To overcome behavioral biases and concerns about turning current savings into retirement income, a new paper contends that lifetime income should be part of DC plan default options and target date funds may be part of the solution.
“It may seem like a bold step to embed an income solution into the default option—and the target date fund, in particular—but we believe it is consistent with the evolution of [the] DC [system], according to the white paper from BlackRock.
In “Income reimagined,” the firm reviews the development of DC plans, how behavioral finance was used to drive that development, participant attitudes about income and how embedding an income solution in a TDF can help reinforce income solution adoption.
Noting that 62% of DC participants are worried about generating their own retirement income, yet today’s DC system leaves them to meet the challenge on their own, the firm suggests that incorporating lifetime income would be an “extension of the tools and principles developed over decades of influencing behavior and framing choices with a single goal: helping participants help themselves.”
The paper observes that many plan sponsors have brought pooled-longevity solutions to their DC plans through annuity platforms, insurance wrap products or various combinations of insurance and investment vehicles, but so far, no approach has emerged as the DC standard. What’s more, despite their stated interest in income, few participants embrace lifetime income solutions, suggesting potentially significant behavioral biases need to be overcome.
And while these vehicles are institutionally priced and may be a considerable benefit to participants, the firm notes that in its view there are substantial drawbacks. “Frequently they require an active decision by the participant at an inflection point around retirement,” the paper explains. “It may feel separate from the activity of saving, as if decisions they made about saving during their career are separate from how they will spend in retirement.”
In addition, the firm suggests that the separation point exacerbates the behavioral biases that prevent many participants from making a rational choice about income solutions. “We believe that merely introducing income solutions is not enough: DC plans need to use behavioral finance, technology and plan design to normalize lifetime income as part of participants’ retirement outcomes,” the paper states.
As such, the authors suggest taking advantage of “what may be the most powerful plan design tool available to drive adoption: embedding the income solution into the default option.” To that end, they submit that there are three characteristics an ideal income solution may need to be successful within the DC system:
- Sustainable: Whether through a guaranteed solution involving insurance products or through a dynamic drawdown strategy that takes remaining longevity into account, an ideal solution would reduce, eliminate or hedge the possibility of running out of money, the paper explains.
- Frameable: Noting that DC plans have used behavioral finance principles and plan design to nudge participants into more appropriate savings deferral rates and investments, the firm suggests that it is critical that plans expand the frame to connect saving activity with the objective of protecting spending ability in retirement.
- Embedded: Finally, the firm recommends that the ideal income solution should be embedded in the default option. Embedding the solution in the default may provide the scale needed to secure the most advantageous institutional pricing and it may help participants see retirement income as the outcome of retirement saving and create a more seamless transition from saving to income, the paper emphasizes.