Transition risk: Rethinking investing for retirement
By Tim Friederich, David Karim and Dr. Wolfgang Mader
Executive summary
Are millions of Americans, retirement-plan sponsors and financial advisors really focusing on the right retirement goal? This white paper explores the critical but often overlooked dangers presented by transition risk—the risk that investors make the transition from accumulation to income at an unfavorable point in time under unfavorable market conditions. Learn why fluctuating interest rates—the most unpredictable factor in the retirement-income equation—make it imperative to help plan participants shift the focus from asset value at retirement to income in retirement.
Key takeaways
◾The focus of retirement plans should shift from portfolio value at retirement to income in retirement.
◾This shift involves transition risk; because it can have a significant impact on retirement income, it must be taken seriously.
◾The effect of transition risk can, in some scenarios, be even more severe than the effect of falling stock markets, particularly when plan participants are close to retirement.
◾ There are thoughtful and effective ways to manage transition risk within existing retirement plans, which can help lead to a prudent retirement-income stream.
Saving for retirement not only involves some of the most difficult and complex financial decisions most investors will make in their lifetimes, but it can have one of the most significant impacts on their quality of life. That is why it is so important for retirement-plan sponsors and advisors to be aware of the different dimensions of risk involved in retirement investing—so they can help plan participants make the right choices for their individual retirement needs.
What is transition risk?
Transition risk is the risk that investors transition from accumulation to income at an unfavorable point in time under unfavorable market conditions.
Transition risk may lead to a substantial decrease in retirement income even in cases where the portfolio value before the transition did not display high losses, but the cost of purchasing an income stream (e.g., annuitization) became significantly more expensive at the transition.
An overwhelming focus on asset value at retirement
There are several risks which should be taken into account to help investors make smart retirement choices. Some are widely known, yet others tend to be overlooked even though their impact can be crucial. One of these neglected risks—transition risk—is the primary topic of this paper.The most common interpretation of risk is financial-market risk, or the risk that investors could lose money if their asset prices fall.
This is the risk that investors are perhaps most aware of thanks to a media environment that reports daily prices of stocks, bonds, mutual funds and other investment products. This steady flow of information keeps investors informed about what their portfolios are worth in terms of dollars, and it gets their attention by playing right into their biggest fear: the risk of declining asset values.
This fear is justified to some extent—after all, asset values have a large impact on retirement savings—but it is not the only risk investors should be concerned about. Moreover, the closer plan participants get to retirement, declining asset values may not even be the most important risk.
The need to shift focus to income in retirement
To understand which risks retirement-focused investors should concentrate on, we need to ask important questions: What are investors saving for? To have money at retirement? Or to have money in retirement? Although the difference between the two concepts is just two letters long, it is key.Because of widespread awareness of financial-market risk, there is a widely held belief that it is more important to focus on maximizing money at retirement, and therefore that accumulation is imperative.
At Allianz Global Investors, we believe this view is wrong, and that plan sponsors and advisors must help participants shift the focus from asset value at retirement to income in retirement. We further believe that retirement income, in most cases, should be derived from a combination of drawing down principal and securing a guaranteed income stream1 to meet basic needs and maintain living standards.
Why is this shift in focus so important? Because maximizing or securing the net asset value of the plan participant’s portfolio at retirement is not necessarily equivalent to maximizing or securing a retirement income stream. This is where transition risk comes into play (see Exhibit 1).
Why transition risk is important
Transition risk is closely related to longevity risk—the risk that investors will “outlive” their money.2 While the demographic trend toward living longer than ever is generally a positive one, it also increases the danger that retirees will run out of money during retirement. As a result, not only is it important that investors consider guarding against longevity risk to some degree, but in many cases it will be advisable that they do so.3 This will require prudently planning an anticipated income stream—and perhaps even securing a certain retirement-income level in the form of a lifelong guarantee.
The issue, however, is that although guaranteed products provide a stable and predictable income stream during retirement, the prices of these products, or the fair value of any retirement-income stream, are volatile and subject to several factors—above all, interest rates.
To illustrate the issue, consider this example: An investor saves for retirement in one currency (portfolio value), yet retirement income is measured in another currency (income stream). At some point in the retirement-savings process (the “transition”), the investor needs to exchange one currency for another. But this “exchange rate” fluctuates with interest rates. If the investor has a high amount of one currency (a high portfolio value), he or she might need to exchange it for the other currency (income) at a time when rates are unfavorable. Even if an investor’s portfolio value continues to increase during retirement, he or she may get less retirement income if the price of getting that income—of exchanging one currency for another—is increasing at a higher rate.
