The Building Blocks of a Retirement Tier

When employees think about what it means to have enough money to retire, more than likely they are unsure how to translate their lifetime savings into income. For their entire working life, these employees receive regular paychecks; from this income, they generally construct a budget to cover their basic expenses. At the point of retirement, they suddenly find they need to shift their mindset from saving to spending (a difficult transition for many given the number of years of having a savings mentality). And studies show that many people’s greatest fear in retirement is running out of money. That fear often leads to pinching pennies unnecessarily (i.e., underspending, or a “retirement consumption gap”1 ). As Nobel laureate Robert Merton2 has stated, the goal of a retirement plan should be to allow participants to maintain the standard of living that they enjoyed just prior to retirement.3

Plan sponsors now have an opportunity to address these concerns. As more plan sponsors encourage participants to remain in their plan post-retirement, it is imperative that participants be offered appropriate tools to meet a wide array of financial needs. If an employee feels financially comfortable and is willing to retire “on time,” this helps the employer with recruiting new employees, or workforce management. Similarly, if employees find the plan is structured to accommodate retirees, they are more likely to maintain their accounts in the employer plan; this may benefit all plan participants by keeping expenses and other service fees lower. Therefore, designing the plan with appropriate features and tools for retirees can be a transformational enhancement to a defined contribution plan. 


Over the past several decades, plan sponsors have successfully focused on helping their employees save for retirement. However, as lifespans lengthen and many people expect retirement to last 20 to 30 years or even longer, experts recognize that participants entering retirement would like—and, in fact, need—additional support to create an income stream that will replace at least some of the paycheck they have become accustomed to receiving on a regular basis. These experts also agree that the time has come for the industry to collectively transform these savings plans into retirement plans.

The Defined Contribution Institutional Investment Association (DCIIA) states a “retirement tier” should allow a defined contribution plan sponsor to expand the plan’s goal from one wholly focused on savings to one that also accommodates and supports participants who are near, entering, or in retirement.4

For plan sponsors, the first step in creating a retirement tier is to embrace the concept that the existing defined contribution plan is no longer solely a savings plan; for many plan participants, it may be their only full-fledged retirement plan, so the plan must be structured to address the risks to retirement security. If the stated goal of the plan is to be a retirement plan, the plan should offer a specific set of tools, services, and investments structured with the retiree population in mind.

Given that there may be differences in the makeup of each employer’s workforce (which can be uncovered by analyzing the plan demographics), the next step is to acknowledge that each plan participant will have different needs and income objectives in retirement. The industry has been able to use automatic enrollment, automatic escalation, and qualified default investment alternatives (QDIAs) to help all employees save for retirement in a consistent manner. While this one-size-fits-all approach has been effective for accumulating/saving assets and improving retirement income adequacy,5 a single decumulation/spending strategy for participants entering retirement may not be the best approach. Rather, a series of building blocks—a carefully chosen selection of investments, tools, and advice that helps participants personalize their own retirement income stream—is likely to be viewed as a best practice. In fact, these building blocks are the critical components of a retirement tier.


As Merton has eloquently explained, “The primary concern of the saver remains what it has always been: will I have sufficient income in retirement to live comfortably?”6 Ultimately, the answer, of course, will depend on the individual household’s unique needs.

Given all the changes in spending patterns and the varying needs of individual households (e.g., single, married, widowed), providing a single retirement income solution is unlikely to prove helpful for all participants. In addition to different spending needs, households also have different risk tolerances, which will require a range of investment solutions to effectively create an income stream. For example, lower-income households generally rely on Social Security to replace most of their preretirement income, whereas households with higher income levels need to rely more heavily on personal savings to duplicate/replace their income.7

By incorporating a retirement tier into the plan, the plan sponsor is offering a framework for participants to use in constructing their own retirement income strategy. This offers participants the components needed to create an income stream that supports their desired standard of living in retirement.

Experts currently recommend targeting (being able to replace) 75% to 85% of preretirement income. It makes sense that most people will spend less in retirement than during their working years, given that their income goes toward taxes, savings, and spending when they’re working. In retirement, people’s spending needs are different, and generally lower. We know that spending over the life cycle tends to be hump-shaped (generally peaking when people are in their mid-40s, with most expenses occurring when children are in college). Once people retire, though, fewer expenditures are needed for work-related items, such as clothing and transportation, and most households will spend less on food (with more time to shop and prepare meals at home).8 However, one can assume that medical expenses will rise; some couples may need as much as $363,000 in savings to pay for those expenses not covered by Medicare during retirement.9

In general, plan participants would like to have a reliable income stream to cover basic budgetary expenses, maintain their lifestyle (the “fun” bucket, or discretionary expenses), have control over their assets, have the flexibility to use assets as needed, allow assets to grow, and potentially leave a legacy. However, plan participants will also need to factor in the unique risks they will face in retirement:


  • Inflation (erosion of purchasing power)
  • Sequence risk (the risk participants face when retiring during times of market volatility, inflationary periods, and/or low interest rate environments)
  • Capital markets risk/volatility
  • Longevity uncertainty (risk of outliving assets) Health care shocks
  • Emergency savings

Constructing a portfolio that meets employees’ retirement goals while factoring in these risks is a daunting challenge for even the most sophisticated investors; the Nobel laureate William F. Sharpe is widely known for saying “Decumulation is the nastiest, hardest problem in finance.”

