would have had less money in high-riskbalance from risky to less risky assets as the assets and would have had smaller losses asinvestor ages. The average equity allocation a result of the global financial downturn.Figure 5: Losses in financial assets of U.S. private households, 2007/2008 [USD trillion] Bank Mutual deposits Shares Pensions funds IRA Other Insurance Bonds -0.1 -0.1 0 0.3 -1 -1.2 -2.9 -3.9 Source: Federal Reserve; Investment Company Institute; Allianz Global Investors estimation for IRA 2008, own calculations12
  • 13. Allianz Global Investors International Pension Papers No. 3|2009 In the future, more 401(k) investors andnear-retirees are expected to be shielded Breakout Box IVfrom the high equity allocations seen today Time needed to recover 401(k) lossesby the increased use of target date fundswith an age-appropriate asset allocation. Using different rates of future equity returns, EBRI calculated the timeHowever, it should be noted that target date it will take to recover from 401(k) losses seen in 2008. The results showfunds are not risk-free. Target date funds have that a worker with a job tenure of more than 20 years and an accountfaced harsh criticism for the high equity sharefor soon-to-mature funds. Last year, the 2010 balance of more than USD 90,000, would need 4, 6.4 or 15.6 years totarget date funds lost about 25%, which rep- recover with assumed equity returns of 10%, 5% and 0%, respectively.resents a huge loss that near-retirees won’thave time to recover before they need to drawon those assets to provide their retirementincome. and people age 55 to 64 will have almost 44% less wealth than their respective age groups Pensions are investments that usually pay had in 2004.* The substantial wealth losses * Values are based on theoff in the long term. According to EBRI, 410(k) are highest, in relative terms, for families at assumption that averageparticipants across all age groups saw a posi- the lower end of the wealth spectrum. In some housing prices will fall antive change in their account balances between cases, the collapse of the housing market additional 10% in 2009January 2000 and January 2009. This increase, has wiped out all of the wealth that a family compared with 2008.in relative terms, was highest for young par- has accumulated over the last two decades15ticipants with a short job tenure (>500%) and (see Figure 6).lowest for the older workers close to retire-ment with a long job tenure (>29%).14 How- The consequences of the stock and housingever, the increase for younger workers was market bubbles are now obvious. The savingspredominantly driven by contributions. For decisions of many people were influencedolder workers, the performance effect domi- during the many years that the bubbles werenated due to their larger account balances. growing. These bubbles temporarily inflated perceived wealth and likely encouraged Residential property is the primary asset people to save less than they would have hadfor a large portion of the U.S. population. they considered the potential for a downturnMore than 76% of people age 45 to 64 owned due to the artificially high value of assets.their homes in 2004. The huge importance Near-retirees who chose risky investmentsof home equity to those people made them are in the worst position because they willparticularly vulnerable to the sharp drop in have little chance to reverse the saving andhousing prices. Those who have accumulated consumption decisions they made in the lastlittle wealth besides their homes and intended few years.16to use home equity to finance retirementpresumably will have to cut down on their Older people living in the United Statesspending in retirement. A report from the are more likely to be homeowners and moreCenter for Economic and Policy Research likely to have larger retirement plan account(CEPR) reveals the effects that the housing balances than their younger counterparts.crash has had on different age and wealth Baby boomers in the lowest income groupsgroups. The study shows that in 2009 people have suffered most from the decline in hous-age 45 to 54 will have almost 35% less wealth ing prices because their primary residence 13
  • 14. Allianz Global Investors International Pension Papers No. 3|2009constitutes the largest asset in their portfo- and stocks. Boomers with substantial wealthlios. Baby boomers in higher wealth classes were least affected by declining housinghave a larger percentage of their total assets prices but were most vulnerable to the dropinvested in mutual funds, retirement accounts in the capital markets.Figure 6a: Projected mean net worth for baby boomer households by quintile of net worth 2009, [USD]Figure 6b: Projected decline in net worth of baby boomer households from 2004 to 2009 by quintile of net worth, [%]Figure 6a 2,663,562 2,663,562 2,498,000 45 – 54 55 – 64 2,498,000 45 – 54 55 – 64 2,663,562 2,498,000 45 – 54 55 – 64 1,998,000 1,998,000 1,998,000 1,542,451 1,498,000 1,542,451 1,498,000 1,542,451 1,498,000 998,000 998,000 998,000 430,485 498,000 498,000 250,160 430,485 164,975 56,639 97,561 250,160 430,485 498,000 -1,643 1,782 29,060 164,975 56,639 97,561 -2,000 -1,643 1,782 29,060 250,160 -2,000 164,975 97,561 Bottom -1,643 1,782 29,060 56,639 Second Middle Fourth Top -2,000 0% Bottom Second Middle Fourth TopFigure 6b 0% Bottom Second Middle Fourth Top -20% 0% -20% -20% -40% -30% -32% -30% -20% -20% -37% -40% -42% -30% -32% -30% -20% -60% -49% -46% -37% -42% -40% -30% -32% -30% -60% -49% -46% -37% -42% -80% -60% -75% -49% -46% -80% -75% -100% -80% -100% -75% -120% -100% -120% -140% -120% -140% -160% -154% -140% -160% -154% * Values are based on the assumption that average housing prices will fall -180% -160% an additional 10% in 2009 compared with 2008. The authors also calculated -180% -154% two additional scenarios, a more optimistic outlook assumes that there will -180% no further decline in housing prices; the more pessimistic scenario assumes an additional 20% fall in housing prices in 2009. Source: Baker, D. and Rosnick, D., Center for Economic and Policy Research, The Impact of the Housing Crash on Familiy Wealth, July 200814
  • 15. Allianz Global Investors International Pension Papers No. 3|2009III. A structural shift is underway – Retirement income sourcesD espite the long history of occupational pensions in the United States, there isstill a considerable portion of U.S. retired 80,000 a year. Top earners must get most of their retirement income from personal savings in non-qualified accounts.17workers who are solely dependent on SocialSecurity benefits in retirement. Only about In 2007, the median household incomehalf of working-age people are covered by for people age 65 and older was USD 28,305, an employer-sponsored pension that will which is only half of the income of thosepay future benefits. Social Security benefits who are younger than 65. The median in-account for at least 90% of every third elderly come for people 64 and younger in 2007 wasbeneficiary income. According to the Social USD 56,545. This illustrates that U.S. retirees Security Administration, average monthly must get by with substantially less moneySocial Security benefits for retired workers than they earned during their working years.amounted to USD 1,157.50 in April 2009. In general, the median household income isReplacement ratios from Social Security are significantly lower for these groups: females,based on the salary a person made while people age 80 and older, blacks, Hispanicsemployed. Low-income earners can expect and people who are single or who have littleto get paid approximately 80% of their pre- education. Poverty rates are highest forretirement income while high-earners need these groups, which receive most of theirto generate income from other sources to income from Social Security. People in themaintain their standard of living. Although top income bracket get less from Socialthe share of income from a private-sector Security and more from earnings, assets andpension increases with higher retirement in- pensions.comes, Social Security and qualified pensionplans will not generate the cash needed to Table 1 shows average values from thematch the wages of top earners, those with different income sources for the elderly U.S.pre-retirement income of more than USD population. Figure 7 contrasts the impor-Table 1: Median annual income from different sources for elderly U.S. households (65+) receiving such income Social Security Private-sector pension Public-sector pension Income from assets (interest income, dividends etc.) Median USD amount* 15,012 8,052 17,400 2,254 %age receiving such 89% 30% 15% 57% income* Median: 50% of the observations are above and 50% lie below this value. The median is a better measure for central tendency than the arithmetic mean for skeweddistributions. It is a more robust measure for samples with extreme values. With a great disparity in income, the simple mean would overstate the average income. Source: Congressional Research Service, Domestic Social Policy Division, Aging Seminar Series: Income and Wealth of Older Americans, November 19, 2008 15
  • 16. Allianz Global Investors International Pension Papers No. 3|2009tance of those sources among different amounted to USD 2,254 in 2007 and ranges income groups. Here are some of the key from USD 282 in the lowest bracket to a findings. median value of USD 11,270 in the highest income class.• Almost 90% of retirees receive Social Secu- rity, which is the main source of income Earnings provide the largest share of for lower-income households. Earnings income for top earners age 65 and older. represent the largest share of income for With increasing age, a person’s ability to the top earners age 65 and older. keep working declines, which leads to a sig- nificant decrease in income. The median• Only 30% of elderly households receive income for people age 80 and older is about a private-sector pension. half as much as the income for people age 65 to 69. Saving for retirement means turning• Most elderly households receive at least human capital into financial and nonfinan- some income from assets. However, for cial assets that can be tapped in the future. most households these amounts are rela- When a certain age is reached, human capi- tively small. The median asset income tal declines and eventually won’t be able toFigure 7: Relative importance of various income sources and median values by income brackets of people 65 and older* >50,064 52,000 19,524 31,200 18,300 11,270 50,064 20,000 17,964 17,136 10,800 2,630income brackets, [USD] 28,911 10,500 15,600 10,800 5,880 1,318 18,622 5,500 12,942 7,200 2,768 634 11,519 3,000 8,262 2,400 1,608 282 Earnings Social security Government employee pension Private pension or annuity Asset income* Data do not take into consideration any non-cash benefits and other potentially important resources as income. These include housing and energy subsidies, foodstamps, lump-sum pension payments and capital gains. Source: Social Security Administration, Income of the Population 55 or Older, 2006, February 200916
