As the qualified default investment alternative (QDIA) in most 401(k) plans, target-date funds (TDFs) have become a critical “one-stop-shop” retirement savings and investment tool for participants during the long accumulation stage of their working lives. As participants move from accumulation to decumulation, their investment needs become less homogeneous with their unique personal circumstances.
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 FundsOpens in a new tab, 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 ModelOpens in a new tab (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.
A hypothetical hybrid annuity TDF with these components is illustrated in Figure 1. As shown, the allocation to the multiasset allocation decreases while the allocation to the income-funding strategy increases along the life-cycle glide path. This is done to gradually reduce exposure to risky assets and increase assets dedicated to the income-funding allocation for annuity liability management.
In a hybrid annuity TDF, the multiasset allocation provides the opportunity for asset growth during the accumulation phase. It is a diversified portfolio with an asset mix similar to that of a traditional TDF, following a glide path that derisks as a participant approaches retirement.
The income-funding strategy is an annuity liability management strategy where invested assets are used to prefund the annuity purchase. Allocation to this strategy gradually increases with a participant’s age and peaks near the time of the final annuity purchase. While the income-funding strategy is always liquid, structure and approach vary among hybrid annuity TDF providers.
Hybrid annuity TDFs use an annuity component as a source for guaranteed income during the decumulation phase. Our analysis focused on fixed-rate annuities that provide a guaranteed income stream based on a payout rate determined at the time of the annuity purchase.2
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