In retirement, a balance must be struck between the need for income and maintaining some equity exposure to counterbalance longevity. The question is: what are the right numbers Much debate has arisen about the right balance between maintaining exposure to equities for growth and preserving capital through more conservative strategies. Equity allocations on either end of the spectrum — less than 20% or more than 80% — do not offer optimum results in terms of the trade-off between risk and return. Luckily, there are many options in between.

With shifts in asset allocation, there is also a need to get the timing right. For this reason, default investment options should incorporate an investment strategy that is sophisticated in its assumptions and design. The strategy should provide a consistency of returns in order to encourage persistency of contributions from members. Lastly, there should be sufficient flexibility in the default fund to manage the transition to retirement income when the member leaves the workplace.

 Considering Default Options

To accomplish these goals, several asset allocation approaches can be considered. These include:

• Target date or lifecycle strategies (commonly used in US 401(k) plans)

• Cash balance plans

• Managed accounts

• Structured guaranteed return products

• Balanced funds (used in Australia’s superannuation funds)

• Constant Proportion Portfolio Insurance (CPPI), a capital protection strategy used widely in Germany

 Each choice has its challenges. Balanced funds take a one-size-fits-all approach, which may not suit everyone. Target date funds, while allowing for different members’ needs, have faced benchmarking challenges and cost burdens. Structured guaranteed return products, including deferred annuities and stable value funds in the United States, suffered during the market crisis and guarantors are looking to exit the business.

While CPPI has experienced high demand among German plans, most went to cash during the crisis - not an optimal move. CPPI also faces implementation challenges due to the frequent transactions required by computer-driven modeling.

 Designed for DC retirement plans, target date funds are multi-asset class funds that alter their asset allocation (generally with greater allocations to fixed income and smaller allocations to equities) as they move toward a specific retirement year (target date). The asset allocation adjustment made over time is also known as a “glide path.”

Lifecycle strategies, which are very similar, are commonly used in the UK. Both types of vehicles have seen dramatic growth in assets. Lifecycle funds now make up an 80% share of most DC plans in the UK, according to Watson Wyatt. In the United States, more than $180 billion has been invested in target date funds and approximately three-quarters of plans with default options use target date funds as the default.

In the United States, target date funds are under scrutiny following a year when many saw losses of more than 30%, even those designed for people verging on retirement. The problem? There is no strict definition of target date and no specific benchmark, making it difficult to judge their risk profile. Many were over-weighted to equities, even for relatively near-target retirement dates, and some were less “automatic” than had been supposed.

Now, discussions are under way concerning creating benchmarks for target date funds. One idea may be to measure target dates against CPPI models, which dynamically adjust the account’s asset allocation according to an individual’s risk tolerances.

Cost is driving investment choice in many retirement markets. Investment fees are expected to have a significant impact on participant choice in Hong Kong’s MPF Schemes, when participants gain more control over the choice of investment vehicle for their plan balances. A bill, passed in July 2009, gives MPF participants the option

of transferring the balance of their MPF account into a vehicle of their own choosing once per year. As a result, once the changes take effect in the next year to 18 months, cost competition among plan providers is expected to heat up in the Hong Kong market.

 How do you build a more outcome-certain income stream in retirement? One approach could be liability driven investing. LDI strategies use swaps to hedge against inflation and changes in interest rates and are commonly used by DB pension schemes in the UK and the United States to match future liabilities and reduce the risk of over- or under-funding.

A form of LDI used to create a no-risk investment option is gaining currency in the German market, which has been ahead of the curve in terms of guaranteed product innovation because the promise of no loss to principle is required by law.

Such an LDI approach uses zero coupon bonds with an appropriate maturity date for each age group over a series of age clusters (e.g., 20-30, 30-35, etc.). In this way, one can achieve a guaranteed return of 0 to 2 percent.

The zero coupon bonds can then be hedged against inflation though inflation swaps. The plan sponsor can lock in a real interest rate for each employee, so the precise level of income that the employee will receive each year can be communicated.

The result is a real - not nominal - income stream that is hedged against inflation. While a deflationary environment may pose a challenge, some type of derivative investment can help. The model needs scale to work - zero coupon bond purchases require asset volume. It is not a standalone solution because a fixed return is not adequate for growth. Nevertheless, the result is admirable: a risk-free option with a high level of certainty that permits employers to make a commitment to provide DC plan members with an income stream in retirement.

To fill the gap between the accumulation and de-cumulation stages, products that offer growth along with capital protection and income drawdown features are needed. Solutions on the drawing board include new forms of annuities, income management funds, hybrid annuity/income payout funds and longevity insurance-wrapped DC products. There is also the prospect of the plan sponsor taking on an increased role during the post-retirement phase and creating asset retention services and thoughtful retirement income products on behalf of employees.

Cost notwithstanding, annuities can provide a useful retirement income vehicle because — all other things being equal — an individual can share the risk of outliving savings within the annuity pool. Those who die “early” pay for those who die “late,” in the same way that, with car insurance, premiums paid by those who don’t have accidents pay for those who do.