Investing May 29, 2018

Sequence Risk at Retirement Can Derail Successful Savers

Target-date fund designs should take into account the risks retirement plan participants face—how to correlate and corral the evolving sources of market, event, longevity, inflation and interest rate risks.

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Talking through the 2018 Guide to Retirement with a small group of financial services trade journalists, Anne Lester, head of retirement solutions for J.P. Morgan Asset Management, highlighted the deep analytical work her team has done regarding the optimal shape of target-date fund (TDF) glide paths during investors’ retirement years.

This is a subject of renewed attention among asset managers, defined contribution (DC) plan sponsors and their advisers and consultants, Lester said. And this is for good reason, as “waves of retiring Baby Boomers are foregoing paychecks for plan payments—distributions from DC plan balances accumulated during their working lives.”

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Lester recounted a commonly told but important story. Until really the last decade or so, DC plans were a nice-to-have supplement to defined benefit (DB) pension plans. Today, for many members of the U.S. workforce, they are a critical source of retirement income that will need to be spent down carefully and with ongoing diligence. Additionally, Lester noted that more than 75% of DC plans with qualified default investment alternatives (QDIAs) have chosen a TDF as their default offering.

With all of this in mind, it is easy to see why the topic of how well target-date funds serve investors near and in retirement is increasingly prevalent. One of the first questions Lester advocates asking is, “What should the glide path look like as participants move from accumulating asset balances to spending down those balances in retirement?” And, the related question will come up, “Should the allocation to equity risk assets continue to decline, increase or plateau?”

The J.P. Morgan view, under Lester’s leadership, is that the allocation to equity risk assets should gradually decline through the working years, reaching its lowest point at or near retirement and remaining static in retirement. Interestingly, Lester explained that her team has come to agree with independent academic research that shows some theoretical merit to re-risking later in retirement from a mathematical/portfolio theory perspective. But she also talked about how behavioral constraints have to be considered here, arguing her firm’s approach takes an appropriate middle ground, balancing the capacity for risk in retirement with the willingness/cognitive ability to take risk effectively.

“We take the stresses of real-life participant saving and withdrawal behavior into account, and we rely on well-diversified glide paths to manage a range of participant-experienced risks associated with DC investing,” Lester explained. These include market, event, longevity, inflation and interest rate risks.

Lester says the firm has recently focused on understanding the behaviors of near-retirement and in-retirement clients. In doing so, the firm incorporated a sizable dataset from Chase on household spending, including the near-retirement years, supplementing the data on participant behavior that has traditionally informed glide path design. In addition, the firm seeks to “quantify and evaluate the implications of two opposing dynamics: the willingness and the capacity to take on risk during retirement.”

“Our latest analyses further validate our thinking on glide path design,” Lester said.

Lester pointed to recent J.P. Morgan research penned by her asset management colleagues Daniel Oldroyd, Katherine Santiago, Marissa Rose, and Livia Wu. As their analysis shows, as participants transition from the accumulation to the decumulation phase, the potential adverse effects of a market downturn on total lifetime wealth reach their peak. Simply put, as net spending continues to deplete balances, it becomes more and more difficult to recover from market losses, even with stronger returns in the later retirement years.

Further impacting glide path decisions is the fact that participant cash flows “are more volatile and varied in the near-retirement years than one might think,” Lester warned.

“Our earlier research on participant withdrawals showed that 14% of those over age 59 ½ withdraw, on average, 30% of their DC plan assets,” the researchers explain. “This volatility can intensify the risks associated with a market downturn near retirement if large spending withdrawals result in assets being liquidated at reduced valuations.”

The latest findings using Chase data on spending validates the team’s initial assumptions, Lester said. Spending in the near-retirement years is volatile and varied, “to a degree that can’t be ignored when structuring glide path allocations in this critical period.”

Another interested factor pointed out by the J.P. Morgan research team is that “average returns in retirement matter far less than the sequence of those returns.” As Lester summarized it, poor performance in the early (vs. later) years can have a far more destructive impact on a portfolio’s ending value.

Data and Research May 29, 2018

More Than $6 Billion in Additional Pension Contributions Made Since Tax Reform

Although increasing pension contributions was not a primary consideration in the decision to lower the corporate tax rate in the Tax Cuts and Jobs Act, it is a positive unintended consequence.

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The Tax Cuts and Jobs Act of 2017 resulted in firms contributing 23.8% more, or $6.6 billion additional funds, to their pension plans last year, according to a report from the Wisconsin School of Business.

The increase was due to a key provision in the bill that lowered the corporate tax to 21% this year and thereafter, from 35% last year, giving companies an incentive to accelerate tax deductions, as those contributions would be deducted at a higher rate.

The Wisconsin School of Business’ estimate is based on a review of 414 firms with pensions that increased their pension contributions by $16 million each.

“Even though the law incentivized increased corporate contributions to defined benefit [DB] pension plans, there were some tax practitioners cautioning firms to assess their cash needs before making those contributions to avoid losing out on investment opportunities,” says Fabio Gaertner, assistant professor of accounting and information systems at the school. “There was also some thinking that internal financial constraints might prevent firms from making increased pension contributions in 2017.”

The researchers said they were able to identify additional corporate pension plan contributions because, under the generally accepted accounting principles (GAAP), firms must disclose their expected pension contributions a year ahead in their annual 10-K reports. To draw their conclusions, the researchers compared the firms’ 10-K reports from 2016 and 2017.

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The researchers additionally looked at how the tax reform affected taxpaying and non-taxpaying firms. Firms with positive federal taxable income stood to benefit the most from the deductions, the researchers said. Taxpaying firms made additional pension contributions in 2017 that were 6 1/2 to 12 times larger than non-taxpaying firms.

The authors also said the firms that stand to lose the most from deferred tax asset write-downs for GAAP accounting purposes related to their pensions are the primary contributors. They said this is consistent with the financial reporting incentives that are related to the corporate rate reduction also playing a role in the decision to make additional pension contributions in 2017.

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