Choice #1: Buy Treasuries

Traditionally, retirees sought the safety of Treasury securities. Although unsophisticated, this was a reasonably sound strategy. Treasuries paid handsomely–well above what stocks delivered–while being guaranteed by the U.S. government. Retirees who held Treasuries until their bonds and notes matured faced no principal risk and thus possessed few worries.  With that approach, the real value of a retiree’s capital eroded. Fortunately, inflation’s effect was less damaging than advertised because, for most retirees, the longer their retirement, the less they spent. True, sometimes this decline occurred by necessity, as reduced purchasing power crimped their spending habits, but for the most part it happened naturally due to health concerns. 

Regrettably, time has ravaged the Treasury strategy. Had couples through time placed $800,000 into 10-year Treasury notes, those who retired in January 1970, 1980, 1990, and 2000 would have generated hefty monthly incomes of $5,240, $7,333, $5,327, and $4,527, respectively. In contrast, today’s couple would earn a mere $1,113. The price for investment safety has become exorbitantly high.

Choice #2: Boost Income

Unlike in the past, retirees cannot simultaneously: 1) generate substantial income, 2) without touching their capital base, 3) while receiving a government guarantee. However, they may still achieve those first two goals, should they jettison the third. That is, retirees can buy investments that generate sufficient yield so that they need not supplement their income by dipping into their investment capital.

For example, our couple could buy a portfolio consisting of the following exchange-traded funds, which would collectively yield 4.17%. The monthly income on the $800,000 investment would be $2,780–far below what 10-year Treasuries paid during bond investors’ glory days but more than double Treasuries’ current level.

The danger with this approach is that although the portfolio ostensibly is diversified, holding both stocks and bonds, almost all the holdings are economically sensitive. Of course, my investment suggestions could readily be altered, but the conclusion would remain intact. Particularly now, with inflation fears abated, so that long investment-grade bonds no longer pay very much, there’s no real way to achieve high yields without courting recession risk. For that reason, “spend income and maintain capital” strategies are quietly hazardous. Unless the retiree is willing to slash the portfolio’s income by seeking proper diversification, such approaches tend to get clocked by economic slowdowns. Sometimes the losses are merely temporary, but on other occasions they are permanent, caused by corporate bankruptcies. That’s a tough way to live.

Choice #3: Spend Capital

A more prudent path is to accept lower portfolio income, then supplement those receipts by gradually removing investment capital. Psychologically, this tactic can be difficult. As financial advisor and author Michael Kitces explains, those who spend their working years increasing their assets tend to dislike doing the opposite. Growing one’s wealth is enjoyable; shrinking it, not so much.

Investing 50% in a broad U.S. stock market index and 50% in high-grade bonds makes for a 1.5% overall yield, which means that, to match the payout from the income portfolio, our couple would need to spend 2.67% of their capital during their first year of retirement. As U.S. stocks over the past century have posted annual price gains of slightly more than twice that amount, growth from the 50% of portfolio held in stocks would more than compensate for the lost principal. On average, our couple will fare just fine.

In practice, though, the financial markets fluctuate. Consequently, the “spend capital” tactic must be flexibly implemented. Those who adopt this approach will need to reduce their withdrawals after equity prices have fallen significantly, thereby avoiding the vicious cycle of raiding a declining asset base. With luck, lost ground will be recouped later. But unlike with the strategy of owning Treasuries, there are no guarantees.

Choice #4: Annuitize

Another possibility for those willing to part with their capital is to annuitize by buying a contract that promises future payments. While such investments come with a cost–just because they lack official expense ratios doesn’t mean that the insurer provides its services for free–they boast the benefit of pooled resources. A group of people can insure themselves more efficiently than can an individual.

There are several ways to use annuities. One is to buy an immediate lifetime annuity. Currently, a 65-year-old couple can earn about 4.8% annually on a joint lifetime annuity, to be paid until both parties have died. If our couple were to place $650,000 into that joint annuity and the remainder into equities, they would match the income portfolio’s yield, while retaining $150,000 that could be used for portfolio growth.

