Category Archives: Risk Management

Managed risk equities can reduce retiree loss aversion

Many individuals entering or nearing retirement encounter the risk tolerance paradox. They seek asset growth with an aversion to losses. This conflicting mindset prompts some investors to acquire low-risk assets when markets become volatile, essentially locking in losses while trading market risk for longevity risk.

According to Milliman’s Wade Matterson, “introducing managed risk equities into the portfolio of clients close to (or in) retirement can provide exposure to higher returns while managing the inherent higher risk.” He provides perspective on what investors should consider when using managed risk equities in his article “Solving the risk tolerance paradox for retirees.”

Changing public pension investment landscape

The global financial crisis shrunk the funding status of many public pensions. Some sponsors are beginning to cut their expected rate of return, and change the way they invest and handle portfolio risk. In this Reuters article, Milliman consultant Tamara Burden provides perspective on how sponsors can better manage their pension investment risk.

The growing recognition that short-term volatility can have a devastating impact on mature pension plans in the $4 trillion sector could herald a sea change in the way public funds invest in the future.

“There is this shift to recognizing risk is a relevant piece of the discussion, it’s not just about how you get the highest returns over a long period of time but that short-term fluctuations in asset levels can be incredibly detrimental,” said Tamara Burden, an actuary at consulting firm Milliman….

Burden is seeking to persuade public pension managers to use Milliman’s risk management strategy to reduce equity exposure in portfolios by shorting stock index futures. This means they don’t have to sell their fund’s equity holdings.

The strategy is being applied to about $70 billion in portfolios with variable annuities, retail mutual funds and collective investment trusts used by 401(k) plans, but so far not in the public pension sector.

Interest, Burden says, has increased this year with about 15 public pension administrators considering a shift versus five during the same period last year.

Risk management roundtable

Milliman’s Kamilla Svajgl recently participated in a Pensions & Investments’ roundtable discussion focusing on the current climate of investment risks and behavior.

Here’s an excerpt:

P&I: What kind of strategies would work to help pre-retirees manage risk in this new world of higher volatility and lower returns — and help to keep them invested?

Kamilla Svajgl: Let’s start with the way people define asset allocation and risk. It used to be that “risk” was defined by an investor’s level of equity allocation. For example, 60% equity/40% bond portfolio was used as a proxy for “moderate risk.” There is a fundamental problem with that — a 60/40 portfolio would have experienced mere 7% volatility in the fourth quarter of 2006, but 67% volatility in the fourth quarter of 2008. I don’t think anyone is a moderate risk investor when they’re experiencing 67% realized volatility. These kinds of large swings in portfolio risk are not only highly correlated with sharp declines in the market, but also expose investors to significant behavioral risk of selling when asset values are deeply depressed.

A better way to define risk is by portfolio volatility. For a moderate investor, that might mean an overall portfolio volatility of 12%, for example. So the first step is to stabilize volatility. And the good news is that volatility lends itself very well to short-term predictive modeling. Therefore, while I will not be able to tell you if the market will go up or down tomorrow, I can be very accurate in assessing whether it will be calm or volatile.

The second step of the strategy is to add some additional downside protection for extra cushion. We achieve it by synthetically replicating a long-dated put option within the portfolio. This further reduces losses during periods of significant and sustained market decline. This approach has been used by large life insurance companies during 2008 to successfully hedge their balance sheets.

Combining volatility management and capital protection allows investors to stay invested in equity during calm market conditions, and at the same time protects them during times of crisis.

For a transcript of the entire roundtable discussion, click here.

How to avoid running out of money in retirement: Final in a series

McCune-JanetEarlier, we described three things 401(k) plan sponsors can do to help participants avoid running out of money in retirement. Offering managed risk equity funds as investment options, and incorporating them into the asset allocation glide path for the plan’s auto-investing tools, addresses two of three fundamental risks for retirement income: market risk and inflation risk. By continuing to service retirees as ongoing participants in the plan, the plan sponsor helps retirees maintain continuity between their pre-retirement and post-retirement investment strategies with lower, institutional investment expenses. But we haven’t addressed the issue of longevity risk—how can participants know how long their retirement savings have to last?

One powerful solution is to use a deferred annuity contract, which transfers longevity risk to an insurance company by starting payouts to the policyholder at an advanced age. On July 1, 2014, final Treasury regulations were issued regarding “qualified longevity annuity contracts” (QLACs) held within qualified defined contribution plans, i.e., 401(k) plans, 403(b) plans, IRAs. The regulations provide an exception to the required minimum distribution (RMD) rules of Internal Revenue Code section 401(a)(9), which require certain distributions to be made from qualified plans starting at age 70½. Without this exception, a deferred income annuity could cause the plan to violate the RMD rules, because the annuity does not begin payments until much later (usually age 80 but at least 85). The regulations state that a QLAC is not subject to RMDs until payments begin under the terms of the annuity, thus expanding retirement income options as an increasing number of Americans reach retirement age.

A QLAC can be purchased with up to 25% (maximum $125,000) of the account balance. If a participant at age 65 were to use 18% to 20% of their portfolio to purchase a QLAC that commences benefit payments at age 80, the remaining 401(k) account need only provide retirement income for 15 years, when the annuity payments would begin. Removing the uncertainty around how long the 401(k) account needs to last allows for a significant increase in retirement income. By adding a QLAC and applying the investment strategies suggested earlier in this series, we have achieved significant improvement in the sustainable withdrawal rate for the participant, while maintaining an equal probability of success!