  • 17. Allianz Global Investors International Pension Papers No. 3|2009contribute to overall income. To maintain a increases. This could mean a cut in Socialcertain standard of living, sufficient retire- Security benefits as well as tax increases.ment savings are necessary to compensatefor the decline in human capital. However, In a recent interview, Wharton professormany near-retirees must stay in the work Kent Smetters said that not even record taxforce longer than they planned to try to re- hikes would be sufficient to pay off the na-coup losses their retirement portfolios suf- tional debt, and he added that cutting backfered during the recent market downturn. on Social Security and Medicare is most probable.18 Long before the global economic Due to changes in the retirement land- crisis hit, experts continually urged the U.S.scape, future retirees might see a structur- government to provide more funding foral shift in the composition of their old-age Social Security. The deep recession has madeincome. Social Security benefits are expect- the system’s future even more uncertain.ed to decrease. This decline will be the result In the long-term, we expect Social Securityof two developments: 1) the retirement of to further decline in importance as a primarybaby boomers; and 2) the huge increase in source of retirement income.national debt caused by the global economiccrisis. The losses in financial and nonfinancial assets that many Americans experienced The Social Security financing basis will be from 2007 to 2009 might force people to workeroded as the 78 million baby boomers start longer than originally planned because theyto retire and begin collecting benefits. By 2017 cannot afford to retire on the benefits theyat the latest, revenues collected from Social expect to get from Social Security. In addition,Security contributions will be lower than the those who intended to use their assets to com-benefit payouts. This will force the Social plement their retirement income need to findSecurity Trust Fund to liquidate its holdings alternative income sources. Income fromof U.S. government bonds. That means the earnings is expected to be increasingly im-government will have to repay national debt. portant in the coming years. A current trendFor financing purposes, the government that is expected to continue is that peoplecould either issue new debt or use general who are covered by a DC plan will remain in tax revenues. The retirement of the baby the work force longer than people who areboomers will boost expenditures for Social covered by DB pension plans. The reason for Security, which is part of the federal budget. this is that DC plans lack characteristics If the buffer funds are exhausted, general tax such as early retirement incentives, lifelongrevenues will have to fill the gap. benefits and reduced investment risk.19 Given the huge increase in national debt Lastly, with the shift from DB to DC plans, from the stimulus packages used to reflate fewer people receive a guaranteed pensionthe U.S. economy, the government might income for life. As lump-sum payments arebe limited in its ability to allocate more tax often preferred over annuities, there mightrevenues to Social Security. In summer 2009, also be a decline in “pension and annuityPresident Obama released a proposal that income” as a future revenue source. Thereforesees that increases in spending or de- are many reasons why people are reluctantcreases in revenues need to be offset else- to buy annuities: One of the key reasons iswhere either through savings or revenue their lack of liquidity. However, this trend 17
  • 18. Allianz Global Investors International Pension Papers No. 3|2009could be reversed if the U.S. government de- in the future income sources used by thecides to provide tax incentives on annuities, elderly U.S. population. There are both long-something that is currently being discussed. term and short-term indicators showing thatA new bill introduced in Congress in June people will need to take more responsibility2009 aims to provide a partial income-tax for securing their retirement incomes. Figureexemption on money earned from qualified 8 illustrates these trends, with DB plans and and nonqualified lifetime annuities. Oppo- Social Security losing importance and thenents of the bill are concerned about giving other sources gaining.up potential tax revenues when the govern-ment has a huge and growing budget deficit. The changing retirement landscapeProponents of the bill argue that with Social is challenging future retirees. The SocialSecurity declining and many retirement Security system will come under increasedaccounts ravaged by the financial market pressure so it will be difficult for it to providedownturn, this legislation is more necessary a general pension safety net in the future.than ever. In any case, governmental guid- As a result, occupational and private pensionance on the design of the payout could be assets will play a more crucial role. Thesevery effective, as was the case with the PPA’s assets will evolve from being a supplemen-regulation on automatic enrollment and tary source to an integral part of a person’squalified default investment options. retirement income. In the future, people will rely more than ever on their DC balances In summary, many arguments support and IRA assets to provide income for their the view that there will be a structural shift retirement.Figure 8: There will be shifts in the composition of retirement income for future retirees Social DB Security Non-qual. DC/IRA savings and housing equity18
  • 19. Allianz Global Investors International Pension Papers No. 3|2009IV. Freedom of choice – Payout solutions in the U.S.F or years, planning and saving for retirement has been a matter of contrib-uting a sufficient amount of income toward In theory, the availability of payout options should be determined by the level of secured retirement income that already protectspensions and making the right investment against longevity risk. The higher the guar-options. People were predominantly focused anteed income from sources such as Socialon accumulating pension wealth. Accumula- Security and DB pensions, income that al-tion remains important, but people are now ready is annuitized, the more payout optionsassuming more responsibility for managing can be made available. By implication,the dissaving process. The objective is to restrictions on the payout options should beconvert accumulated pension assets into imposed in cases where accumulated DC a retirement income stream. assets are supposed to finance a significant share of retirement income, a view supported The baby boomers are shifting their focus by the OECD. However, there is no empirical from asset accumulation to income genera- evidence that shows governments follow thistion. The design of the payout phase is an im- recommendation. In fact, quite the opposite isportant issue for assets accumulated in DC true. There is no logical link between the statepension plans and IRAs. There a several op- pension replacement rate and the flexibilitytions possible, although, employer-sponsored in the payout phase of DC pension assets.20DC plans do not always offer the whole spec-trum of choices. In general, the options are: There is a powerful argument that withtake a lump-sum payment, buy an annuity, a sufficient level of financial literacy greaterdefer distributions or receive installment flexibility in the payout phase should bepayments from the plan. Employers decide allowed. A higher level of financial savvy in-which options the pension plans will offer. creases one’s chances to effectively handleFigure 9: Distribution options selected by retirees having more than one option, [Percentage of respondents who had multiple options from their DC plans] 54 25 21 10 Lump-sum distribution Deferral of distribution Annuity Installment payments Source: Investment Company Institute, Defined Contribution Plan Distribution Choices at Retirement, 2008 19
  • 20. Allianz Global Investors International Pension Papers No. 3|2009the complex job of overseeing retirement In contrast to the United States, severalassets. This is the logic behind the imple- European countries force annuitization ormentation of programs aimed at increasing at least encourage it through tax incentives.individuals’ financial education. On the In these countries, where lifelong annuityother hand, some people may hire financial payments are favored, there are rules thatadvisers to manage their accounts. Research aim to prevent retirees from spending allshows that pre-retirees often are more will- their retirement income and then having toing than younger workers to take financial rely on the social safety net to avoid poverty.advice and consolidate assets for easier The United States only requires that payoutsincome management.21 from qualified plans, excluding Roth 401(k)s and Roth IRAs, begin no later than age 70½. The U.S. regulatory framework gives in- There are no rules on the payout alternatives.dividuals a lot of freedom with regard to thepayout option for accumulated retirement According to a survey of the Investmentassets. This freedom comes despite the fact Company Institute, 70% of employees enrolledthat many investors have a limited under- in a pension plan at work have multiple dis-standing of finances and many will have to tribution options. These include: lump-sumrely more and more on account-type pension payments, installment payments, deferralsavings, which can be outlived if they are of distribution and annuities. The remainingnot properly managed. Americans pride 30% generally are required to take a lump-themselves on their ability to be self-reliant; sum payment. The majority of retirees whotherefore, there is less emphasis in the U.S. were given more than one retirement distri-on providing state-regulated social benefits bution option chose to receive the balancethan in other industrialized economies. in one sum. Only every fifth retiree opted toFigure 10: Use of lump-sum distributions at retirement [Percentage of respondents] Rolled over all to IRA: 65% Reinvest some or all of the proceeds: 86% Spent all proceeds: 14% Rolled over some to IRA*: 23% Reinvested outside IRA and/or spent: 12% *remaining was reinvested outside an IRA and/or spent Source: Investment Company Institute, Defined Contribution Plan Distribution Choices at Retirement, 200820
