Portfolio Design: A Modern Approach to Asset Allocation

HOW CAN I TURN A DEFINED CONTRIBUTION PLAN INTO A DEFINED BENEFIT PLAN?

Many retirees relying on their savings to finance a retirement envy the financial security of those with defined benefit plans. Such plans guarantee an income flow for the rest of the retiree’s life. In some cases, the income flows are indexed to inflation. The great advantage of such plans is that they insure against the most important risk in retirement—longevity risk.

Retirees relying on defined contribution plans can try to create a defined benefit plan ex post. This income stream is obtained by investing a portion of the initial wealth in an immediate fixed annuity. The annuity works by pooling a large group of retirees of the same age in the same pool. Some will die early and will end up not capturing as much income as the average member of the pool. Others will die much later and will capture much more than the average member of the pool. By joining a pool of other retirees of the same age, retirees can guarantee that they never run out of money.

Why does that increase income in retirement? The reason is that the wealth invested in the annuity can be deliberately exhausted before death. It’s always possible to increase the income on a bond portfolio if we are willing to use up the capital in that portfolio. The immediate fixed annuity does just that. Individual retirees cannot take the chance of using up all of their capital unless they know the date of their death in advance! But a pool of retirees ...