Conversely, the couple could buy a deferred annuity. The purchase occurs today, but the benefit is paid in the future. For example, the couple could devote $300,000 of the portfolio toward a joint deferred annuity that would pay $3,000 per month, starting at age 80. That would cut their current portfolio to $500,000 from $800,000, but that half million would only need to last for 15 years because, after that date, the deferred annuity would fully meet their needs.

Annuitizing is even harder psychologically than dipping into capital because the retiree forgoes a bigger chunk of money when annuitizing, which will never return. Also, the decision to annuitize can be complex, given how many options exist. For these reasons, the tactic isn’t very popular. However, it is worth considering. There is an advantage to locking down income, thereby freeing the remaining assets so that they can be invested for capital appreciation.

Wrapping Up

By design, this column surveys the topic of retirement income from the stratosphere. It will surprise nobody who works in the field. However, from my experience, workers who haven’t yet thought about how to convert their investment assets into income during retirement often struggle to find articles that lay the groundwork. This one makes that attempt.

General Advice Warning

Any advice/ information provided is general in nature only and does not take into account the personal financial situation, objectives or needs of any particular person.

Admittedly, the 401(k) network is incomplete; being unavailable to one third of private-sector workers, but 401(k) access could readily become universal by modifying the regulations.

The beauty of the retirement-accumulation approach is its simplicity. When 401(k) plans feature automated enrollment, employees succeed by doing nothing. Both their projected Social Security payments and the value of their 401(k) accounts quietly increase, with the latter typically invested in a highly diversified target-date fund that requires little investor attention. The machine runs itself.

Not so when retirement arrives. The Social Security benefit is straightforward, aside from the choice of when to begin, but converting lump sums into income is devilishly complex. Use the assets to buy an immediate annuity, thereby avoiding investment decisions? Spend some of the monies on a deferred annuity, for longevity protection, while keeping the rest invested? Skip annuities altogether?

With the investments themselves, preserve capital while spending its income? Adopt a total-return approach that involves regularly drawing down capital? If so, how much capital, what should be the asset allocation, and how flexible should be the withdrawal rates, should the markets perform poorly? Place the assets in a single portfolio, or separate them into several buckets, each of which is designed to meet a different investor need?

The Happy Few

Financial advisors answer those questions. They are paid to tailor solutions that reflect each retiree’s preference. For example, while some investors cherish the security provided by annuities, others shun them, because buying annuities means losing control of those assets. Experienced advisors recognize the differences among their clients, making their recommendations accordingly.

Regrettably, such advisors cannot serve the masses. Their services require time and expertise and thus are too costly for smaller accounts. Michael Kitcesrelays the story of a financial planner who explained his occupation to a Philippine citizen. The response: “Wow, you folks have so much money that you can hire somebody to tell you what to do with it.” Exactly. Traditional financial advice suits the relatively wealthy, but it fails everyday retirees.

Potential Solutions

In response to this need, the marketplace has developed two innovations: 1) digital advice, and 2) new retirement-income products. A third possibility is to extend the 401(k) framework so that it covers employees from job to grave.

1) Digital Advice

This approach has made the largest inroads. Delivering retirement-income counsel electronically (or by telephone) is an inevitable outcome of the technology revolution. No longer must financial experts hold individual meetings, dispensing their knowledge one client at a time. Instead, they can build systems to clone their insights, thereby serving more investors at a lower cost.

Various parties have made the attempt, including traditional advisory firms, discount brokers, and venture-capital upstarts. Adoption has been moderate. An October 2020 list of digital-advice providers (which admittedly, omits the efforts of the traditional advisory firms) estimates the industry size at $320 billion–about 0.3% of the value of U.S. stocks and bonds. Of that figure, more than half comes from Vanguard’s program, which was seeded by existing Vanguard assets. While it’s too early to conclude that digital advice will not become the mass solution, there are concerns. The major hurdle is that it requires investor activity. Even at its most streamlined, digital advice demands participation from its customers. As the 401(k) industry has shown, many workers dislike confronting their retirement realities. They will go to great lengths to avoid such experiences.