  • 21. Allianz Global Investors International Pension Papers No. 3|2009receive annuity payments (see Figure 9). Sustainable spending is central to everyOf those who opted for a lump-sum payment, decumulation strategy. The asset allocation86% reinvested all or some of their assets. of the retirement portfolio from which in-Most transferred the assets to an IRA (see come is supposed to be generated shouldFigure 10). match individual needs and should depend on individual circumstances. These can in- Surveys showed that most people who clude personal tolerance for risks in financialreceived their pension plan balances acted markets, the flexibility when it comes to get-responsibly and reinvested the proceeds. Most ting access to assets and what investors wantrolled over the payout to an IRA. In almost to pass on to their heirs.69% of the cases, people consulted a profes-sional adviser to reinvest the proceeds. Ofthe people in that group, 73% followed thisadvice.22 Investing lump-sum payments froma DC plan into an IRA account is the preferred way to preserve the tax-deferred status ofthose assets. An analysis of the withdrawalactivity from IRA accounts shows that in the majority of cases people take the requiredminimum distribution required by law.Others make a lump-sum withdrawal. Onlya small percentage of IRA account holders withdraw a fixed dollar amount or a fixed per-centage each year. Most people say that theyconsult with their financial advisers to helpdetermine how much they should withdraw.23 Research done by the Investment Compa-ny Institute (ICI) indicates that withdrawalactivity from IRAs is mostly the result of the required minimum distributions. This meansthat the majority of households with an IRA do not intend to tap this asset until forced todo so. Those age 70 and older are most likelyto make a withdrawal. The money primarilyis used to cover living expenses. The second-most-frequent use of the funds is for reinvest-ment, which once again shows that theseindividuals are less dependent on their IRAs to provide a regular income stream in retire-ment.24 Research indicates that IRA values are the highest for people in the wealthiestincome brackets.25 21
  • 22. Allianz Global Investors International Pension Papers No. 3|2009V. Sharper focus on risk management and fiduciary dutyT he U.S. financial industry offers a wide range of products designed for theaccumulation phase. These products are ucts provide flexible access to cash to cover unanticipated liquidity needs. Dividend- yielding stocks, mutual funds and variablespecifically geared toward building assets annuities with living benefits are popularto finance retirement. Products designed investment products used to constructto effectively use those retirement assets are retirement income portfolios.in the early stages of development. The needfor decumulation products was triggered by Only recently a new category of mutualthe pending retirement of the baby boomers, funds has emerged – so-called target dis-who represent the largest segment of the U.S. tribution funds – which are geared towardpopulation and control a massive stockpile the payout phase. Funds in this category areof assets. based on the target date model and employ a lifecycle or life-style concept. But insteadThere are some basic product types that are of accumulating toward a specified date,commonly used to generate income during these funds pay a certain percentage eachretirement. These include banking, invest- year from an originally invested amount.ment and insurance products as well as There are two types of target distributionhybrids that combine features of at least two funds: endowment-style funds and pay-downof the three previously mentioned categories. funds. Endowment-style funds pay out aIn general, investors must make a trade off. fixed percentage annually with the purposeThey can pick between longevity coverage of capital preservation. The percentage with-and downside protection or flexibility and drawn should be aligned with the expectedliquidity. Insurance products usually satisfy return on investment. This preserves the prin-the need for security while investment prod- cipal and provides the investor the returns.Figure 11: Variable annuity net assets [USD billions] 1,485 Non-qualified Qualified 1,3571,300 1,187 1,124 1,1271,100 994 957 886 900 796 700 500300100-100 2000 2001 2002 2003 2004 2005 2006 2007 2008 Source: Insured Retirement Institute, Annuity Fact Book 200922
  • 23. Allianz Global Investors International Pension Papers No. 3|2009Depending on the payout rate, this fund also is strong enough to survive such adversecan provide growth. In contrast, pay-down market developments.funds are geared toward asset consumption.They provide a regular income stream. The Individuals increasingly wish to protectpercentage withdrawn annually increases against capital market volatility and the riskover time to 100% at the specified target date. of outliving their savings. The demand for liv-Target distribution funds, and mutual funds ing benefits in variable annuities has gainedin general, neither guarantee a certain re- momentum.27 Traditionally, private investorsturn nor do they cover the longevity risk. But in the United States have tended to have athey provide flexibility and liquidity to cover smaller portion of their overall assets allo-unanticipated expenses as well as the possi- cated to insurance products than people inbility to leave an inheritance. continental Europe. Whether the current increase in the demand for products with Like target date funds, variable annuities guarantee features indicates a structural shifthave experienced impressive growth (see and a long-term trend will be determinedFigure 11). Net assets in VAs have almost when the stock markets start to grow again.doubled over the past few years to approxi-mately USD 1.5 trillion in 2007. But variable The global financial crisis has demon-annuities have been hit hard by the huge strated the vulnerability of retirementdecline in the equities market. The 24% drop portfolios to unexpected shocks. In suchin the value of VA assets between 2007 and situations what is crucial is generating2008 was largely due to a 45% decrease by sustainable income while simultaneouslyequities.26 considering a range of auxiliary conditions. When it comes to wealth decumulation Minimum investment guarantees of vari- the key risks are (see chart below):able annuities have been popular with manycontract owners. The value of these assets fellsharply during the credit market meltdown, Table 2: Key risks in the context of wealth decumulationwhich means the provided guarantees wereput under pressure. This led to massive loss- Risks Product requirementses for insurance companies. On one hand,insurers were not perfectly hedged. On the Volatility of capital markets • Downside protectionother hand, the costs of hedging strategies • Suitable asset allocationhave skyrocketed as a result of the marketvolatility and significantly reduced profit Longevity risk • Longevity coveragemargins. Some VA providers made adjust-ments to their product range and frequently Inflation risk • Inflation protectionadjusted prices to reflect the changing marketenvironment. As a result, annuities became Rising health care costs • Flexible access to cover more expensive or offered reduced benefits. unanticipated expensesInsurers considered reducing the possibleequity share and the number of funds offered Depletion of assets • Principal preservation for bequestwhen a certain guarantee was demanded.The experience has shown that it is extreme- Source: Allianz Global Investorsly important that an insurance company 23
  • 24. Allianz Global Investors International Pension Papers No. 3|2009Volatility of capital marketsTwo economic crises in one decade and the counterparts. Hence, the downturn had aincreasing volatility of capital markets pro- much greater effect on investment portfoliosvide proof that retirement assets should not in the United States. In 2007, about two-thirdscarry the same risk as other long-term invest- of 401(k) assets were allocated to equitiesments that are not due at a certain point in through equity funds, the equity portion oftime. What people need to ask themselves is lifecycle funds and company stocks.30 Recent how much volatility in portfolio value they results have shown that most portfolios werecan tolerate before jeopardizing their current not well positioned to handle the sharp de-spending needs. Downside protection is par- cline in the capital markets. Already in theticularly important prior to retirement as the accumulation phase, a retirement portfoliolast 8 to 10 years of the accumulation phase must be designed to provide sufficient in-generate half the dollar amount saved for come once a person leaves the work force.retirement.28 Most retirees will be unable to The accumulation phase cannot be managedrecover their losses if their retirement funds separately from the payout phase; both mustdrop sharply in the last decade they work. be connected through an appropriate asset mix. Having a balanced retirement portfolio Over the past few years people have is a step in the right direction.changed their views on saving for retirement.More emphasis has been placed on balancing The benefits of diversification are one ofretirement assets. People are diversifying the key findings of modern portfolio theory.their assets rather than concentrating them The financial crisis, however, has changedon one stock, which was the case with Enron. the general market conditions. A recentThere has been a steady increase in aware- study by risklab investigating the correlationness of the risks of concentrating too much between asset classes over the past 20 yearswealth in a limited number of assets. Recent has revealed that prices move increasinglyresearch shows that new employees are much in accordance reducing the benefits of di-more likely to try to balance their portfolios versification. An ever more globalized worldby choosing assets such as target date funds creates greater uniformity among financialfor their 401(k) plans.29 However, large across- markets. The phenomena of growing corre-the-board losses resulting from the most lation were particularly evident in times ofrecent downturn illustrate that despite this market turmoil. These findings force inves-shift many retirement assets remain in risky tors to adjust their strategies. Broadeninginvestments. In 2007, almost half of 401(k) the asset base which would then compriseparticipants who were close to retirement new asset classes, prudent monitoring ofhad at least 70% of their balances invested market developments as well as the use ofin equities, company stock and the equity a dynamic asset allocation can help to tackleportion of balanced and target date fund. the shortfalls of increasing correlations among traditional asset classes.31 Compared with people in other industrial-ized nations, investors in the United Statestend to have more allocated toward equities.Western European investors, for example,invest more conservatively than their U.S.24