Transition
Retirement Income Portfolio
Value
Exhibit 1: How transition risk fits into the retirement equation
Most plan participants spend years focusing on accumulating wealth for retirement. But transition risk can happen quickly and at a critical time, and it is often overlooked. It is important to factor transition risk into the investment strategies of retirement plans to help shift the focus from asset value at retirement to income in retirement.
Retirement Savings Phase
30+ years of saving Income Phase
20+ years of spending
Market Risk
Did your asset value decline at an unfavorable time?
!
Transition RiskHow much income can you afford at current interest rates?
!
Longevity RiskWill you outlive your money given your asset value and current rates?
!
Timeline
Primary focus areas
Major risks for individuals
We believe that smart retirement strategies should not only aim at growing portfolio values but also at growing retirement income.
That is why it is important to reduce transition risk by setting up the portfolio in such a way that it keeps the expected future retirement- income stream as stable as possible and reduces the exposure of retirement income to changes in the interest-rate environment.
The impact of transition risk on retirement income
The main driver of transition risk is the level of interest rates. In general, lower interest rates make the fair value of the retirement-income stream—and therefore the price of guaranteed products—more expensive. Higher interest rates, on the other hand, make the same income stream less expensive.
Another driver of transition risk is survival probabilities—in other words, life expectancies. Life expectancies, however, do not fluctuate the way interest rates do; in fact, they go steadily in one direction.
Interest rates are the big, unpredictable stochastic factor in the retirement-income equation. Pricing that income stream is exactly
what issuers of guaranteed products like annuities or guaranteed minimum withdrawal benefits (GMWBs) do when determining the prices for their products.
To get an idea of how significant the impact of transition risk is, consider a world with flat interest-rate curves. In reality, interest rates tend to be higher for longer maturities.
Exhibit 2 shows the fair value of a retirement income stream of
$1,000 per month for two 65-year-old US investors—one female, one male—at different interest rates. As Exhibit 2 shows, female investors pay a higher amount for retirement income than male investors for a simple reason: statistically, women have longer life expectancies than men. Also of note:
◾Given a 6% interest rate, a female investor would need to pay roughly $135,000 for this income stream. In a 2%
interest-rate environment, the same retirement-income stream would cost $197,000.
◾For a male US investor, the price would rise from $124,000 to $176,000 in the same scenario.
Exhibit 2: How interest rates can affect future income
Fair value of monthly income stream of $1,000 for a 65-year-old US
investor at different (flat) interest-rate levels Monthly income for a 65-year-old US investor for a fair value of
$100,000 at different (flat) interest-rate levels
Female Male Female Male
0% $248,276 $216,153 $403 $463
1% $220,522 $194,215 $453 $515
2% $197,361 $175,644 $507 $569
3% $177,883 $159,815 $562 $626
4% $161,380 $146,235 $620 $684
5% $147,297 $134,508 $679 $743
6% $135,197 $124,322 $740 $804
7% $124,733 $115,423 $802 $866
8% $115,628 $107,605 $865 $929
9% $107,658 $100,702 $929 $993
10% $100,643 $94,575 $994 $1,057
11% $94,436 $89,112 $1,059 $1,122
12% $88,916 $84,219 $1,125 $1,187
13% $83,983 $79,818 $1,191 $1,253
14% $79,555 $75,844 $1,257 $1,318
15% $75,564 $72,241 $1,323 $1,384
Source: Allianz Global Investors. These are hypothetical examples for illustrative purposes only and do not factor in potential fees or expenses incurred by securing an income stream. See the disclosure at the end of this document for information about survival probabilities and interest rates.
Exhibit 3: The effect of historical interest rates on the fair value of an income stream
Fair value of income stream of $1,000 monthly for 65-year-old male and female US investors over time, based on historical interest rates.
$60,000
$80,000
$100,000
$120,000
$140,000
$160,000
$180,000
$200,000
$220,000 Male Female
2013 2010
2007 2004
2001 1998
1995 1992
1989 1986
1983 1980
1977
See Exhibit 4
See Exhibit 5
Source: Allianz Global Investors. The 60/40 hypothetical portfolio consists of 60% stocks (represented by the S&P 500 Total Return Index) and 40% bonds (represented by the Exhibit 4: The effects of interest rates and market volatility
during 2008
Close-up view of 1/1/2008–1/1/2009, comparing the same income streams in Exhibit 3 with the performance of a hypothetical 60/40 portfolio, all indexed to 100.