2) New Retirement-Income Products

I had high hopes for these. In 2007, Fidelity introduced a mutual fund series called Income Replacement. The following year, Vanguard and Schwab launched Managed Payout and Monthly Income funds. The names differed, but the goals were identical: Provide single-fund solutions that delivered income for retirees who possessed investments with the aim of supplementing their Social Security and/or pension benefits but who lacked sufficient assets to hire financial advisors.

The sponsoring fund companies were the right organizations, being industry leaders. Unfortunately, the time was very much wrong. As anybody who has studied retirement withdrawal rates can attest, the worst outcomes occur when stocks crash at the beginning of the withdrawal period. That is what happened, in a big way through the 2008 financial crisis, and the funds never recovered. Eventually, Fidelity and Vanguard merged their offerings. The Schwab funds remain alive but just barely, commanding a piddling $250 million.

I still like the idea. Such funds permit retirees to pool their resources, while also permitting them to redeem their shares on command. Unlike with annuities, the purchase decision is not final; the investor continues to own those assets. And unlike with digital advice, the process is exceedingly simple. Buy the fund, spend the income distributions, and forget about the rest.

However, if such funds ever do find favor, it will not be anytime soon. That three behemoths couldn’t sell the concept has understandably frightened others from launching such funds. It will take a while for the memory of that marketing failure to fade.

3) Extending 401(k)s

The most logical scheme is to expand the scope of 401(k) plans. Rather than assume that retirees will shift their workplace assets into individual retirement accounts, enhance the 401(k) structure so that it becomes the best solution for most retirees. Of course, those with greater wealth may decide to leave the system to receive customized advice, but rank-and-file employees will stay put.

This could be accomplished by defaulting retirees into investments that are more standardized and better defined than today’s “retirement income” funds, which vary widely and are not well understood by their shareholders. For example, one could default new retirees into structured products that protect against significant capital losses, while paying a competitive interest rate (such a combination is possible, if the investor foregoes stock market gains).

Over time, as the retiree better understands her financial situation, she could select other options, such as annuitizing a portion of the assets or buying a conservative allocation fund that would increase market risk but also improve the chances for capital appreciation. But that could come later. On the retirement date, the process would be automated unless the investor chose otherwise.

Summary

With retirement accumulation, businesses were given an inch of daylight through Section 401(k) of the IRS Tax Code. They seized the opportunity. The same can and should occur with retirement income. The need exists. What remains is for market ingenuity to align with investor demand. Regrettably, that has not yet occurred with mainstream retirement-income services     

General Advice Warning

Any advice/ information provided is general in nature only and does not take into account the personal financial situation, objectives or needs of any particular person.

If they take out too much, they risk running out of assets later in life, especially if they’re fortunate enough to enjoy a long lifespan. If they take out too little, they might miss out on some of the fruits of a lifetime of savings, such as travel, dining out, giving money to charity or family members, or spending more on leisure activities. Pinning down a number that’s neither too high nor too low is notoriously difficult, and the stakes are high.

Even retirement experts often disagree on the right number for retirement withdrawals. The 4% rule—which assumes that retirees set an initial withdrawal rate equivalent to 4% of the starting portfolio value and adjust the previous year’s withdrawal amount each year for inflation—has been widely adopted by financial advisors and individual investors. But there has also been debate about whether withdrawals should ratchet down (to account for lower market returns) or up (to account for lower inflation), as well as the need for more flexible systems that don’t assume a fixed withdrawal rate.

In this article, I’ll dig into the key assumptions behind the different estimates and what they mean for retirees. Assuming that future market returns are lower than in the past, an initial withdrawal rate closer to 3.5% looks like a reasonable starting point.

The Origins of the 4% Rule

Financial planner Bill Bengen’s landmark study was notable because it stress tested withdrawal rates based on return patterns over actual historical periods instead of relying on average returns over time.1 He examined each 30-year period with starting dates from 1926 through 1976, adjusting withdrawals for each year’s actual inflation rate. Based on this data set, he concluded that for a portfolio combining 50% stocks and 50% bonds, a 4% withdrawal rate never fully depleted the portfolio’s value, even during some of the worst periods, such as 1928 through 1957 and the 1973–74 bear market.