  • 25. Allianz Global Investors International Pension Papers No. 3|2009Longevity riskLongevity risk refers to the risk of living fewer and fewer years working. This is be-longer than expected and eventually out- cause they are spending more time gettingliving one’s assets. If this happens, a person their educations and are retiring earlier. Theexperiences a decline in his or her standard combination of these factors creates an un-of living. The traditional way to avoid longev- sustainable work-to-retirement ratio, whichity risk is to purchase annuities that provide presumably will make it challenging for thea guaranteed lifelong income stream. average household to save enough money to retire.32 Today’s generations live longer than In 2004, the average U.S. life expectancy previous generations and this trend presum-was 77.8 years. But this can be misleading as ably will continue. Life expectancy steadilythe actual life expectancy increases as a per- increases over an individual’s lifetime, there-son ages and significantly differs from the fore a retirement plan needs to be reviewedfigure at birth. Life tables from the National and adjusted regularly. Longevity risk is sig-Vital Statistics Report show that people nificant and should not be underestimated.who have reached age 65 are expected tolive another 19 years (see Figure 12). Theolder a person gets the more the actual lifeexpectancy expands (see Figure 13). In the last 100 years, life expectancy hasincreased significantly while the retirementage increased only slightly. People spendFigure 12: Increase in life expectancy of the U.S. population at age 65, 1900 – 2004 [years] 22.0 female total male 20.0 18.0 16.0 14.0 12.0 10.0 1900–02 1909–11 1919–21 1929–31 1939–41 1949–51 1959–61 1969–71 1979–81 1989–91 2004 Sources: National Vital Statistics Reports, Vol. 56, No. 9, December 28, 2007 25
  • 26. Allianz Global Investors International Pension Papers No. 3|2009Inflation riskSaving for retirement requires a long-term real estate, commodities and equities – cancommitment. Inflation is a major concern provide a natural hedge against inflation.as purchasing power can deteriorate wheninflation exceeds the nominal return on the In general, property that generates ainvestment. What matters most to people regular cash flow has proved to provide ais inflation-protected income. Over time, hedge against inflation because rents andrising inflation decreases a person’s pur- terminal value move in line with inflation.chasing power considerably. For example, In the case of equities, it is assumed that theat an inflation rate of 10%, USD 1 invested corporate sector can pass on inflation in thetoday loses more than 96% of its current form of higher prices to the consumer. Em-value over a 30-year period. Even at a moder- pirical evidence has shown that equities areate inflation rate of 2%, almost half of the an effective hedge, however, only over the veryassets’ value is eaten up. Figure 14 charts long term. Research shows that commodities the remaining value of USD 1 invested today provide an effective short-term inflationbased on different inflation levels and differ- hedge. The demand for commodities usuallyent time periods. increases when the economy recovers and is highest during a boom. A positive correlation Social Security benefits are adjusted between commodity values and inflationregularly for inflation. However, people with also has been found for longer-term horizonsprivately managed retirement portfolios in the United States. However, commoditiesmust guard against inflation by picking the provide varying levels of protection.33 Treasuryright investments. Several assets – such as inflation protected securities (TIPS) are an-Figure 13: Life expectancy at increasing ages, 2004 80.0 70.0Expectation of life at age x 60.0 50.0 40.0 30.0 20.0 10.0 0 0–1 10–11 20–21 30–31 40–41 50–51 60–61 70–71 80–81 90–91 100+ Age Sources: National Vital Statistics Reports, Vol. 56, No. 9, December 28, 200726
  • 27. Allianz Global Investors International Pension Papers No. 3|2009other popular investment tool used to hedge Even if inflation rates are moderate overagainst the risk of eroding buying power. the medium term, inflation protection isTIPS are long-term investments with maturi- expected to be a key part of designing long-ties ranging from 5 to 20 years. The principal term investment strategies. Retirement spans against which semi-annual coupon payments multiple decades so any loss in purchasingare calculated is regularly adjusted in line power could have a far-reaching effect.with inflation. The terminal value, however,cannot be less than the original investedamount. Opinions are divided on how the inflationrate will develop in the future. On one hand,a steep increase in inflation could result fromthe massive stimulus packages and injectionsof liquidity that governments around theworld have used to reflate their economiesand to fight against a deep global recession.In addition, experts worry about the expan-sive monetary policy and predict that infla-tion will rise in the coming years. Othersargue that inflation rates won’t be a majorshort- or mid-term concern because of theeconomy’s low capacity utilization rate andrecord high unemployment.Figure 14: Real value of USD 1 invested today at various inflation levels 0.98 1.00 1.00 2% 5% 10% 0.90 0.95 0.90 0.82 0.80 0.70 0.60 0.67 0.60 0.55 0.50 0.40 0.35 0.36 0.30 0.21 0.20 0.12 0.10 0.04 0 today 1 year 10 years 20 years 30 years investment horizon Sources: Own calculations 27
  • 28. Allianz Global Investors International Pension Papers No. 3|2009Rising health care costsWith health care costs increasing faster than Employers are increasingly backing awaygeneral inflation and wages, there is a risk from subsidizing post-retirement medicalthat medical inflation will erode retirement coverage, which means that future retireesassets, threatening many retirees’ nest eggs. will have to use much more of their retire-Health care expenditures in the United ment income to pay their private health careStates amounted to USD 2.1 trillion in 2006 insurance premiums. The structure of the(16% of the GDP) and are estimated to sky- current health care system is very fragment-rocket to USD 4.3 trillion (19.5% of the GDP) ed; a universal system does not exist. Theby 2017. According to these figures, more system is made up of a mixture of privatemoney is spent on health care in the United and public funding, with private out-of-theStates than any other industrialized country, pocket payments accounting for 14.6% of allboth in per-capita terms and in relation to personal health expenditures in 2006. Thisthe GDP. means that at least a portion of a person’s retirement assets will have to be invested into some form of liquid investment to cover unanticipated medical expenses.Depletion of assetsBased on the traditional lifecycle hypotheses, are a strong desire to leave an inheritanceconsumption is smoothed over the entire and the uncertainty regarding future expens-lifetime. People save while they work in order es. Intergenerational wealth transfer requiresto finance spending needs in retirement, people to hold a portion of their assets inwhich implies a decumulation of accumulat- inheritable forms; this excludes certain prod-ed wealth while retired. In reality, however, ucts such as annuities and other investmentsthe average savings rate among the elderly where the principal capital is consumedis still positive, which contradicts the view of during retirement. Consequently, producta hump-shaped accumulation of wealth dur- requirements are different for people whoing one’s lifetime. The main reasons for this plan to leave a financial legacy.Challenges for product providers and financial advisersThe sunset years of many retirees and pre- The crisis revealed some weak spots inretirees are at risk. The current financial product design. The soon-to-mature targetcrisis has revealed the vulnerability of many date funds were too heavily invested in theindividuals’ retirement portfolios. Their loss- stock market while variable annuities start-es have been significant. For years, people ed to hurt insurance companies at the samefocused more on generating equity market time that prices for risk hedging exploded.returns than on sustainable spending. Years Risk management has become strategically of exceptional performance caused people more important for both individuals andto underestimate the risks associated with product providers. Individuals need to safe-investing in capital markets. guard the assets that they have spent decades28
