|
Target Date Funds: The Case for a More Conservative Glide PathBy Paul T. Torregrosa, Ph.D., Director of Research, Global Index Advisors, Inc., and David A. Koenig, CFA, Wells Fargo Funds Distributor, LLC Target date fund assets have been growing rapidly in recent years, reaching $152 billion at the end of the second quarter of 2007, according to the Investment Company Institute (ICI). 1 That’s up from $114 billion at the end of 2006 and $71 billion at the end of 2005. In light of new legislation, target date funds are expected to become the dominant default option for automatic enrollment in defined-contribution (DC) retirement plans. 2 In making this shift, plan sponsors need to carefully consider the differences among fund offerings as they face the fiduciary responsibility of providing a prudent choice from among the growing number of fund families that offer these retirement solutions. Target Date Funds as Default Option As of June 30, 2007, about 90% of target date fund assets were held in retirement plans. With U.S. plan participants holding $3.0 trillion in 401(k) plans and $4.4 trillion in all employer-based defined-contribution (DC) retirement plans, according to ICI, the assets held in target date funds are forecast to continue to grow rapidly. Indeed, target date fund flows exceeded the flows into domestic equity funds during the 12-month period that ended October 2007, according to Strategic Insight. 3 Facilitating that growth are the Pension Protection Act (PPA) of 2006 and final rules from the Department of Labor that went into effect in December 2007 that permit the use of target date funds as the default option for automatic enrollment in DC retirement plans. A 2007 Wells Fargo survey of plan sponsors reported that 66% of those who intended to change their default option planned to switch to a target date fund. 4 The Glide Path: A Key Differentiator While various target date funds may initially appear similar, beneath the surface they can be quite different in terms of construction and risk exposure. One of the most significant differentiators among target date fund offerings is the "glide path," or the dynamic asset allocation strategy used to construct the funds. The choice of weightings among various asset classes as participants move along the path from accumulation to distribution is what provides the greatest impact on fund returns and potential downside volatility for participants. While greater equity exposure has the potential to produce higher returns in rising markets, it is important to determine whether those higher returns are the result of better active management or just more market risk. In choosing from among the many target date fund options, plan sponsors need to ensure that they select a product that shares their philosophy about the appropriate risk level at each stage along the glide path and that provides a diversified, transparent, and repeatable investment process. Equity Exposure of Various Target Date Products Across Target Maturity Dates
Source: Fund family Web sites DC Plan Participants Shoulder the Risk The evolution of retirement savings plans from traditional defined-benefit (DB) pension plans to DC plans has shifted the risk from plan sponsors to individual participants. While this has been occurring over many years and is well-understood, it is important to remember that individual participants have limited time horizons, unlike DB plan sponsors whose investment horizons can be infinite. Depreciation in DB plans due to market volatility can be absorbed more easily than in DC plans, as losses in the DB plan can be counterbalanced by gains over a longer future. In DC plans, however, each participant’s investment experience is path-dependent and a direct result of the specific time period when that individual is a participant in the plan. Because of this, participants with similar time horizons and risk exposure but different investment periods could have significantly different outcomes. A significant market decline at or near retirement can be catastrophic for individual plan participants as they do not have sufficient time or income to replace those losses. With this transfer of risk to individual DC plan participants, as default options increasingly shift from stable value or money market funds to target date funds, fiduciary responsibility dictates that a more conservative approach to glide path construction be used in seeking to provide prudent downside principle protection. Longevity Risk: A Savings Issue In assessing retirement savings risks, two significant types of risk must be carefully considered: market/volatility risk and longevity/shortfall risk. Market risk is one of the primary drivers of irrational participant behavior, but its impact on individual investors can be mitigated through product design that incorporates a more conservative approach to glide path construction. Longevity risk, or the risk of outliving your nest egg, is a predictable risk and is most influenced by participant saving behavior. It is impossible to eliminate this risk through product design, but research shows that automatic enrollment and automatic contribution increases can reduce it significantly. 5 Plan sponsors need to understand that product design can only attempt to address one of these two types of risk. While some target date options attempt to mitigate longevity risk through greater equity exposure near and into retirement, we believe that this is an inappropriate response. Longevity risk is a savings issue, which is unlikely to be solved with an investment solution. Shortfalls in retirement savings should not be made up through aggressive allocation to risky assets. Why Greater Equity Exposure Isn’t the Answer More exposure to equities can’t be the answer to inadequate savings levels. Markets are inherently volatile, as evidenced in recent quarters, and significant declines will occur. Higher levels of equity exposure mean more market/volatility risk, which can be catastrophic for plan participants who are at or near retirement and lack the time or income to replace significant losses. While higher equity exposure should increase the expected average return over a long time horizon, it also increases the dispersion of expected returns among participants. With the relatively short time horizons of individual participants, that wider dispersion translates into a greater number who would be expected to fall short of their retirement savings goals. In reviewing the table below, a plan sponsor needs to consider how many months or years of distributions an investor would have lost in just a few days. With significant market declines, a participant could lose an entire year’s distribution in just one or two trading days. To plan participants, it’s not the probability of an event that matters, it’s the magnitude of the loss. Impact of Risk Posture on Plan Participants: October 10, 2007-March 10, 2008
Conclusion Plan sponsors should consider whether their chosen target date solution delivers an appropriate level of risk dictated by the original target date investment philosophy that they determined was appropriate. With the recognition that markets are inherently volatile and that declines will occur, sponsors need to understand that no one product can completely address both volatility risk and longevity risk. Significant market declines can be catastrophic for participants at or near retirement, so we believe that a more conservative glide path provides a more appropriate balance between upside potential and prudent downside protection at this crucial stage in the investment lifecycle. Plan sponsors should consider a target date product’s role in overall plan design and seek a fiducially sound product foundation on which behavior-enhancing changes such as auto-enrollment and auto-increase can be implemented. They should then monitor the chosen product on how well it delivers on their philosophy about appropriate risk levels, not necessarily on how well it does compared with its peers. Target Date Selection Criteria
Footnotes 1 The U.S. Retirement Market, Second Quarter 2007, Investment Company Institute, December 2007. 2 Trends and Experience in 401(k) Plans 2007, Hewitt Associates, November 2007. 3 Strategic Insight. Domestic equity is defined as the Morningstar nine-box categories plus domestic sector funds. 4 Strategic Initiatives in Retirement Plans 2007 Survey Analysis, Wells Fargo Institutional Trust Services, August 2007. 5 Pension Design and Structure, New Lessons from Behavioral Finance, ed. Olivia S. Mitchell and Stephen P. Utkus, Oxford University Press, 2004. NOT FDIC INSURED | NO BANK GUARANTEE | MAY LOSE VALUE Contact Information |
