Painting a Fuller Picture: A Framework for Comparing Lifetime Income Solutions
The distinctions among lifetime income solutions are wide-ranging—from cash-flow patterns to investment exposures, and from explicit fees to hidden implicit costs. The differences are multi-faceted, which may make them hard to quantify using common frameworks for analyzing investment solutions. In our view, using traditional metrics risks painting an incomplete picture of lifetime income solutions.
This partial picture could lead defined contribution (DC) plan sponsors to reach a less-than-optimal decision when selecting a lifetime income solution to meet their plan’s needs. We think there’s a better, more complete way to stack different approaches up against each other, which is vital when making such a critical decision.
Developing a Comprehensive Framework
A holistic framework may paint a fuller picture, enabling DC plan sponsors to better compare lifetime income solutions (Display). It should consider all key factors that could impact participant outcomes. And—as with any sound framework—we think it should be rooted in core principles:
- Focus on the individual—not the average. Everyone’s retirement time horizon is unknown, but finite. Not every participant lives to the average life expectancy of 87 years or experiences the average market return during their lifetimes. Incorporating some type of income insurance may reduce this risk, but it’s important to analyze retirement outcomes over a variety of time horizons and market outcomes to represent what different participants might actually experience.
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Take a broad look at all key participant risks. All forms of lifetime income insurance are designed to eliminate longevity risk—outliving retirement savings. But some types require surrendering assets to an insurer up front in exchange for that income. This may create another risk: mortality. A person might die before the average life expectancy, failing to fully recoup income benefits from forfeited assets. Insurance riders that address mortality risk may be costly in terms of reduced income.
Most income insurance may also help tackle the short-term risk of equity market losses that could make income streams less sustainable. But some insurance types, such as fixed annuities, require reducing equity exposure too much, in our view, which could hurt long-term growth potential. Inflation may exacerbate this issue by further eroding spending power. - Evaluate more aspects than income. Plan participants understandably want income from their lifetime income solution, but that’s not the only thing they value. Based on our surveys, nearly two-thirds of participants also want the ability to access their assets to handle unplanned expenses or leave a legacy if they have an account balance left at the end of their lives. The specific preferences may vary by participant, but these twin needs call for considering liquidity and access to assets.
- Measure total insurance cost. From a participant’s perspective, the total cost of a lifetime income solution includes both explicit and implicit costs. On the explicit side, there are stated annual insurance premiums, charges and commissions, as well as management and administrative fees. Fixed annuity–based solutions also carry implicit costs under the surface, which stem from mortality risk and growth opportunity cost. With growth opportunity cost, consider a hypothetical participant who surrenders assets to an insurer up front. If the market rallies, the participant no longer has the assets to take part in that growth. It’s a missed opportunity that can be viewed as a cost. And for participants, all costs matter.
