Building the Retirement Tier

By Richard Fulford, Sean Klein, Steve Sapra, Joseph Healy, Christina Pihos

• The onset of retirement – and the cessation of a steady paycheck – create a new sense of vulnerability for most DC participants. This partly explains DC participant retirement preferences to control their assets, anchor spending to income and preserve or grow account balances. They also look to their employer for financial advice and guidance.
• To better serve participants, we believe plan sponsors could usefully establish a retirement tier that offers a small set of investment options with varying features and risk profiles. These must align with participant preferences and have appropriate levels of risk, including the ability to mitigate two big ones – sequence-of-returns and longevity risks.
• Based on our modeling, we believe the retirement tier should be composed of income-oriented solutions with moderate levels of expected downside volatility.
• Creating a new retirement tier is a big step. Sponsors must ready new investment options, plan for a growing population of participants and prepare a significant participant communications campaign. Done right, though, the result could be a larger, more confident and better prepared group of participants, both active and retired.

The Case for the Retirement Tier

The steady erosion of corporate defined benefit (DB) plans as a pillar of retirement stability in America helps explain the need for a new retirement tier in defined contribution (DC) plan menus. Gone are the days when private sector retirees could count on a consistent, lifelong stream of income from DB plans. Beginning with the first wave of baby boomers, individuals have become increasingly reliant on DC plans for retirement, as Figure 1 shows.

This secular trend has prompted growing support from both plan sponsors and consultants to introduce a retirement tier as an in-plan, foundational design element. Fully two-thirds of consultants we polled recommended a retirement tier, according to the 2020 PIMCO Defined Contribution Consulting Study.

There’s an urgent need for a retirement tier, but for sponsors and participants, the reasons differ.

The sponsor perspective

Plan sponsors see the retirement tier as a substantial participant benefit that may also help keep retirees in-plan – the preference of two out of three plan sponsors, according to PIMCO’s 2020 Defined Contribution Consulting Study – and sponsors have made significant progress: 2019 recordkeeping data show more than 60% of retirees remain in plan one year after retirement. Five years ago, the figure was 45%.¹

Once in retirement, though, retirees may find that their DC plan has not been designed to suit their specific needs. Indeed, the majority of consultants recommend three key plan sponsor actions to address the needs of retirees, all of which are foundational elements of the retirement tier – adding distribution flexibility, employee education and retiree-focused investment options.

Importantly, no single investment option can meet the needs of all retirees. This heterogeneous group needs access to a variety of investments, ease and flexibility in monitoring and managing their account balance, and applicable guidance and tools.

The participant’s perspective

As participants near retirement, they become more engaged and show a preference to control their retirement assets and maintain flexibility rather than rely on the plan’s default investment. Indeed, data show that older participants are far less likely to invest in the most common form of default – target date funds (TDFs).^2,3 Specifically, 70% of participants age 30 and under invest 100% in the target date default, a ratio that plunges to only 25% for individuals above 60.

However, older participants face a conundrum: Although they desire control, they may lack the expertise to manage their retirement savings. This may explain why over 80% of plan participants indicated they would welcome education and advice from their employer on converting savings into income in retirement.⁴

The retirement tier

In our view, a retirement tier should offer a small set of investment options with varying features and risk profiles. Importantly, investments appropriate for the tier must address the needs, behaviors and preferences of retirees while addressing the key risks every retiree faces – sequence of market returns and longevity.

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