  • 29. Allianz Global Investors International Pension Papers No. 3|2009accumulating. Product providers must financial professionals. In the past, some ofidentify and price their risk exposure effec- them steered consumers toward financialtively while simultaneously developing decisions that benefited their own interestnew solutions that, in the context of wealth rather than that of their clients. Part of thedecumulation, will be sustainable in various issue is that professional advisers havemarket environments. pursued short term profits instead of long- term sustainable business practices. Professional retirement planning Regulations that concentrate on solving advice is important because it can provide these problems are constantly demandedan understanding of the complex product by consumer federations.landscape while offering guidance on whichcombination of investments can help to reach Misselling most frequently occurs inindividual retirement targets. The advice markets with complex products. This prob-from financial experts should transform real lem is particularly severe in the market forretirement needs into an investment and retail financial products including pensions,decumulation strategy. securities and insurance policies. People who lack expertise in financial matters often Because of the pressure on the U.S. Social rely on financial advisers for guidance. TheSecurity system, the importance of supple- problem is that some financial advisers domentary retirement income is growing. Indi- not to act in the best interest of their clients.vidual investors are playing a more crucial Instead, their advice is biased toward maxi-role than ever in their financial futures. These mizing short-term profit35. This happenedpeople are making key decisions regarding because of the organizational structures ofthe retirement savings held in individual a firms sales process, competition withinaccounts and employer-sponsored pension the industry, as well as compensation andplans. However, it is well documented that incentive structures.financial illiteracy is widespread amongolder investors in the United States. Even There are various regulatory regimes thatbasic financial concepts may not be under- apply in the area of consumer protectionstood34. Professional retirement planning and pay heed to the important role that pro-advice can fill this knowledge gap and help fessional consultants and advisers play.the person reach individual retirement However, many professionals who providetargets. investment advice to their clients are not required to comply with fiduciary standards. At present, there is an ongoing discussion These include certain advisers at banks,in the United States regarding the judicial lawyers and broker-dealers. In the Unitedframework of professional financial advice. States, the title “financial adviser” is not wellThe current regulations governing financial defined, which has led to investor confusion.advisers are considered insufficient when it The unevenly developed standards that reg-comes to addressing the problems arising ulate investment advisers and broker dealersfrom changing market conditions. Various are susceptible to multiple and differing def-groups are therefore calling for a reform of initions and interpretations. Broker-dealersthe relevant laws. On top of that, consumer are often called financial advisers even thoughadvocates consider the inconsistencies in they are not subject to the same regulationsregulations a cause for misguided advice by as investment advisers. As the boundaries 29
  • 30. Allianz Global Investors International Pension Papers No. 3|2009between investment advisers and broker- financial advisers use a basic set of financialdealers have blurred, it has been increasingly products to construct a retirement-incomedifficult for individual investors to under- portfolio. The adviser business model is ori-stand the differences between the services ented toward capital accumulation becausethey provide and the legal duties they are decumulation would mean a loss in fee in-owed36. come as advisers are usually paid a percent- age of their clients’ assets or at conclusion The Consumer Federation of America of the contract. If the providers of wealth(CFA) considers the inconsistent regulatory decumulation products want to be success-treatment between broker dealers and in- ful with pushing their products into thevestment advisers as a reason for recent distribution channel, they will need to offerabuses and has called for the creation of attractive fee-based incentives to those whoconsistent standards37. To strengthen the are supposed to sell these packages.protection of investors, the U.S. Treasuryhas proposed legislation to apply a fiduciary Retirement assets are growing faster standard to broker-dealers offering invest- than household financial assets. Retire-ment advice. The proposal, which is entitled ment assets are the single-largest driver of“Establishment of a Fiduciary Duty for Bro- the increasing wealth of the U.S. population.kers, Dealers, and Investment Advisers, and However, within the retirement market aHarmonization of the Regulation of Brokers, huge decumulation market is emerging.Dealers and Investment Advisers,” provides The financial industry is preparing to serveplenary authority to the SEC to regulate that market.disclosure requirements for conflicts of in-terest, sales practices and compensationschemes for financial intermediaries. Recent unprecedented financial events have left a lasting effect on the overallretirement landscape. The result of thesechanges is two challenges: 1) productproviders will have to adapt to the newenvironment by adjusting their generalproduct range to take into considerationthe increased volatility, instability anduncertainty of capital markets; 2) the hugewealth decumulation market needs to beaddressed because the requirements ofdecumulation products are different. Product providers and advisers must makean effort to support the wealth decumulationmarket in the future. The objective is to de-velop new solutions and educate adviserson how to best incorporate these offeringsinto their clients’ portfolios. Currently, most30
  • 31. Allianz Global Investors International Pension Papers No. 3|2009VI. FOCUS: The dilemma with variable annuities by Bernhard Brunner and Mikhail Krayzler, risklabVariable annuities – an overviewVariable annuities (VAs) have been available ficiaries). This feature protects policyholdersin the United States since the mid-1980s. from outliving their assets. Second, a VAIn its basic form, a variable annuity (VA) is tax-favored. Depending on the local resembles a package of mutual funds pur- regulations, VA contributions can be tax-chased by an investor or policyholder. A VA deductible if the VA is part of a retirementdiffers from a classic mutual fund in several plan. Money can be transferred from oneimportant ways. investment option to another within a VA without being subject to taxes at the time First, a VA allows policyholders to receive of transfer. However, when money is with-periodic payments for a defined period, usu- drawn from a VA, it is taxed on the earningsally for the rest of their lives (or the lives of at ordinary income tax rates rather thantheir spouses or any other designated bene- capital gains rates, which might be lower.Table 3: Variable annuity guarantees Benefit GMDB GMAB GMWB GLWB GMIB Description Lump sum on Guaranteed lump Guaranteed amounts Guaranteed amounts Guaranteed income via parital death to the ben- sum after accu- via parital withdrawals via parital withdrawals withdrawals after annuitization eficiary mulation period over a specified period during the whole life (policyholder loses the control after during accumulation (policyholder retains investment is converted to annuity) and/or decumulation control over the invest- period with the possibil- ment) ity to surrender the guarantee Payoff Phase Accumulation/ Accumulation Decumulation Decumulation Decumulation Decumulation (occasional Accumulation) Guaranteed • Initial premium Annual withdrawals defined as maximum % of Minimum annual income defined amounts • Roll-up: premiums paid accumulated • Initial premium as % of at guaranteed rate • Fund value • Initial premium • Ratchet: optional adjustments of • Ratchet: optional adjustments of guaranteed • Fund value at the time of guaranteed amount to the actual amount to the actual account value at specified annuitization account value at specified dates dates • Roll-up: premiums paid accumulated • Greater of fund value, ratchet and • Bonus options: ability to increase the guaranteed at guaranteed rate roll-up amount if no withdrawals have been redeemed • Ratchet: optional adjustments of during predetermined periods guaranteed amount to the actual • Greater of fund value, ratchet at roll-up account value at specified dates • Greater of fund value, ratchet and roll-up Source: risklab 31
  • 32. Allianz Global Investors International Pension Papers No. 3|2009 When a VA is part of a retirement plan, entire amount is completely recovered, re-tax-deferred benefits will outweigh the costs gardless of market performance. This meansonly if the tax rate in the decumulation phase that if the underlying investments performis lower than in the accumulation phase and well, there might be even more money thanthe VA is held as a long-term investment to expected at the end of the withdrawal period.meet retirement or other long-term goals. Additional features may include a step-upThird and most important, VAs combine an that periodically locks in higher guaranteedinvestment in mutual funds with an insur- withdrawals if investments do well.ance component in the form of a guaranteeon underlying fund performance. The GLWB rider is another type of withdrawal guarantee. It allows the policy- Over the years, the guarantees offered holder to make withdrawals for life. Theon VA products have evolved as the market actual percentage allowed to be withdrawnhas adapted to meet customer needs. While varies according to the person’s age and/orthe vast majority of current VAs offer a death fund performance at the time of the firstbenefit rider as a default feature, more so- withdrawal.phisticated designs include a variety of livingbenefit riders (see Figure 1). A GMIB rider is designed to provide the investor with a base amount of lifetime in- The guaranteed minimum death bene- come at retirement, which is at least as valu-fit (GMDB) addresses the concern that the able as the account value of the investmentspolicyholder may die before all payments at the point of conversion. This guarantee isare made. If this happens, the beneficiary similar to purchasing a typical annuity.receives a payout, typically the amount ofpurchase payments made by the deceased In addition to these three living benefits,policyholder, if at the time of the policy hold- which focus on the decumulation or payouters’ death the account value is less than the phase of a VA, there is also a type of livingguaranteed amount. benefit guarantee particularly designed as a wealth-accumulation product. The guaran- In contrast, living benefits can be de- teed minimum accumulation benefit (GMAB) scribed as wealth-preservation or wealth- rider guarantees that the final contract valuedecumulation products. They enable the at the end of the accumulation phase willpolicyholder to preserve wealth during the not fall below a specified level regardlessdrawdown period. They combine some of of the actual investment performance. Thisthe advantages of traditional defined benefit type of guarantee is particularly interestingand defined contribution retirement plans. to younger investors.There are three common types of living ben-efit riders: guaranteed minimum withdrawal Over the last decade, VAs have been abenefit (GMWB); guaranteed lifetime with- major success story in the North Americandrawal benefit (GLWB); and guaranteed insurance market. They even have overtakenminimum income benefit (GMIB). traditional fixed annuities to become the primary form of protected investment. VAs GMWB riders guarantee that a certain per- also have been successful in Japan, wherecentage (usually 5% to 7%) of the amount in- the market grew to USD 140 billion in March vested can be withdrawn annually until the 2008 from USD 1.3 billion in 2001. 32
