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While the defined contribution (DC) industry has largely solved the accumulation stage of the life-cycle journey through TDFs, it still seeks consensus on the best products and services to help retirees in the decumulation stage. The only broad agreement reached thus far is recognition that retirement often looks different for most participants.
Given the increased attention on TDFs and retirement income sufficiency, a new investment product has emerged that combines annuities with a TDF. We refer to this as a hybrid annuity TDF,1 a professionally managed product intended to stabilize assets as the participant approaches retirement and then, upon participation selection, provide guaranteed income during it (subject to the claims-paying ability of the issuing insurance company).
In this article, which is a summarized version of From Theory to Practice: Guaranteed Income and Hybrid Annuity Target-Date Funds, we review the investment merits of hybrid annuity TDFs by first describing them and their underlying components. We also explain how our Vanguard Life-Cycle Investing Model (VLCM) is used to evaluate the impact of hybrid annuity TDF strategies on participant outcomes. Our analysis shows that hybrid annuity TDFs can provide investment merit, especially for participants who prioritize longevity risk mitigation. However, beyond investment merit, there are usability, acceptability, implementation, and feasibility considerations. Ultimately, the decision to purchase an annuity is a highly personal one and will involve multiple factors.
Hybrid annuity TDFs combine the asset accumulation offered by a traditional TDF with an annuity that provides guaranteed lifetime income during retirement. Most hybrid annuity TDFs have three components:
- A multiasset allocation to support asset growth.
- An income-funding strategy for the guaranteed income purchase.
- An annuity for guaranteed income.
Source: Vanguard.
Multiasset allocation
Income-funding strategy
Annuity
Many available hybrid annuity TDFs currently use fixed-rate annuities. The annuity types commonly used in hybrid annuity TDFs include:
- Single premium immediate annuity: Starts providing income immediately after annuity purchase.
- Deferred income annuity: Starts providing income at a future date after annuity purchase.
- Qualified longevity annuity contract: Starts providing income at a later stage of retirement (age 78 or older). This deferred annuity is exempt from required minimum distributions.
Evaluation framework
We evaluate the investment merits of hybrid annuity TDFs by using our proprietary Vanguard Life-Cycle Investing Model (VLCM).3 The VLCM is a utility-based framework that incorporates participants’ goals, characteristics, and preferences while evaluating different investment strategies.
As shown in Figure 2, the model leverages long-term asset return expectations derived from the Vanguard Capital Markets Model® (VCMM), incorporates multiple income sources, and accounts for factors such as retirement consumption, bequest, and stability of portfolio balance.4 Although hybrid annuity TDFs provide investment value, there are other considerations that providers and participants should examine to determine if this new solution is beneficial.
How can hybrid annuity TDFs help create investment value?
The TDF has a lower average income shortfall than the hybrid annuity TDF given that the hybrid annuity TDF makes up for this income shortfall in the later years of the participant’s life cycle. Depending on their goals and preferences, participants will value this trade-off between reduced wealth and retirement income sufficiency differently. The caveat is that most DC participants either do not have the resources to fully fund that risk mitigation or prefer not to. Participants seeking a simple and transparent solution are still well served by traditional TDFs.
As previously covered in Evaluating Hybrid Annuity Target-Date Strategies, making this decision is not simply about investment merit. There are several considerations that a plan sponsor needs to examine when deciding (1) if they should select a hybrid annuity TDF and (2) which hybrid annuity TDF to choose. It is important to note that these considerations are not all negative. Although there are certainly risks involved, there are also some benefits that plan sponsors should consider. In Figure 3, we outline some of the more prevalent considerations for plan sponsors when evaluating hybrid annuity TDFs.
Description |
Considerations |
|
|---|---|---|
| Suitability | The annuity component may not be optimal for everyone. The type, timing, and amount of the annuity are likely to differ significantly across the participant population. | Include a few personalization options for more engaged participants that can be tailored to their individual financial goals and life circumstances. |
| Liquidity | Transitioning from liquid assets to illiquid annuity contracts is a barrier for many participants due to the control they relinquish over their accumulated assets. | Offer educational workshops that address the benefits and safety of annuities, reinforcing the security they provide in retirement. Providing additional benefits to participants such as access to emergency savings accounts and financial support services further enhances participant readiness. |
| Cost | Hybrid annuity TDFs tend to cost more than off-the-shelf TDFs. There are additional, often opaque, expenses associated with the annuity component. | Offer transparent information on costs and charges, reinforce it with the value of the solution, and provide financial planning support. |
| Integration | It can be difficult to integrate DC plans with annuity recordkeeping, potentially resulting in a disjointed user experience. | Invest in technology solutions that streamline integration and improve the user experience for plan participants. |
| Engagement and financial literacy | Participants often show limited engagement and lack comprehensive understanding of financial products. Effectively using an annuity for retirement planning requires participant engagement, at a minimum, to opt in or opt out of annuitization. | Because successful implementation requires active engagement from both the plan sponsor and participants, considerable effort should be devoted to targeted communication campaigns and interactive tools, with a goal of boosting financial literacy and engagement. |
Note: The above list of considerations may not be exhaustive depending on the plan population. As with any decision by a plan sponsor, whether the hybrid annuity TDF is the right or wrong one is determined by the unique needs of their participants.