However, some observers argued that because it’s based on testing worst-case scenarios, the 4% rule could be considered overly conservative. Financial planner Michael Kitces looked at historical returns going back to 1871 and concluded that while a 4% withdrawal rate worked for a 60/40 portfolio in every scenario, actual sustainable withdrawal rates varied significantly (from 4% to 10%, with a median of about 6.5%) over different 30-year periods.2 As a result, retirees relying on the 4% rule would have often ended up with large remaining portfolio balances at the end of retirement.

Similarly, Cornerstone Wealth Advisors’ Jonathan Guyton argued that a 65% equity weighting combined with a more dynamic withdrawal strategy could produce safe withdrawal rates as high as 5.8% to 6.2%.

General Advice Warning

Any advice/ information provided is general in nature only and does not take into account the personal financial situation, objectives or needs of any particular person.

However, most investors may not have access to dedicated, or intentional, sustainable investment products owing to their general absence from 401(k) plans. In our research, we find that investors may still have a route to expressing their environmental, social, and governance preferences by taking advantage of their voting power regarding shareholder resolutions. Proxy voting, an often-unrecognized channel through which ESG concerns can be expressed, can be seen as the sleeping giant of ESG-oriented investing.

Building on previous Morningstar research into the sustainable investing options available in defined-contribution plans, we examine whether proxy voting on ESG issues is something that plan participants care about, and to what extent the most popular mutual funds offered via 401(k) plans support ESG resolutions in their proxy voting. We also discuss how proxy voting could extend plan participants’ influence on ESG investing.

 Key Takeaways

× Sixty-one percent of individuals surveyed felt that ESG issues should be addressed in their funds’ proxy voting, and a little more than 50% would consider a fund’s proxy voting record in making fund choices.

× Funds with the most 401(k) assets regularly vote against key ESG resolutions and tend to follow the voting strategy set at the asset manager level.

× A few asset managers dominate the 401(k) fund space, which limits the degree to which plan participants can choose funds to align with their voting preferences.

× Regulatory and market initiatives could raise the profile of fund ESG proxy voting, which may introduce greater choice for ESG preference alignment in fund selection at the individual and plan level.

General Advice Warning

Any advice/ information provided is general in nature only and does not take into account the personal financial situation, objectives or needs of any particular person.

Consistent with this overall trend, our survey findings suggest that there is an appetite among fund investors for understanding how their funds voted on ESG issues and that they may be prepared to act on this information. Sixty-one percent of our sample felt that ESG issues should be addressed in their funds’ proxy voting, and 75% indicated that they would like to have more of a say in how their funds voted.

Given that sustainable funds are rarely provided as investment options in workplace 401(k) plans, proxy voting may offer fund investors another way of aligning their ESG preferences with the funds they choose for their retirement savings. Some investors may prefer to use both approaches where available. Theoretically, plan participants could choose among funds based how funds voted on ESG issues on the proxy ballot. Just over half of survey participants indicated that they would be likely to use fund ESG proxy voting as a guide to fund selection.

We find that many of the funds with the most 401(k) assets vote predominantly against key ESG resolutions on corporate proxy ballots. Closer inspection shows that low 401(k) fund support for ESG is linked to voting positions taken by asset managers that dominate the list of the funds with most 401(k) assets—American Funds and Vanguard, which both have low overall levels of voting support for ESG issues.

The SEC’s interest in strengthening mutual fund proxy voting transparency—announced in March—is aimed at giving retail investors more insight into how their money is voted, especially in light of the growing interest in ESG shareholder proposals. SEC acting chair Allison Lee cited retirement savings’ contribution to index fund investing as a primary consideration in this initiative. And, in December 2020, the U.K. government set up a task force to investigate how pension funds’ voting policies can be better reflected in the voting practices of pooled funds in which they invest.16 This means that pension funds, as end investors, may get a greater say in the proxy voting of funds offered by asset managers. In February a partnership involving asset managers DWS and Northern Trust, together with proxy service providers AMX and Manifest, announced a new service that would split proxy voting in pooled funds according to the preferences of pension fund investors.

