A global perspective on investment and retirement

The stock market has had an extraordinary rally over the past five years: the S&P 500, including dividends, is up 104% on a cumulative basis — 15% annualized, as of Nov. 21. Yet this rally has lacked the “irrational exuberance” of past rallies.

Despite some post-election optimism, we remain in an environment characterized by low growth, low inflation and ultimately, low expected returns. Importantly, interest rates have come down globally to near or below zero.

Low interest rates hurt individual investors in two ways: they translate into lower expected returns in the accumulation phase, and they make it harder to generate income in retirement. Consequently, no matter where we look around the world, there is a growing gap between the level of wealth investors want or need to retire (their “number”), and what they can reasonably expect to accumulate (their outcome).

People like to think of their “number” in terms of a dollar amount, but the size of your “pot” at retirement might translate into very different retirement income levels if interest rates are high or low. In the report “Pensions at a Glance, 2015” the Organization for Economic Co-operation and Development estimated income replacement rates across countries. For each country, they calculated how much of the average employee's lifetime average salary can be replaced by purchasing an annuity at retirement assuming 2% real interest rates, a generous assumption given current levels. For example, average income replacement is 28% in the United Kingdom, 40% in Japan, and the United States is not much better at 45%. If we assume that most people would be happy to retire with a 75% income replacement ratio, the gap is quite wide.

However, the data include only mandatory pensions, for example, Social Security in the United States. Individuals may also have access to accumulated wealth in the value of their homes, defined benefit plans or defined contribution plans. For DC plan sponsors, the question remains: After accounting for other sources of retirement income, can DC plans bridge the gap?

Low expected returns are not the only challenge. Society's problem with underfunded pensions is expected to grow as life-expectancy of the population continues to extend. In the United States, the OECD shows that the percentage of the population 65 years and older has grown to 15% in 2014 from 10% in 1974. Australia, Canada, Germany, Japan, and the U.K. all show significant increases as well. In Japan, the number of people 65 and older has grown to more than 25% from 8% during that period.

To be fair, the size of retirement systems globally has increased significantly as well. According to Willis Towers Watson PLC's 2016 global pension assets study, from 2005 to 2015, global pension assets have grown to $35 trillion from $21 trillion — a 5% annualized growth rate. Are these assets being invested to bridge the gap?

There are significant differences in how assets are invested across retirement systems around the world. Some focus on glidepaths that derisk as individuals approach retirement (such as target-date funds in the U.S.); some allocate mostly to diversified growth funds and start derisking only five to 10 years before retirement (the U.K.); while others have significant allocation to equities and alternatives, with a home bias (Australia).

Yet these systems are all trying to solve the same problem: help people save for retirement. And the laws of finance, like the laws of physics, are the same across countries. Compound interest works the same; the chartered financial analyst exam questions are the same; and the opportunity set offered by global capital markets is the same.

So why the differences? We surmise that the wide range of glidepaths has nothing to do with investment considerations. Instead, regulation and taxes seem to be driving plan design, product offerings and asset allocation decisions. Plan sponsors must constantly monitor regulatory changes and adapt accordingly. In the United States, fiduciary risk might have taken over as the No. 1 consideration in most investment decisions, such as manager selection.

Based on our experience working with plan sponsors around the world, as well as reports published by Aon Hewitt (“Retirement and Investments,” released July 16), and State Street Global Advisors (“10 Best Practices for Global DC Plans” in 2016), we submit three “best practices” that plan sponsors should consider:

nLook at the big picture: Plan sponsors, consultants, and providers of investment solutions should study participant demographics. For example, what's the average age of participants? Do most participants also have access to a defined benefit plan? Are they high-income earners relative to the average population? Plan design should adjust to this information.

nDon't underestimate inertia: It is very difficult to engage participants because most are not investment professionals and do not like to focus on their retirement savings. Proactive communication is important. Features that recognize and harness inertia lead to better funded plans.These features include the use of diversified, “auto-pilot” default solutions such as target-date funds, as well as mechanisms that encourage or mandate contributions.

nManage the transition to retirement: In most countries, when individuals reach retirement, they must decide whether to stay in their DC plan, cash out or move their savings into some retirement income solution. Tax implications make this already complex decision even more daunting. Plan sponsors should work with consultants and providers of investment solutions to help individuals manage this important transition.

These recommendations might sound like motherhood and apple pie, but we believe they deserve more attention, especially in a low expected return environment in which the underfunding gap is growing. While taxes and regulations will continue to differ and drive differences in plan design across countries, we believe these three recommendations are as close as it gets to the “laws of physics” for DC best practices around the world.

Sébastien Page is co-head of asset allocation and James A. Tzitzouris, director of research for the asset allocation group, T. Rowe Price Associates Inc., Baltimore.