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Playing Defense to Help Reduce Risk at Retirement

By Wells Fargo ITS

The key to understanding a target date fund's asset allocation philosophy is to examine its glide path. The basis for this strategy is simple: sometimes the best offense is a good defense.

Transitioning Into Retirement
The current debate about the appropriate glide path model revolves around longevity risk. The longer a person lives after retirement, the greater the possibility that they could outlive their nest egg. For this reason, some target date funds remain heavily invested in equities at the retirement target date and beyond.

In reality, the years just before and after retirement are a crucial yet risky period for retirement investments. At this stage of life, a wide array of risks can have an adverse impact on retirement assets and income resources. The result may be a long-term, if not permanent, setback to an individual's ability to outlive their investments.

A Variety of Risk Factors Can Affect Retirement Resources

Market Risk	Stock market losses can substantially reduce retirement assets.
Interest Rate Risk	Lower interest rates may reduce available retirement income to meet day-to-day expenses, while rising interest rates may impact the value of long-term fixed-income investments.
Inflation Risk	Inflation can erode the purchasing power and overall financial well being of retirees, even at low levels.
Employment Risk	Employment for this age group varies, and changes to health, family circumstances (death of a spouse or divorce), or economic conditions may lead to a loss of anticipated income or forced early retirement with the need to prematurely dip into a nest egg.
Public Policy Risk	Legislative changes to Social Security and Medicare may include benefit cuts, or increases in taxes may raise income, property, or sales taxes.
Business Risk	Insolvency of an employer can lead to reduction or loss of defined benefit plan payouts and other retirement benefits.

A Mistimed Market Decline Can Take a Toll
Retirement is a time of transition for employees. Not only are they preparing to adjust to a new lifestyle, they're also making many changes to their 401(k) plans. This is evidenced by a recent study that shows only 13% of retirees left money in their 401(k) plan. Half of retirees rolled their 401(k) balances into an IRA and a full 60% of those who rolled over to an IRA did so within two months of leaving their employer. 1

A significant market downturn during this already emotionally stressful time can make participants take drastic action, often making their portfolio ultra-conservative in an effort to minimize losses or ultra-aggressive to try to make up for losses.

In fact, a market downturn that precedes or coincides closely with a planned retirement date can have a long-lasting negative impact on retirement assets. Without the luxury of time to recover, plan participants may need to make dramatic adjustments to their planned lifestyle in retirement.

What's more, plan sponsors may be subject to fiduciary exposure if plan participants experience a large decrease in account value as they near retirement and start to withdraw their investments. While there is no steadfast remedy for this situation, target date funds that provide a more conservative posture at retirement may help reduce the impact of market risk.

What's the impact of a market downturn that coincides with retirement?
In our example, we've assumed market declines of 10% and 6% in two consecutive years leading up to retirement, resulting in an overall portfolio loss of 18%. At a 7.40% annual rate of return and annual withdrawals of 4% from total assets, it would take five years to recover from this loss.

Managing Risk at Retirement

Broad Diversification
Target Date Funds Should remain broadly diversified throughout a participant's investment lifecycle. Overall exposure to stocks, bonds, and cash should be adjusted to help manage risk as the target date approaches. The decisive differentiator, though, is that risk is not managed by excluding asset classes, but rather by including all asset classes at all times. This approach seeks to find a balance between possible upside performance and downside risk.

Glide Path
Once the many risks faced by preretirees and new retirees is understood, it's easy to see why it's important for investors to move from an accumulation to a preservation bias over time, with lower levels of risk in the years just before and after retirement.

A method that provides a more prudent approach at a time when preservation of assets is crucial. Further, given the risk-averse nature of many retirees/ pre-retirees, investors at this stage of life are typically less willing or less able to tolerate negative returns that exposure to higher equity allocation strategies may produce. This might drive them from the fund, possibly selling at a low point.

A more conservative approach is also a positive for retirement plan sponsors who are concerned about the detrimental impact of market declines on accounts of employees who are approaching retirement.

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1 Based on percent of retiree's plan assets. Source: LIMRA International, Capturing Rollover Assets, 2006