Adding guarantees to the mix

Jokes about 401(k)s' becoming 201(k)s are no longer funny.

Jokes about 401(k)s’ becoming 201(k)s are no longer funny. Baby boomers looking to retire in the next few years now wonder if retirement is even possible. Those already in retirement worry about being able to continue drawing income from shrunken portfolios.

Their shock and concern are understandable: For the second time in a decade, your clients have had their retirement pool drained out from under them.

The first shock came with the bursting of the tech bubble in 2001-02. Investors who believed that their retirement could be financed by placing a concentrated bet on companies that would shape the economy’s future were severely disappointed.

In the wake of that market rout, the investment industry created products that delivered guardrails for investors who tend to get caught up in the mania of the moment. “Don’t worry about overconcentration,” fund managers said. “We’ll take care of that for you.” In response, managers launched hundreds of asset allocation funds, including the extremely popular target date and life cycle funds.

To sell the funds, wholesalers armed themselves with slide presentations preaching the gospel of diversification.

Their efforts were hugely successful; in the years that followed, asset allocation funds accounted for 25% to 30% of net new flows into domestic-equity funds. Asset allocation funds appeared everywhere, including in individual retirement accounts, and 401(k) and Section 529 plans. In fact, many plans used target date funds as the default investment for participants.

The most recent market downturn, however, exposed a flaw in target date funds: the lack of guarantees.

In other words, while diversification works most of the time, what happens when it doesn’t? What if a client plans to retire in 2015 and his or her 2015 target date fund provides nowhere near the money the investor anticipated or needs? This is an all-too-real question for those 60-year-olds whose target date funds have suffered a 30% or 40% decline and are questioning whether asset allocation is all it was cracked up to be.

Given the problem, what’s a boomer to do? Make no mistake — diversification and asset allocation still are critical, but product companies realize they have to provide more.

In response, asset management firms have come to market with solutions geared toward managing market and retirement risks. Most notable have been funds that provide managed distributions and warrantees including offerings from The Vanguard Group Inc., Fidelity Investments, Russell Investments and DWS Investments.

Another attempt at solving the problem involves hybrid products that marry risk controls from money managers and guarantees from insurance companies. These “hybrid annuities” apply guarantees to non-annuity vehicles such as mutual funds, exchange traded funds, separately managed accounts and unified managed accounts.

As a result, advisers now have a variety of solutions that combine asset management and insurance. The marriage of the two worlds creates a union in which asset allocation products provide diversification, while insurance covers market, longevity and investor behavior risk.

When investors opt to add a guarantee to their portfolio, a base is established that is used to calculate an income stream, which is typically 5% of the portfolio.

The base is not affected by gyrations in the actual account value, and the base may grow as the account value rises, providing the investor with larger guaranteed-income payments.

Because the income stream is guaranteed for life, hybrid solutions address longevity risk.

The guarantee also encourages sticking with a long-term asset allocation strategy. Currently, my company, as well as Genworth Financial Inc., Nationwide Mutual Insurance Co. and Allstate Insurance Co. offer hybrid products, while products from other carriers await Securities and Exchange Commission approval.

Beyond threats to income, the risks associated with greater longevity must be examined. Medical improvements and greater attention to health and wellness are translating into individuals’ routinely living to 90, 95 and beyond.

Several longevity solutions specifically designed for fee-based advisers are under development by insurers and asset managers. These will offer a range of options for investors and should make retirement more secure.

Edwin D. Friderici III is managing director of alternative retirement solutions at The Phoenix Cos. Inc. in Hartford, Conn.

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