As we discussed in our article Interest rates 2019 – the effect of recent declines on DC plans, if we assume (as is generally the case) that the purpose of 401(k) savings is to provide income in retirement, then both gains/losses on the participant’s account balance and increases/declines in interest rates will affect the “funded status” of the participant’s retirement income target.
The effect of asset gains/losses is obvious. The effect of interest rate increases/declines is less intuitive. In effect, interest rate declines represent an increase in the cost of retirement income; interest rate increases represent a decrease in that cost.
Mandatory lifetime income disclosure – adopted in the SECURE Act – is intended to make this relationship explicit, generally requiring annual disclosure of the amount of retirement income (joint/single life annuity) a participant’s defined contribution account can buy.
When is mandatory lifetime income disclosure effective? DOL is, within a year of SECURE’s enactment, required to issue model disclosures and assumptions and rules for “converting total accrued benefits into lifetime income stream equivalents.” The new, mandatory lifetime income disclosure is effective one year after the latest of this guidance is issued by DOL.
Calculating the effect of market volatility on DC lifetime income
With that background – that what is happening both in the asset and interest rate markets matters to the DC participant’s lifetime income equation – we have been tracking the effect of the current market turmoil on two example participants: (1) a 35-year old invested in a 2050 target date fund (TDF), and (2) a 55-year old invested in a 2030 TDF.
Going forward, we are going to model these effects by tracking the lifetime income that these two example participants can buy, given changes in asset values – in our example, our 55-year old’s 2030 TDF and the 35-year old’s 2050 TDF – and in market interest rates.
What is important in this analysis is not the explicit amount that the participant will be getting based on a given account balance – that will (in the end) be determined by the market conditions at the time the participant chooses to convert her account balance to an annuity. Instead, our analysis will show direction: the net effect on the participant’s benefit, positive or negative, of current changes in asset values and interest rates. This will help the participant – and the sponsor – understand where he is vis a vis his retirement income goal.
To do this, we will start each year, for each participant, with an assumption that the participant has enough DC assets to finance a $1,000 per month annuity at age 65. We will then, as the year progresses, adjust that $1,000 per month figure to reflect gains/losses in asset values the participant’s hypothetical account balance and the effect of increases/declines in interest rates on the cost of retirement income.
Effect of market volatility on DC lifetime income as of early May 2020
Using that methodology, here is where we are through May 6, 2020.
As the chart indicates, the amount of retirement income our age 55 participant can buy with his account balance has gone down 19% since the beginning of the year, and the amount of retirement income our age 35 participant can buy with her account balance has gone down 26%.
The point of this exercise – the role of interest rates in retirement income
The reason that tracking this number – the effect on net retirement income of changes in asset values and interest rates – is critical (especially in current, volatile markets) is that these declines are not just a consequence of asset losses.
The relevant TDFs (an average of the performance of three large TDFs) account for only about half of this decline – the 55-year old’s 2030 fund is off 9%, and the 35-year old’s 2050 fund is off 13%. But the net loss in retirement income for both participants is 10 percentage points higher, because of the significant decline in interest rates so far this year.
Markets remain volatile
Of course, what matters in the long run is long run results. As we have discussed, at the present moment the critical question – to which no one knows the answer – is, will extraordinary federal monetary and fiscal stimulus result in higher inflation or will the effects of the pandemic result in a significant and (relatively) long-lasting recession? Or neither, or both? Which of these outcomes turns out to be the (actual, long run) case will produce different long run outcomes for 401(k) plan participants – conceivably, even different results for our 55-year old, on the one hand, and our 35-year old, on the other.
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We intend to update this analysis more or less monthly, at least as long as markets remain as volatile as they currently are.