Downside Risk Protection of Retirement Assets: A New Approach

Over the past few decades, 401(k) plans, IRA accounts, and other self-directed investment vehicles have become the most important pool of retirement savings, leaving retirees exposed to the risk of outliving their assets, a hazard largely absent from traditional pension plans. Prior research has examined asset diversification, annuities, put options, and dynamic withdrawals as ways to mitigate this risk. This study proposes an alternative: explicit downside risk protection (or DRP) at the individual account level. The proposed DRP takes the following form: in years the account suffers a loss, that loss is capped at a predetermined amount. In return for this protection, the account holder gives up a portion of the gains only in years where the account’s performance is positive. The net effect of this protection is to reduce the retirement account’s down-side risk, significantly reducing the likelihood of early account depletion. A Monte Carlo simulation demonstrates that the chance of outliving one’s assets over a retirement horizon of 45 years drops from nearly 15% without DRP to about 4% with DRP. Furthermore, by eliminating extreme negative outcomes, DRP has the potential to increase the average portfolio return (even accounting for the cost of protection) while simultaneously reducing the portfolio volatility. This paper also demonstrates that DRP can be profitably offered by a financial institution. It provides lower bound estimates of the rate of return a financial institution is likely to earn by offering DRP to retirement accounts.