In order to maintain simplicity and portability of the 401(k) plan, as well as to minimize fiduciary exposure for the plan sponsor, the best practice may be to encourage participants to hold the QLAC within an IRA. The participant may initiate a rollover distribution from the 401(k) to an IRA in order to pay the premium. The retiree takes installment payments from the 401(k) from age 65 to 80, then the annuity benefits provide retirement income from age 80 until death.1

This is Step 4 in helping 401(k) participants create sustainable retirement income from their 401(k) accounts (see the first three steps here). Undoubtedly, creative strategies will continue to emerge as the industry tackles this issue.


1This statement is not a recommendation to buy investment or insurance products. An individual should consult their personal adviser to determine the suitability of any investment or insurance product.

How to avoid running out of money in retirement: Third of a series

McCune-JanetA 401(k) plan sponsor or a financial advisor who has been following our blog series, understands these best practices: 1) offering managed risk equities within the investment fund options, and 2) providing a lifelong asset allocation tool with explicit, age-appropriate risk management. In addition, the plan sponsor as fiduciary must monitor fund performance and expenses on behalf of the participants. With all of this in place, why would you encourage retirees to exit the 401(k) plan right when they need these services the most? Isn’t the point of all of this to provide a sustainable income stream for participants embarking on their retirement journey?

As a third best practice, we would suggest that plan sponsors include an installment payment provision in their plan documents that allows retirees to use their account balance as a source of retirement income. Generally, participants are encouraged to roll their account balances into retail IRAs, or perhaps to purchase some form of annuity to guarantee a minimum income level needed to support their living expenses. However, the employer sponsored retirement plan offers significant benefits some other options cannot. First, it provides a seamless approach for their preretirement and postretirement investment strategy. The retiree continues to access a familiar website and call center and there are no new, complex insurance contracts to understand or purchase. The retiree retains flexibility and the control of his or her own assets, and does so with institutional investment expenses, which are generally lower. Finally, the entire account balance passes to the designated beneficiary upon the death of the retiree.

This solution offers benefits to the plan sponsor as well. Additional assets remaining in the plan provide economies of scale for investment and administration costs, and any additional costs may be borne by the retiree accounts. And, in a way, this feature facilitates an experience similar to defined benefit (DB) retirees, which may be especially meaningful when a plan sponsor freezes and/or terminates a pension plan in favor of an enhanced 401(k) or defined contribution (DC) program.

We cannot forget about the 401(k) providers, like the recordkeeper and the investment advisor. Servicing retirees through the plan can be a win for them as well, since the relationship with the participants continues, as do the economies of scale that keep plan expenses down. This opens the opportunity to expand the services specifically aimed at retirees, such as:

• Targeted education and communications focused on retiree needs
• Direct interaction with retirees for change of name, address, benefit amount, and status
• Expanded website tools and call center services to provide broader services
• Assistance with projections of sustainable withdrawal rates and probability of success
• Final account settlement services upon the passing of the retiree

Offering an installment payment provision in the 401(k) plan and continuing to fully service the retirees through the plan offers a win-win-win solution for participants, plan sponsors, and providers. That is Step 3 for a winning retirement solution.

How to avoid running out of money in retirement: Second of a series

McCune-JanetOur first blog focused on the need to address the fundamental risks to sustainable income during retirement: market risk, inflation risk, and longevity risk. We identified “managed risk equities,” such as those offered by Milliman Financial Risk Management, LLC, as an important tool for managing those risks.

Plan sponsors seeking to provide a retirement income solution in their 401(k) plans are well advised to include managed risk equity funds in the 401(k) investment fund lineup. Because participants may need help with the investment decisions in their personal accounts, it’s wise to take it a step further and incorporate these funds into the plan’s automatic investing features. For example, Milliman offers a portfolio service called InvestMap that creates an asset allocation glide path for each participant, based on each one’s current age. Using the underlying core funds offered in the 401(k) plan, InvestMap adjusts the allocation each year on the participant’s birthday, and automatically rebalances to that allocation each quarter. Rather than selecting a “model,” participants elect to be enrolled in InvestMap, and their entire account balances are then invested according to the glide path. InvestMap is easy to understand, it meets the Qualified Default Investment Alternative (QDIA) requirements, and is easily integrated into the plan’s investment policy statement. In addition, it takes advantage of the best-in-class managers and funds selected by the plan sponsor and the advisor, particularly with regard to monitoring performance and transparency of fees. InvestMap is an ideal vehicle for delivering explicitly integrated, age-appropriate risk management for the individual participant.

Other recordkeepers and advisors offer similar solutions, and some provide custom model portfolios or proprietary collective funds, most of which include appropriate asset allocations for young investors, investors nearing retirement, and everyone in between. Any of these “do it for me” tools can be helpful in delivering professional help to participants. What is important is that the glide path continues to adjust for the participant, even in retirement, and includes larger allocations to managed risk equities, rather than to cash or bonds, as the time horizon shrinks. As discussed earlier, this may reduce the volatility and improve the risk-adjusted return of the portfolio. The desired outcome is an increase in sustainable retirement income.

For many years, recordkeepers and advisors have tried to educate participants into becoming good investors – with varying levels of success. A better approach would be to create good investors by providing the right tools. An automatic investment alternative, which provides a lifelong asset allocation strategy and incorporates managed risk equities at increasing amounts over time, may be the most effective way for participants to be good investors and become successful retirees in a 401(k) plan. That is Step 2.