Exhibit 5: The effects of interest rates and market volatility, July 2011 to July 2012
Close-up view of 7/1/2011–7/1/2012, comparing the same income streams in Exhibit 3 with the performance of a hypothetical 60/40 portfolio, all indexed to 100.
70 80 90 100 110 120 130
7/1/2012 4/1/2012
1/1/2012 10/1/2011
7/1/2011
Female Male60/40 Portfolio Female
Male60/40 Portfolio
70 80 90 100 110 120 130
1/1/2009 10/1/2008
7/1/2008 4/1/2008
1/1/2008
Due to changing interest rates, the price of securing the same income stream increased by more than 40% in both cases. Looking at it from a different angle, the amount of retirement-income one can afford for a certain amount of money can drop significantly when interest-rates fall. For example:
◾ Assuming a 6% interest rate, a 65-year-old woman with
$100,000 could transform $100,000 into a monthly income of $740. If interest rates dropped to 2%, the monthly income would drop to $507.
◾For a man, the monthly income would decrease from $804 to $569 in the same scenario.
Exhibit 3 displays the development of the fair value of the retirement- income stream depending on the actual interest-rate curve at any point in time. To illustrate the fact that transition risk does not always strike at the same time that the financial market risk causes asset values to fall, consider the following two scenarios.
Over the course of 2008 (see Exhibit 4), low US interest rates caused the fair value of a $1,000 monthly retirement-income stream for a 65-year-old US woman to rise from $161,863 to $183,813. Assuming that she had the same amount of money to invest in a retirement- income product, this would mean 12% less retirement income.
Depending on how high her allocation to stock markets was in 2008, this drop in income may have been even more severe than the drop in portfolio value caused by falling stock prices. In other words, by not hedging against transition risk, this hypothetical investor would have taken two big hits in 2008.
Now consider the period between July 2011 and June 2012 (see Exhibit 5). The S&P 500 Total Return Index gained 5.4% in this time period. But because interest rates were moving lower, the fair value of a monthly
$1,000 retirement-income stream for a 65-year-old male US investor increased from $156,297 to $179,084 (by 14.8%). Again depending on the portfolio allocation of the investor, prices of guaranteed products likely would have increased more during that time than the portfolio value. For example, an investor with a 60/40 allocation would have seen a 5.9% return in asset value during this period, which would have compensated for only half of the decline in retirement income. In general, despite rising asset prices, lower interest rates meant that the anticipated retirement income might have decreased for investors who did not hedge against transition risk.
Our view
Investing for retirement is a complex task that involves multiple dimensions of risk: financial-market risk, inflation risk, longevity risk and transition risk, to name some of the most important. It is crucial that plan sponsors and individual investors alike take them all into account in order to achieve their retirement goals.
Accepting the need to shift the focus from portfolio value to retirement income—which is exactly what we can observe in form of the “DB-ization” of DC plans, an important and right trend for plan participants and plan sponsors alike—transition risk becomes even more important.
Although underestimated or even totally neglected in the past, effectively managing transition risk can have a major impact on investment goals —one that is no less significant than the impact of financial-market risk. Investment strategies must take all these risks into account to avoid losses in retirement income and provide investors with a sufficient and predictable retirement-income stream.
How can transition risk be managed?
There are several thoughtful and effective approaches for managing transition risk within plan-participant portfolios.
Certain glidepaths can incorporate retirement income into the savings phase—for example, via forward annuities. In these cases, glidepaths can gradually adjust the allocation and thereby mitigate transition risk. Other possible products that can be included in a glidepath to produce an income stream are guaranteed minimum withdrawal benefits (GMWBs), other types of variable annuities, laddered-bond portfolios or Treasury Inflation-Protected Securities (TIPS). It is important to ensure when including these investments that the glidepath accounts for their particular risk-return profile to determine the optimal allocation.
Other sophisticated approaches can manage a portfolio with respect to retirement income as one dimension of risk. These approaches aim at delivering a retirement-income stream rather than maximizing the portfolio’s value. They do not necessarily require investment in guaranteed products before retirement, and are designed to provide a large degree of flexibility.
The optimal solution will always take into account the specific retirement plan, its characteristics and investment goals, as well as the plan’s setup and regulatory requirements.
