Overview & Calculation

In the field of personal finance, a great deal of attention has been paid to asset accumulation, but much less to asset decumulation, the planned spending down of accumulated savings in retirement. The DCDBtm is designed to be a post-retirement investing benchmark. Because this benchmark is most likely to be applied to a defined-contribution (DC) savings plan, the name is DCDB, defined contribution decumulation benchmark. A well-engineered DC plan should be experienced by the participant in much the same way as a well-engineered, and funded, defined benefit (DB) plan. Hence, the acronym DCDB is intended to convey this aspiration.

The benchmark is intended to embody the lowest-risk strategy available for converting accumulated capital to post-retirement income while satisfying three essential conditions: (1) the strategy must protect the investor against longevity risk (the risk that one will outlive one’s money), (2) to the extent possible, the income should be inflation protected, and (3) the strategy must be appealing enough that it is likely to be used by a broad cross-section of investors. Immediate life annuities achieve the first condition but not the second. The apparent reason that investors shy away from immediate life annuities is that the loss of liquidity from transferring one’s capital irrevocably to an insurance company is too onerous. Thus, the benchmark strategy preserves most of the investor’s liquidity while achieving the goals of longevity protection and minimal investment risk.

The strategy that forms the DCDBtm benchmark is to buy, with most of one’s capital, a portfolio of laddered inflation-indexed bonds (TIPS) out to the latest TIPS effective maturity date, currently about 20 years. The remainder of the capital is used to buy a deferred annuity that begins its payout when the cash flows from the TIPS ladder end. The proportions invested in each asset class – TIPS and a deferred annuity – are set in such a way as to make the first deferred annuity payout equal to the last TIPS payout (plus an allowance for inflation).

The challenge is to determine (1) how to split the retirement portfolio between the portfolio allocation (TIPs, or possibly an active portfolio of choice) and the deferred annuity and (2) the income into which the portfolio can be converted at current market rate?

The resulting benchmark differs from ordinary benchmarks by consisting of a set of future cash flows produced by a given amount invested. (Ordinary benchmarks are lists of securities and security weights which, when summed, produce a market price or present value.)

Here is an example: As of September 30, 2010, a single 65-year-old male who invests $100,000 in the benchmark portfolio can expect to receive a first-year payment of $5,118, increasing at the CPI rate until year 20. Thereafter, the deferred life annuity pays $7,332 (in today’s money) annually until the participant dies.

This schedule of expected cash flows can be compared with the expected cash flows from other post-retirement investment strategies to determine which one a given investor might prefer. Three alternatives to the benchmark strategy are evaluated: (1) an immediate, real (inflation-indexed), life annuity purchased from an insurance company; (2) a target-date portfolio of risky assets (equities and bonds); and (3) an immediate, nominal life annuity purchased from an insurance company.

The immediate real annuity pays $4,856 in the first year, almost exactly the same as the first year’s payout in the DCDB. The cash flows from both strategies inflate at the CPI rate until the 21st year, when the DCDB stops inflating but the inflation-indexed annuity continues to inflate. Thus, over any life span, the inflation-indexed annuity either matches or dominates the DCDB if the investor does not care about liquidity or counterparty risk. However, most investors are strongly averse to these risks, particularly with regard to post-retirement assets.

The target-date portfolio produces cash flows that cannot be accurately forecast. Given today’s low yields, however, these cash flows are likely to be lower than those from the benchmark in the initial years. Over time, however, the target-date portfolio can be expected to yield more than the benchmark due to growth in equities. The participant must thus decide which cash flow pattern he or she prefers, one that is front-loaded (the benchmark) or one that may be more uncertain and more back-loaded (the target-date fund).

Finally, the immediate nominal annuity pays $6,811 (nominal, not in today’s money) every year. The participant needs to weigh this certainty – and high current income – against the likelihood that inflation will erode his or her purchasing power significantly in the later years.

The benchmark strategy is not only useful as a measuring stick for evaluating alternatives, but is also potentially an investment in itself, akin to indexing. Such an investment would have to be offered by an entity that can issue or sell deferred annuities as well as conventional investment portfolios.

The Allianz DCDBtm Index is the property of Allianz Global Investors Solutions, P-Solve Cassidy, and Hudson Pilot.

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