  • 33. Allianz Global Investors International Pension Papers No. 3|2009 Following their success in the United in the industry and by governments thatStates and Japan, VA products are being existing retirement models have to be im-launched in a number of European markets. proved to better meet consumer needs.What makes these products attractive is In particular, consumers require access tothat they address the long-term savings and market returns in order to keep pace withretirement needs of Europe’s rapidly aging the rising cost of living, but they also needpopulation. As individuals also become more to protect their assets and lifestyles fromheterogeneous in terms of their demand negative economic trends.characteristics, there is growing recognitionRisk management for variable annuitiesBecause of increasing sales volumes and ris- or pension funds; an absence of good modelsing product profitability in the United States capturing life expectancy data; and a lowerand Japan, it is implied that VAs offer strong degree of standardization in the market.opportunities for providers. However, cautionis needed because VAs can have a high nega- Another type of insurance risk is causedtive impact on the VA provider’s balance sheet. by unexpected policyholder behavior and theProper risk management is still the main unanticipated rate of policy terminationsrequirement for a successful product. In ad- (lapse risk). This has become a very impor-dition, issuers gain a competitive advantage tant issue for many insurance companiesin the market if they clearly understand and and pension funds. Recently, we have seen can provide a transparent demonstration of an increased demand on the VA productsVA risks. Given the highly complex structure by professional investors and hedge funds.of VA products, risk management deserves These professionals can make more effectivespecial attention. decisions than individual policyholders on optimal allocation between underlying funds Risks associated with VAs can be divided and when to sell the products. High lossesinto three main categories: market risks, in- might arise if policy issuers are not preparedsurance risks and operational risks. The most to handle the type of policyholder behaviorimportant insurance risks are: longevity, typical of professional investors and hedgemortality, lapse risk and policyholder behav- funds. Many of these insurance risks can beior. Insurance risks rarely can be hedged out. outsourced or partly eliminated by increas-Just a few instruments have been developed ing the size of the VA portfolio – as most ofto manage longevity and mortality risks, two these risks follow the law of large numbersexamples are longevity- and mortality-linked (pooling of risks).derivatives. However, the market for theseproducts has not been established yet due to In contrast to insurance risk, market risk,the number of different issues one faces when which primarily includes equity, interest ratetrying to combine these instruments. Com- and volatility risk, won’t decrease by enlarg-panies launching longevity bonds have ex- ing the size of the VA portfolio. However,perienced major problems, such as very high these risks can be controlled by appropriateprices; the basis risk between the underlying hedging strategies. Finally, insurers shouldindex and longevity risk faced by insurances be aware of the so-called operational risks. 33
  • 34. Allianz Global Investors International Pension Papers No. 3|2009These consist of model risk, legal risk, After products are designed and pricedwrong implementation of risk management the so-called hedging programs come intoframework, IT breakdowns and similar risks. play. There are four basic approaches toUnfortunately these risks cannot be easily hedge VAs: run naked, reinsurance, statichedged, so they need to be monitored close- and dynamic hedging.ly. We will now look at the market risks andexamine how the VA issuer will have to Run naked means an absence of any manage them. hedge. This approach is often applied if the provider’s VA business is small; the expenses While the entire risk monitoring system combined with a hedge program are too high;and some hedging programs play an essen- or the instruments needed to hedge are nottial role in the success of the product, actual available at a reasonable cost. The advantagerisk management starts even earlier – during of this approach is that it provides the abilitypricing and product design. There are several to participate in the full upside potential.options that can be implemented in the design In addition, there is no need for special riskphase that give more flexibility to insurers. management and/or asset-liability manage-The following measures help to eliminate ment (ALM) expertise. However, the absencesome potential risks: of downside protection and high earnings volatility mean that only a few VA providers• possibility to change the guarantee costs; now employ this type of hedging strategy as a stand-alone approach.• restrictions on fund investments to re- duce a portfolio’s volatility and to increase Another approach is to transfer the risk to its diversification; a reinsurer and pay a premium. The advan- tage is having well-structured, customized• incentives to defer the option (such as a global protection as well as the possibility bonus for not withdrawing funds); and to outsource some insurance risks. Again, no special risk management expertise is re-• callable features (such as the right of the quired. However, this hedging approach is issuer to buy back the guarantee from the expensive and illiquid. A separate problem guarantee holder, which means to cancel with this strategy is that it can be difficult to the guarantee). adjust the designed reinsurance protection to meet changing market conditions or other Caps on benefit levels in addition to some requirements. Like any strategy that includesof the above-listed options help reduce costs a third party, reinsurance leads to some ad-of expensive guarantee riders. ditional risks due to counterparty credit and operational risk. The factors to consider when pricing prod-ucts, which is the next phase, should include The last two concepts are in-house hedgingthe potential costs of hedging, risk capital strategies. The first is the static approach. Atand unknown policyholder behavior. In addi- the beginning of the product’s life, the writertion, market data should be used to calibrate of the VA purchases over-the-counter options,the pricing models. For all this, a comprehen- or, if possible, exchange-traded options, tosive pricing framework is necessary. hedge against the potential liability risks. In addition to the counterparty risk, a major34
  • 35. Allianz Global Investors International Pension Papers No. 3|2009disadvantage of this strategy is that underly- As a consequence, dynamic hedging pro-ing liabilities might be over or under hedged grams often use exchange-traded derivatives,unless they are rebalanced frequently during which are generally less expensive and morethe term of the investment. To overcome this, liquid than over-the-counter instruments.insurers often buy a specific over-the-counter This makes it easier and cheaper to unwindinstrument that allows them to keep the positions and leads to more flexibility insame hedge level over time. However, these product design and pricing. In addition,protections are expensive and again involve the credit risk from third-party instrumentscounterparty risk. is less than it is with static hedging or re- insurance because the exchanges use the In contrast, a dynamic hedging program mechanism of clearinghouses, which guar-dynamically manages a portfolio of deriva- antees fulfillment of the contract. Thattives with sensitivities (in industry parlance, means the VA writer is no longer linked tothese are referred to as “Greeks”) that corre- one bank or one reinsurance company.spond to VA liabilities. Depending on the type of sensitivities or risk factors to be hedged, A disadvantage here is that the riskthe following subtypes of dynamic hedging management team must have a high levelare common: of expertise as well as the advanced systems necessary for continuous checks, monitoring• Delta hedging: insurance against move- and execution. In contrast to other approach- ments in the underlying fund price; es, total costs cannot be determined in ad- vance because of the frequent rebalancing• Rho hedging: protection against negative required (which can involve potentially high movements in risk free interest rates; transaction costs). Using this approach also requires a significant capital outlay for train-• Vega hedging: taking into account changes ing and systems. in volatility; One additional strategy is a hybrid ap-• Gamma hedging: insurance against proach that combines static and dynamic changes in delta due to a change of the hedging. The static hedging involves pur- underlying fund price. chasing an over-the-counter hedge when market rates are low, which mitigates some The so-called “higher order Greeks” or complex risks. Dynamic hedging is used to “cross Greeks” are mainly used in more com- bridge the remaining gaps.prehensive hedging programs. The finalhedge portfolio is expected to match move- All hedging programs have their ad-ments in liabilities over a short period of vantages and disadvantages. To find thetime. As a result, the portfolio is adjusted optimal approach, a cost/benefit analysisfrequently. The rebalancing period should has to be done and key factors such as thebe defined so that it provides an acceptable size of the VA product, the VA provider’strade-off between transaction costs and risk appetite and market conditions shouldhedge accuracy. be considered. 35
