The Nobel laureate Bill Sharpe once called defined contribution (DC) decumulation the “nastiest, hardest problem in finance”. 

For decades the standard wisdom has been to draw down 4% of a retirement pot annually, with assets invested in a mixture of bonds and income generating stocks – a methodology first set out by William Bengen in 1994.

DC decumulation has largely been the preserve of the wealthy in the UK at least, and DC income options have mostly been a choice between very expensive annuities and expensive, often intermediated, withdrawal plans of some form. Since the introduction of pension freedoms in 2015, withdrawing the entire pot has become an option for British retirees, and a preferred route for the many who have limited assets. The recent continued high volatilty and low asset returns have also challenged the ‘4% rule’ for plan withdrawal.

For most members of UK DC plans, the problem of how to structure DC income is far down the road: average pot sizes are still small and many members are far from retirement age. For the average UK worker, immediate employment prospects and finances are of a greater order of magnitude than the question of how to access a retirement pot far into the future. Many or even most will not even realise it is a problem.

There are also many unknowns in UK auto-enrolment. For one, there may potentially be fewer people in the system if the economic downturn leads to an increase in portfolio careers, where people take two or more part-time roles paying less than the auto-enrolment minimum, which is currently set at £10,000 (€11,000).

But UK DC assets are growing as auto-enrolment continues to bed in, meaning the problem will only grow as average pot sizes increase and the number of retirees swells. 

Aggregate assets in DC plans were up a healthy 9.5% in the 12 months to July 2020, now totalling £471bn, according to the DC Future Book, published last month by the Pension Policy Institute and Columbia Threadneedle. The number of people automatically enrolled into workplace DC schemes has almost doubled in five years, now totalling 10.3m. 

IPE has reported on a number of interesting options over the years to do with DC investment and withdrawal. Per Linnemann’s ‘iTDF’ concept is of particular interest (IPE December 2019); it combines two multi-asset funds for capital accumulation and withdrawal, with algorithmically derived smoothing mechanism to allow for steady retirement income. 

Insight Investment is now looking at translating its expertise on defined benefit (DB) decumulation to the DC market and has identified a number of issues. One is to better identify and isolate stable, income producing assets to overcome the ‘rule of thumb’ approaches that prevail in many traditional income funds. 

Another is the ‘sequencing’ of return: given that more risk assets may be needed to fund longer retirements, the return profile is particularly important. Periods of low returns and volatility can knock income targets way off kilter when an asset portfolio is in drawdown, so you may need to return more than you previously thought to compensate. Increasing risk to make up temporary shortfalls can just exacerbate the problem.

Fees are a major issue – and DC markets like the UK’s could do with a disruptor to provide real competition and seed new ideas for retirement.

Writing in IPE in April 2017, the Nobel economics laureate Robert Merton and Arun Muralidhar proposed that governments issue ‘standard-of-living indexed, forward-starting, income-only securities (retirement ‘SelFIES’ for short). 

These income-only bonds would pay a coupon from retirement for average life expectancy – which in the US is 20.6 years for a woman reaching Social Security retirement age this month. A deferred annuity would cover any shortfall for those surviving beyond retirement age.

Nasty problems can be overcome

Market yields are probably too low for this kind of issuance to be attractive right now. But watch this space, if inflation does edge up, as many are predicting, and yields creep upwards too.

Inflation-linked and green bonds have been recent innovations in the fixed-income market; bonds with a coupon linked to populationlongevity have been proposed before, but have never taken off. 

The next few years could be a fertile time to think about innovative new designs of bond instrument that would really benefit investors and savers. Politicians and governments have so far this year proved willing to innovate and act swiftly to mitigate the effects of COVID-19. Debt management offices should be willing to listen, and politicians have an incentive to be on the lookout for innovative policies. Given the preponderance of older voters in Western countries, paying attention to their needs will always go down well.

Retirement income is a ‘nasty’ problem for many reasons, and those drawing down on an asset pot will probably always run the risk of either running out of money too soon or spending too cautiously and leaving too much behind.

But a new wave of innovation can mean that it becomes less of a nasty problem than it currently is. It can certainly become a cheaper problem.

Liam Kennedy, Editor