About the authors
Tim FriederichVice President, Solutions Specialist
Mr. Friederich is a solutions specialist and a vice president with Allianz Global Investors, which he joined in 2009. As a member of the AllianzGI Global Solutions team, he is responsible for solutions services in the North American market, working with local business units to develop investment solutions tailored to clients’ individual investment needs. Mr. Friederich has an M.S.
in finance and information management from the Technical University of Munich and the University of Augsburg. He is currently working on his Ph.D. thesis in financial mathematics at the Technical University of Munich in cooperation with the University of Toronto.
About the Authors David Karim
Vice President, Analyst, risklab*
Mr. Karim is a vice president at risklab, the expert for risk within the Global Solutions division of Allianz Global Investors. As a member of the DC & Retirement Strategies team, he is primarily responsible for designing investment strategies and for managing defined contribution (DC) mandates. Mr.
Karim has an M.Sc. in applied mathematics and scientific computation from the Univer- sity of Paris. He is an honorary lecturer in finance at the University of Paris and has worked with the OECD to publish studies on the management of DC pension plans.
About the Authors Dr. Wolfgang Mader Managing Director,
Head of Asset Allocation Strategies
Dr. Mader is a managing director at risklab.
As Head of Asset Allocation Strategies and Economic Scenario Generation, he is primarily responsible for the fields of strategic asset allocation, dynamic asset allocation and risk management. Before joining risklab, Dr.
Mader was an asset-management consultant to insurance companies and investment- consulting firms. He also worked as a lecturer in banking and finance at the University of Augsburg. Dr. Mader has a diploma in business management from the University of Augsburg; he earned a Ph.D. in finance in 2005 with a thesis on “Hedge Funds—
Alternative Investment Strategies and Portfolio Models.”
Endnotes
1. One straightforward way to achieve such a combination is with a deferred annuity, as suggested by the DBDC Index. See Sexauer et al (2012):
“Making Retirement Income Last a Lifetime,” Financial Analysts Journal, Vol. 68. No. 1.
2. In 1989, Z. Bodie highlighted the importance of longevity risk and the guarantee aspect of pensions in his NBER paper, “Pensions as Retirement Income Insurance.”
3. See “A Pension Strategy That’s Worth The Wait” by Professor Shlomo Benartzi, published in the Financial Times, July 8, 2012.
*risklab GmbH (“risklab”) is an Allianz Global Investors company registered with Bundesanstalt für Finanzdienstleistungsaufsichtt as a provider of financial services in Germany.
The risklab brand name is used according to the trademark license agreement between risklab GmbH, Germany (licensee) and Algorithmics Trademarks LLC and Algorithmics Incorporated, Canada (licensor) (both companies now IBM). risklab provides risk management and strategic and dynamic asset allocation solutions to support the investment advisory activities of the properly registered and licensed affiliates of Allianz Global Investors , including Allianz Global Investors U.S. LLC, an SEC registered adviser. While risklab is not registered with the SEC, AllianzGI US may use the resources of its investment advisory affiliates (“Participating AllianzGI Affiliates”), including risklab, to provide portfolio
and retirement solutions. We tailor our services to meet the specific requirements of our institutional clients through a broad range of customized service offerings.
About Allianz Global Investors
Understand. Act. This two-word philosophy is at the core of what we do. To stand out as the investment partner our clients trust, we listen closely to understand their needs, then act decisively to deliver solutions. We are a diversified active investment manager with a strong parent company, a culture of risk management and $496 billion in assets under management.* With 24 offices in 18 countries and over 500 investment professionals, we provide global investment and research capabilities with consultative local delivery.
Survival probabilities are based on the Period Life Ta- ble of the Social Security Administration of the USA, as of 2009.
Interest rates are the US Treasury Constant Maturity Rates as published by the St. Louis Fed. Interest rates for maturities between reported maturities are inter- polated.
*Combined worldwide assets under management as of June 30, 2015.
The material contains the current opinions of the au- thor, which are subject to change without notice.
to be, and should not be interpreted as, recommen- dations to purchase or sell such securities. Forecasts and estimates have certain inherent limitations, and are not intended to be relied upon as advice or inter- preted as a recommendation.
Allianz Global Investors U.S. LLC (“AllianzGI US”) is an SEC registered investment adviser that provides in- vestment management and advisory services pri- marily to separate accounts of institutional clients and registered and unregistered investment funds.
AllianzGI US manages client portfolios (either directly
analytics. NFJ Investment Group LLC is an SEC regis- tered investment adviser and wholly-owned subsid- iary of AllianzGI US.
© 2015 Allianz Global Investors. All rights reserved.
WP-13-0615 | AGIUS-2015-09-30-0728 | 01012