  • 36. Allianz Global Investors International Pension Papers No. 3|2009Impact of recent market crisis on variable annuitiesThe recent severe market turbulence has ments for risk transfer, will become moreresulted in significant declines in equity important.values. Because of this, most guarantees em-bedded in VAs have become “in-the-money”. Most existing hedging programs haveThis means that the guarantee benefit has been effective at mitigating the increase ingreater value than the assets accumulated in liabilities resulting from the recent capitalpolicyholders’ account balances. As a result, market crisis. However, despite the dynamicit is likely that the market downturn will hedging approach used by most of the com-boost demand for VA products because cus- panies, there were some significant differ-tomer perception of the value of guaranteed ences in implementation (for example, someproducts has increased. companies used “higher order Greeks” and “cross Greeks” rather than simple Delta In contrast, insurance companies face new hedging). This led to considerable differenceschallenges in their VA business as a conse- in hedging performance.quence of the dramatic market development.First of all, the sharp decline in equity prices The main sources of variations are theimplies that the profitability of the VA busi- Greeks that are hedged and the frequency ness will reduce an insurer’s income stream with which hedging is applied. The increasesignificantly as fees are based on the actual in market volatility has generated losses toaccount values. hedging programs that do not guard against changes to market volatility (Vega hedging). Another consequence of the increased Although it is often argued that these lossesequity volatility will be higher guarantee are not realized cash losses, the effect on thecosts, which will be reflected in higher rider required risk-based capital can be significant.fees in new VA products. Policyholders dis- As a result of the market downturn, hedginglike higher product fees. Insurance companies activity will increase and hedging programswill need to revise their new VA products and will be enhanced to cover more risk factors.rider designs to limit the risks of the underly-ing fund investments and avoid expensive The current market environment alsoguarantee riders. will affect the underlying fund investments included within VA contracts. Generally, However, the most important conse- the funds cannot be hedged directly. Instead,quence of the market crisis is related to they are mapped to hedgeable indices orrisk management and hedging programs. risk factors. This mapping is often basedAs the guarantees from existing products on simple linear relationships determinedbecome more valuable and the possibility by historical data. However, during extremerises that the guarantees will end up in-the- market fluctuations this simple approachmoney, insurance companies, which provide has often caused basis mismatches (devia-the guarantees, are forced to increase their tions between funds and correspondingrisk-based capital requirement. Hedging indices), which directly contributed to hedgeprograms, which are used to counter this ineffectiveness.increase in liabilities or reinsurance arrange-36
  • 37. Allianz Global Investors International Pension Papers No. 3|2009 What we see now is an increasing tendency antee costs to be shifted to the fund level. Toto include investment funds that employ dif- avoid further guarantee costs and to benefitferent risk mitigation strategies in VA policies. fully from these risk management strategies, it is essential to model these funds properly Examples of these types of funds are by using advanced mapping techniques andvolatility target funds and funds with a built- accounting for the current fund allocation.in downside protection. These allow VA guar-ConclusionThe market for variable annuities has been significant decrease in equity values. Thisbadly affected by the financial crisis; howev- caused huge losses for companies withouter, the demand for annuities continues and appropriate hedging programs. At the sameis even on the rise. VAs are likely to make up time, this market downturn showed thean increasing share of total assets in the attractiveness of such guarantees for policy-retirement market. For that reason, product holders and led to increased demand forproviders have a vital interest in increasing VA products, which we assume will continue.the calculability of annuity products as well However, providers need to address potentialas providing attractive offers to the customer. problems in product design without the price of guarantees rising to a level that reduces VA providers have been offering new fea- demand. New VA products must limit thetures and guarantees in their products. This risks of the underlying fund investments andhas made the products more attractive but avoid expensive guarantee riders.at the same time it has made them moreexpensive and more complicated to monitor To achieve this, providers are likely toand to hedge. In order to manage all types of enhance hedging strategies. They will dorisks arising in this business, a powerful and this to ensure that more risk factors arecomprehensive hedging platform is required. addressed. There is a trend toward using funds with built-in risk management strate- The current market downturn has under- gies, such as volatility target funds, and fundsscored the need for a proper risk management that include downside protection because,system. Many guarantees included in VA prod- if modeled properly, they can help to reduceucts became in-the-money because of the the costs of additional riders. 37
  • 38. Allianz Global Investors International Pension Papers No. 3|2009VII. ConclusionsT wo severe downturns in the financial markets in only one decade significantlyhit the pension wealth of the world’s largest sponsored pension plans. Instead, lump-sum payments that have to be managed individu- ally are more common. This signifies a shifteconomy. However, compared with the crises in responsibility to the individual, who mayin 2000 and 2001, the current downturn has not have the knowledge and time to designhad a much greater adverse effect on the a winning retirement planning strategy.financial circumstance of many U.S. house-holds. Within one year, from 2007 to 2008, Defined contribution plans and IRAs are the value of overall retirement assets dropped expected to fund an increasing share of re-by more than USD 4 trillion – and this does tirement income. The role of supplementarynot yet include losses in housing values and pension plans will change from providingother financial assets. Because of the increas- complementary income to providing aning dependency on supplementary pension essential and integral portion of the moneycoverage to maintain a certain standard of needed to cover required spending require-living in retirement, the crisis underscored the ments in retirement. Guaranteed income need for proper risk management to protect from Social Security and defined benefita person’s much-needed assets from adverse plans will account for less than in the past.market movements. Only 21% of the work force is currently cov- ered under a DB pension plan and this share The downturn foiled the retirement plans is decreasing. Even before the financial crisisof many pre-retirees who now have to work of 2008, Social Security finances were at riskout alternative strategies. Delaying retire- because the baby boomer generation wasment and settling for a lower retirement starting to reach retirement, which put moreincome are two likely scenarios. However, pressure on the system’s finances. The largethe situation becomes even worse when this amount of government financial aid usedbackdrop is considered in the context of the to support troubled companies will increasegeneral state of the pension system and the the national debt to new record highs.trends affecting employer-sponsored pension Experts warn that even record tax increasesplan design. The role of Social Security is un- will not be sufficient to repay this debt. It iscertain. Smaller payouts from an already-low likely that these factors will tempt the govern-level are presumably unavoidable. As a result, ment to cut back further on Social Securityoccupational and private pension assets will benefits, which are one of largest items ofhave to provide for an increasing share of public expenditure.retirees’ income. The increasing importance of self-directed Making matters more difficult is the on- retirement plans challenges individuals ingoing trend by companies to close or freeze many ways. Defined contribution plans have their more-generous defined benefit schemes been overtaking defined benefit plans, leavingand instead offer less-costly defined contri- most individuals with risks that previouslybution schemes in which retirement benefits were handled by the employer. The Pensiondepend on the return on the chosen invest- Protection Act of 2006 introduced legislationment. What’s more, with the ongoing shift that authorized employers to automaticallyfrom defined benefit to defined contribution enroll employees in the company pensionpension plans, individuals no longer enjoy plan. If the employee does not play an activelifetime payments from their employer- role in his financial future, an employer does38