Furthermore, several startup initiatives, like U.K.-based Tumelo, are offering platforms and proxy services that aim to close the gap between the end investor and the voice that their investments carry through proxy voting and engagement. The general strategy is to offer transparency into ESG issues on proxy ballots and to drive shareholder involvement by allowing investors to share their ESG voting or engagement preferences via an online, streamlined process.18 Not only do these tools help companies understand their investors’ values, but they also have the potential to promote engagement and commitment between end investors, plan providers, and fund providers.

Although many individual investors may not yet be aware of the link between the retirement investments they make via their 401(k) plans and the voting power these investments carry, as general interest in ESG grows so will plan participants’ appetite for influence. We believe that it’s only a matter of time before proxy voting becomes another tool for fund investors to express their ESG preferences

General Advice Warning

Any advice/ information provided is general in nature only and does not take into account the personal financial situation, objectives or needs of any particular person.

12 Collectively, these 100 mutual funds account for $5.6 trillion in total assets, according to Morningstar Direct. Of these, 58 are funds that hold equity investments—accounting for $4.3 trillion in assets.

The massive volume of assets that the funds control is largely a function of their availability across workplace retirement plans. These funds will have found their way into numerous 401(k) plans available to employees, where their mandate is to protect and grow the retirement savings of millions of worker investors across the country.

To understand how strongly the largest mutual funds in 401(k) plans voted in support of ESG issues, we benchmarked their 2020 proxy votes against 67 key ESG resolutions that came to vote at U.S. publicly traded companies in 2020. Each was supported by at least 40% of shares cast by minority outside shareholders, which means this set resonated broadly with the broad shareholder base. Given the high levels of overall support, we would therefore expect to see high levels of support for our set of key resolutions from funds. Appendix 1 lists and describes the key resolutions set.

We began our analysis by narrowing down the BrightScope 100 funds list to those that had the opportunity to cast a vote on at least one of the 67 key resolutions—in other words, funds that contained a holding that voted on one of these issues. Of the list, 51 cast a vote on at least one of the 67 key resolutions and 38 cast at least 10 votes across the key resolution set.

Appendix 2 provides a fund-by-fund vote comparison across the 38 funds with 10 or more votes. It shows that support ranged from 100% to just 4%. As a group, funds in the BrightScope 100 ranking generally exhibited low levels of support for key ESG resolutions. Only eight of the 38 supported 75% or more of the resolutions they voted on; 15 supported at least half; while 23, or 60%, supported less than half.

Our previous research shows that proxy voting by individual funds closely maps to the “house view” of the provider of a fund, or the fund advisor with voting authority. Our current analysis supports this arrangement. Exhibit 4 compares individual funds’ votes with the “house view” of the parent or advisor of each of the BrightScope 100 funds with more than $100 billion in assets. “House view” is determined by examining votes across all funds offered by the asset manager.

For example, the Fidelity funds managed by Geode Capital Management supported nearly 90% of key ESG resolutions, whereas Fidelity’s FMR-managed funds supported around 50% of resolutions. An even starker contrast can be drawn between Vanguard’s index funds’ low support for key ESG resolutions—tracking the Vanguard “house view” at 24% support—and the Wellington-managed Vanguard funds, which supported almost 80% of the ESG resolutions voted on.

The 38 funds with at least 10 votes on our key resolution set account for $3.4 trillion in assets. They hold powerful sway over vote outcomes that shape ESG practices in the U.S. equities market. Yet most of these funds supported fewer than 50% of the key ESG resolutions.

To extend our analysis, we also examined votes by the largest 401(k) mutual funds on 14 resolutions put forward by public sector and labor union pension plans, whose concerns can be assumed to align more closely with those of workers invested via workplace retirement plans.

 General Advice Warning

Any advice/ information provided is general in nature only and does not take into account the personal financial situation, objectives or needs of any particular person.