Source: Vanguard.
Conclusion
Hybrid annuity TDFs are a new generation of retirement solutions to support both the accumulation and decumulation phases of retirement savings. The value offered to a participant depends on the design of the hybrid annuity TDF and is influenced by a number of factors. Our analysis, outlined in significantly greater detail in our research paper, shows that hybrid annuity TDFs can provide investment merit and could boost retirement consumption, especially for those looking for longevity-risk mitigation.
Despite the investment case for certain participants, hybrid annuity TDFs also come with significant hurdles. Plan sponsors and participants would need additional support and education for appropriate adoption of this product. In addition, most hybrid annuity TDFs involve a decision to annuitize, and many DC participants are not actively engaged or informed enough to make an appropriate decision about when to purchase an annuity and how much to annuitize. The analysis summarized in this article highlights that there are both rewards and risks associated with hybrid annuity TDFs. But the jury is still out on whether hybrid annuity TDFs, like traditional TDFs, can be a solution for the masses.
If you missed our virtual event, From Savings to Income: Potential Cases for Hybrid Annuity TDFs
1 Although we refer to this product type as a “fund” for simplicity, it can also be structured as a trust.
2 Our analysis does not cover all forms of guaranteed income products. Hybrid annuity TDF providers also use other insurance products, such as guaranteed lifetime withdrawal benefits, that are not considered in this paper.
3 Roger Aliaga-Díaz, Harshdeep Ahluwalia, Victor Zhu, Scott Donaldson, Ankul Daga, and David Pakula. Vanguard’s Life-Cycle Investing Model (VLCM): A General Portfolio Framework for Goals-Based Investing. Vanguard, 2021.
4 The VCMM is a proprietary financial simulation tool developed and maintained by Vanguard’s primary investment research team. The VCMM projections are based on a statistical analysis of historical data. The model forecasts distributions of future returns for a wide array of broad asset classes.
5 Blanchett (2016) showed that the optimal level of annuitization varies among participants and is highly dependent on participant and plan attributes.
Notes:
Investments in target-date funds are subject to the risks of their underlying funds. The year in the fund name refers to the approximate year (the target date) when an investor in the fund would retire and leave the workforce. The fund will gradually shift its emphasis from more aggressive investments to more conservative ones based on its target date. An investment in target-date funds is not guaranteed at any time, including on or after the target date.
All investing is subject to risk, including the possible loss of the money you invest. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Diversification does not ensure a profit or protect against a loss.
Annuity product guarantees are subject to the claims-paying ability of the issuing insurance company.
The Vanguard Life-Cycle Investing Model (VLCM) is designed to identify the product design that represents the best investment solution for a theoretical, representative investor who uses the target-date funds to accumulate wealth for retirement. The VLCM generates an optimal custom glide path for a participant population by assessing the trade-offs between the expected (median) wealth accumulation and the uncertainty about that wealth outcome, for thousands of potential glide paths. The VLCM does this by combining two sets of inputs: the asset class return projections from the VCMM and the average characteristics of the participant population. Along with the optimal custom glide path, the VLCM generates a wide range of portfolio metrics such as a distribution of potential wealth accumulation outcomes, risk and return distributions for the asset allocation, and probability of ruin, such as the odds of participants depleting their wealth by age 95.
The VLCM inherits the distributional forecasting framework of the VCMM and applies to it the calculation of wealth outcomes from any given portfolio.
The most impactful drivers of glide-path changes within the VLCM tend to be risk aversion, the presence of a defined benefit plan, retirement age, saving rate, and starting compensation. The VLCM chooses among glide paths by scoring them according to the utility function described and choosing the one with the highest score. The VLCM does not optimize the levels of spending and contribution rates. Rather, the VLCM optimizes the glide path for a given customizable level of spending, growth rate of contributions, and other plan sponsor characteristics.
A full dynamic stochastic life-cycle model, including optimization of a savings strategy and dynamic spending in retirement is beyond the scope of this framework.