  • 39. Allianz Global Investors International Pension Papers No. 3|2009not have to assume fiduciary responsibility products must consider and addresswith regard to the investment return as long retirement-specific risks.as the employer directs contributions to oneof the defined Qualified Default Investment The baby boomer generation is on theOptions. Many employers are taking advan- verge of retirement and has accumulatedtage of this new rule; the introduction of a massive stockpile of assets. At least aauto-enrollment has gained speed. portion of those assets will be needed to finance some of their spending needs in Regulation has shaped the design and retirement. There is a structural shift in thedevelopment of company pension plans. composition of retirement income, whichThe response to the new rules on automatic will increasingly come from the pools of as-enrollment and QDIAs shows that govern- sets in defined contribution and Individualmental guidance has a strong impact not Retirement Accounts. The product spectrum only on the structure of pension plans but to create income solutions is large, complexalso on investments and asset allocation in and sometimes confusing. In addition, therethose plans. Prior to the PPA’s rules on QDIAs, is a lot of flexibility when choosing a suitablemany employers chose to invest very conser- withdrawal strategy.vatively to avoid being held responsible forlosses in their employees’ accounts. Today, Pension-related regulation has a strongtarget date funds have developed into the focus on the accumulation phase. A requiredinvestment of first choice. Almost 90% of tar- minimum distribution from tax-exemptget date fund assets are held in retirement retirement accounts is the only rule thataccounts.38 Experts predict that in the future applies to the retirement phase. Financialthese funds might account for the majority illiteracy is widespread among older peopleof all DC assets. The “auto-pilot” feature with in the United States. Even basic financiala continuing rebalancing mechanism from concepts may not be understood. But retire-risky to less risky assets makes them very ment planning and income generation goattractive. beyond basic concepts. Even for the best fi- nancial minds, these are complex problems The products currently used to generate to solve given the number risks and uncer-income in retirement do not make much of a tainty linked to an individual’s retirementdifference to those people investing in them investments. At the same time, Joe Averageduring their working years. Recent experienc- is being asked to translate his DC and IRA es have shown that most portfolios were not account balances into a regular stream ofwell positioned to weather the storm on the income that lasts for a lifetime.capital markets. With the increasing impor-tance of supplementary income sources in The conjunction of financial illiteracy,retirement, the construction of retirement a complex product landscape and missingportfolios must be geared to provide a reli- governmental guidance makes it difficult forable income stream once an individual stops most people to design a suitable retirementworking. Risk management is of particular income strategy. In the past, the governmentimportance. Products and financial advice was very effective in shaping the retirementthat are geared to support people in the market. Regulation could again be used to decumulation phase still need to adapt to provide guidance, especially for the long-this changing environment. Decumulation neglected payout phase. At the same time, 39
  • 40. Allianz Global Investors International Pension Papers No. 3|2009product providers need to develop productsthat target the payout phase and that priori-tize the retirement-specific risks that wereoutlined in detail in Chapter V. Productsimplicity and robustness are also required.These products must be easy for the custom-er to understand and, most importantly, theymust deliver promised results regardless ofthe market situation. Finally, product provid-ers and advisers need to cooperate to bringthese new solutions and products to the cus-tomer. Advisers will need to be educated onthe offerings and then determine how to bestincorporate them into their clients’ portfolios.This might involve changing business modelsand incentive structures. Providers andadvisers must make changes to support thewealth decumulation market in the future.Retirement products will likely be less focused on generating equity market returns,and more focused on sustainable spending.40
  • 41. Allianz Global Investors International Pension Papers No. 3|2009References1 Allianz Global Investors, Retirement at Risk – The U.S. Pension System in Transition, 2008.2 EBRI Databook on Employee Benefits3 Allianz Global Investors, International Pension Issues 02/09, Severe Setback in Financial and Retirement Assets, March 2009.4 U.S. Federal Reserve, Flow of Fund Accounts, June 2009.5 Congressional Research Service, Domestic Social Policy Division, Aging Seminar Series: Income and Wealth of Older Americans, November 19, 2008.6 Allianz Global Investors, International Pensions Issues 2|09: Severe Setback in Financial and Retirement Assets, March 2009.7 Rosnick, D. and Baker D., Center for Economic and Policy Research, The Wealth of the Baby Boom Cohorts After the Collapse of the Housing Bubble, February 2009.8 Rosnick, D. and Baker D., Center for Economic and Policy Research, The wealth of the Baby Boom Cohorts after the collapse of the Housing Bubble, February 2009.9 Investment Company Institute, The U.S. Retirement Market, 2008.10 Allianz Global Investors, International Pension Issues 02/09, Severe Setback in Financial and Retirement Assets, March 2009.11 EBRI, Issue Brief No. 326, The impact of the Recent Financial Crisis on 401(k) Account Balances, February 2009.12 Fidelity, News Release, Fidelity Reports on 2008 Trends in 401(K) Plans, 28. January 2009.13 Fidelity, News Release, Fidelity Reports on 2008 Trends in 401(K) Plans, 28. January 2009.14 EBRI, Issue Brief No. 326, The impact of the Recent Financial Crisis on 401(k) Account Balances, February 2009.15 Baker, D. and Rosnick, D., Center for Economic and Policy Research, The Impact of the Housing Crash on Family Wealth, July 2008.16 Baker, D. and Rosnick, D., Center for Economic and Policy Research, The Impact of the Housing Crash on Family Wealth, July 2008.17 Aon Consulting, Replacement Ratio Study – A Measurement Tool for Retirement Planning.18 Knowledge@Wharton, interview with Kent Smetters: A Thought for Tax Day. The Real Fiscal Crisis Is Yet to Come, 2009.19 National Institute on Aging, The Health & Retirement Study, Growing Older in America, 2007.20 Antolin, P., OECD, Policy Options for the Payout Phase, 2008.21 McKinsey&Company, The Retirement Journey, year unknown.22 Investment Company Institute, Defined Contribution Plan Distribution Choices at Retirement, 2008.23 Investment Company Institute, The Role of IRAs in U.S. Households’ Saving for Retirement, 2008.24 Investment Company Institute, The Role of IRAs in U.S. Households’ Saving for Retirement, 2008.25 National Institute on Aging, The Health & Retirement Study, Growing Older in America, 2007.26 Insured Retirement Institute, 2009 Annuity Fact Book, 2009.27 Allianz Life US, Allianz Consumer Confidence Survey, 2008.28 Retirement Income Industry Association: Key Retirement Challenges and Opportunities, 2006. 41
  • 42. Allianz Global Investors International Pension Papers No. 3|200929 EBRI, Issue Brief No. 324, 401(k) Plan Asset Allocation, Account Balances and Loan Activity in 2007, December 2008.30 EBRI, Issue Brief No. 324, 401(k) Plan Asset Allocation, Account Balances and Loan Activity in 2007, December 2008.31 risklab germany, Rethinking the Herd, August 2008.32 Pollock, A., American Enterprise Institute for Public Policy Research: Retirement Finance: Old Ideas, New Reality, September 2006.33 Attié, A. and Roache S., IMF Working Paper, Inflation Hedging for Long-Term Investors, April 2009.34 Lusardi, A. and Mitchell, O., Financial Literacy and Planning: Implications for Retirement Wellbeing, 2005.35 Inderst, R. and Ottaviani, M., Misselling through Agents, June 2008.36 RAND, Institute for Civil Justice, Investor and Industry Perspectives on Investment Advisers and Broker-Dealers, 2008.37 Consumer Federation of America, Hearing on “Enhancing Investor Protection and the Regulation of Security Markets” before the U.S. Senate, March 2009.38 Investment Company Institute, The U.S. Retirement Market, First Quarter 2009.37 Inderst, R. and Ottaviani, M., Misselling through Agents, June 2008.42
  • 43. Allianz Global Investors International Pension Papers No. 3|2009Recent publicationsInternational Pension Studieshttp://publications.allianzgi.com/en/PensionResearch/Pages/PensionStudiesandPapers.aspxHow the financial crisis affects pension funds: What analysts expect September 2009Private household financial assets: the golden days of the past are a long way off August 2009Investment Regulations and Defined Contribution Pensions July 2009Funded Pensions in Western Europe 2008 Feb 2009Retirement at Risk: The U.S. Pension System in Transition Jan 2009Pension Trends in Emerging Markets - The Rise of DC Plans and Its Consequences Nov 2008Funding Unfunded Pensions: Governance and Investments of Asian Reserve Funds Sept 2008Evaluating the Impact of Risk Based Funding Requirements on Pension Funds May 2008International Pension Issueshttp://publications.allianzgi.com/en/PensionResearch/Pages/Internationalpensionsissues.aspxPension funds and the financial crisis July 2009Western Europe: Fiscal pressures-ageing costs still on the horizon April 2009United States: Severe setback in financial and retirement assets March 2009Germany: Households financial assets dive Jan 2009& http://publications.allianzgi.com/en/PensionResearchImprintPublisher: Allianz Global Investors AG, International Pensions, Seidlstr. 24-24a, 80335 Munich, Germany | International.Pensions@allianzgi.comhttp://www.allianzglobalinvestors.com | Author: Isabel Bodlak, Pensions Analyst, Allianz Global Investors AG, Isabel.Bodlak@allianzgi.comContributors: Dr. Bernhard Brunner, risklab; Mikhail Krayzler, risklab | Layout: volk:art51 GmbH, Munich | Printing: Christian Döring GmbH, MunichClosing Date: August 31, 2009The entire content of this publication is protected by copyright with all rights reserved to Allianz Global Investors AG. Any copying, modifying, distributingor other use of the content for any purpose without the prior written consent of Allianz Global Investors AG is prohibited. The information contained in thispublication has been carefully verified by the time of release, however Allianz Global Investors AG does not warrant the accuracy, reliability or completenessof any information contained in this publication. Neither Allianz Global Investors AG nor its employees and deputies will take legal responsibility for anyerrors or omissions therein.This publication is intended for general information purposes only. None of the information should be interpreted as a solicitation, offer or recommendationof any kind. Certain of the statements contained herein may be statements of future expectations and involve known and unknown risks and uncertainties,which may cause actual results, performance or events to differ materially from those expressed or implied in such statements. 43
  • 44. www.allianzglobalinvestors.comAllianz Global Investors AGInternational PensionsSeidlstr. 24 -24a80335 Munich, Germany