Despite this overriding truth, only four in 10 employees use a professional financial advisor—or, stated differently, 60% of employees are tackling this problem completely on their own.10 Employees may therefore benefit from fixed income options that provide an income stream offering a tradeoff between liquidity and guarantees. The original rule of thumb, for instance, was that a 4% withdrawal rate would be sufficient to manage one’s retirement assets without running out of money. That is now considered a dubious strategy to meet the specific needs of retirement, given the impact that interest rates and inflation may have on a participant’s standard of living.

As an example of an array of fixed income options, one can compare an inflation- sensitive fixed income strategy with total liquidity (i.e., the most flexible) to the highest form of guarantee, such as a fixed income annuity (i.e., irrevocable, the least flexible), as well as an array of choices between these two endpoints. Plan sponsors have the opportunity to provide educational tools and investment vehicles that will assist employees, including, most importantly, soon-to-be retirees, who are dealing with this vexing problem.


Many employees consider their employers to be trusted advisors and will deeply appreciate these retirement-tier services and solutions. In fact, two in three workers (66%) would like more education and advice from their employers on how to reach their retirement goals.11 Retirees will also benefit from the simplicity of the retirement-tier solution, as well as the fiduciary oversight and lower fees that are inherent in an employer-sponsored plan.

Employers, in turn, will benefit from having employees who are fully engaged in the retirement planning process. Plan participants age 50 and older control 63% of all plan assets.12 Retaining these assets even after participants retire can assist plan sponsors in achieving and retaining plan economies of scale. As a plan loses its larger accounts, both its total size and the average size of its individual accounts decline. All else being equal, such losses work against securing lower recordkeeping and investment management fees for all employees, whether active or separated.


It is critical that plan sponsors evaluate the goal of their retirement plan to ensure the program meets the range of needs of their employee base. Researching and understanding the structure of the current plan, and how employees are using it, is the first step in determining the appropriate structure for the retirement tier. If the research underscores the potential benefits of a retirement tier for participants, the steps outlined in the Decision Tree and the Building Blocks (see below) will provide a road map to the issues worth considering when structuring the retirement tier. A well-designed retirement tier can be beneficial for both the employer and the employee, and there are many tools and resources available to support plan sponsors in developing a retirement tier that is most appropriate for their plan participants.

  1. “Right-Sizing Retirement: Exploring the Retirement Consumption Gap in Early Retirement,” Defined Contribution Institutional Investment Association, September 2020.
  2. Robert Merton provides consulting services to Dimensional Fund Advisors 
  3. Robert Merton, “The Crisis in Retirement Planning,” Harvard Business Review, July-August 
  4. “Design Matters: The Retirement Tier,” Defined Contribution Institutional Investment
  5. “The Impact of Auto-enrollment and Automatic Contribution Escalation on Retirement Income Adequacy,” EBRI, Issue Brief 349, November 2010. 
  6. Merton, “The Crisis in Retirement ”
  7. “How Much Should I Save for Retirement” (white paper, Dimensional Fund Advisors, 2013).
  8. “The Retirement Income Equation,” DC Dimensions Summer 2012, Dimensional Fu
  9. “Savings Medicare Beneficiaries Need for Health Expenses in 2019: Some Couples Could Need as Much as $363,000,” EBRI Issue Brief 481, May 2019.
  10. “Retirement Security Amid COVID-19: The Outlook of Three Generations—20th Annual Transamerica Retirement Survey of Workers,” Transamerica Center for Retirement Studies, May 2020.
  11. “Retirement Security Amid COVID-19: The Outlook of Three Generations, 20th Annual Transamerica Retirement Survey of Workers,” TransAmerica Center for Retirement Studies, May 2020.
  12. Jack Vanderhei, Sarah Holden, Luis Alonso, and Steven Bass, “401(k) Plan Asset Allocation, Account Balances, and Loan Activity in 2016,” EBRI Issue Brief 458, September 2018

Dimensional Fund Advisors LP (“Dimensional Fund Advisors”) is an investment advisor registered with the Securities and Exchange Commission. This article is distributed for informational purposes only and should not be considered investment, tax, or legal advice or an offer of any security for sale.

The views and opinions of the third-party authors do not necessarily represent the views of Dimensional Fund Advisors. Dimensional Fund Advisors makes no representations as to the accuracy of, and assumes no duty to update, the information provided herein.

There is no guarantee investment strategies will be successful, and it is possible to lose money. Risks include loss of principal and fluctuating value.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates, and they are subject to various other risks, including changes in credit quality, liquidity, prepayments, and other factors. 

Inflation-protected securities may react differently from other debt securities to changes in interest rates.

Target date funds are designed to target a year in which an investor may withdraw funds for retirement or other purposes. Investments in target datefunds are subject to the risks of their underlying funds, and asset allocations are subject to change over time in accordance with each fund’s prospectus. An investment in or retirement income from a target date portfolio is not guaranteed at any time, including on or after the target date. An investment in a target date portfolio does not eliminate the need for investors to decide—before investing and periodically thereafter—whether the portfolio fits their financial situation.


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