Preparing for retirement is perhaps the most important financial planning exercise in which most Americans will ever engage. For those in the workforce today, a retirement journey of 70 years or more―filled with bull markets, bear markets and occasions of gut-wrenching crisis―would not be unusual.
Despite this extended and nuanced investment horizon, the retirement industry maintains a troubling emphasis on short-term metrics when assessing manager performance, which, in our view, compromises the ability of sponsors to identify investment options that over the long-term may prove to be more resilient, all-weather investment options.
There is an inherent dissonance in evaluating long-term, objective-based investment plans using short-term, returns-based data. Retirement investing is no place to chase the “hot dot;” long-term planning requires long-term solutions, the effectiveness of which can only be gauged across full market cycles that capture performance in different investment environments.
As 2020 to date has laid bare, one-, three- and even five-year metrics drawn from the 2010s are hardly indicative of the market returns or volatility retirement savers are likely to experience over the course of their multi-decade journeys.
Long-Term approach for a long-term horizon
The journey to retirement tends to be less monotonous interstate and more scenic byway, filled with twists and turns, breathtaking vistas and white-knuckle mountain passes. For American workers, the trip consists of three distinct legs. The bulk of the journey is spent in the accumulation phase, the 45 years or so of working, saving and investing to build a portfolio of retirement assets―in 401k plans prominently, but also other tax-advantaged savings vehicles, personal savings, Social Security benefits, etc.―sufficient to support their lifestyles in retirement.
What should follow is a brief but potentially frenetic multi-year transition period during which savings efforts should be maximized across accounts while investment risk is dialed back to insulate accumulated assets from a sharp market selloff. Finally, retirees turn to these assets for an adequate income stream for the rest of their lives.
A long-term investment horizon demands a long-term investment approach. None of us can predict the market ebbs and flows over the next seven decades but, if history is a guide, any extended investment period will consist of a mix of good, bad and indifferent market environments, peppered with periods of abject distress.
The timing, degree and duration of these episodes is anyone’s guess, of course, which is why we believe manager evaluation and selection metrics that capture full market cycles are more likely to reflect a plan participant’s experience over time and represent a more prudent approach to plan design for sponsors and their advisers.
We’d suggest plan sponsors first define their plan’s objectives and then identify the investments that appear best suited to meeting those objectives based on their historical record through multiple full market cycles―periods that include a variety of investment environments and ideally at least one crisis period.
Over the past 25 years alone―a period during which the S&P 500’s cumulative total return exceeded 730%[1]―we can identify multiple time periods that meet these criteria and may offer a useful perspective on manager performance across market conditions. Crisis environments have not been in short supply despite the long-term upward trend: dot-com bubble (2000–02); 9/11 (2001); global financial crisis (2007–09); EU debt crisis (2009–14); trade wars (2018, ongoing); and Covid-19 pandemic (2020, ongoing).
Support better outcomes through a long-term focus
While understanding risk is critical to a plan sponsor’s ability to evaluate long-term investment strategies, ERISA’s guidance on the topic is not all-encompassing.
In our view, its ambiguity is prescient. Since the most serious risk retirement investors face is the permanent impairment of capital, ERISA directs fiduciaries to focus on market drawdowns (e.g., sponsors must “minimize the risk of large losses”).
Take first quarter 2020, for example; while sharp selloffs like this often are viewed through the prism of sequencing risk―e.g., the drawdown’s impact on the recent retiree, who suddenly finds her nest egg trimmed by 20% and has little opportunity to recover the difference―market shocks are an obstacle retirement savers of all ages must overcome to reach their goals. Not only do mathematics become a headwind following a large loss, the study of behavioral finance tells us that volatile periods increase the likelihood that participants will act in opposition to their long-term needs.[2]
Investment menus composed of strategies with diverse risk and return characteristics and complementary performance drivers may enable participants to construct portfolios that offer a more cushioned ride across the retirement journey’s rough patches, with the potential for reduced short-term volatility and limited downside capture, which, in turn, would likely encourage adherence to long-term plans that seek a steady compounding of assets in real terms over time.
Building a retirement-outcome-focused investment lineup involves more than merely checking off various style boxes; it requires decomposing the long-term performance of investment products to establish a track record of performance in different investment regimes. While we’re continually warned that past performance is not an indicator of future results, mapping multicycle historical performance patterns against prevailing market conditions―consistent outperformance in down markets, for example, or superior risk-adjusted returns over full cycles―may help plan sponsors assemble a lineup of investment strategies with complementary styles, philosophies and goals.
In our view, such an approach likely would better align manager evaluation criteria with participants’ time horizons, reduce some participants’ impulse to overreact to short-term anomalies and improve plan sponsors’ prudent fiduciary processes.
That is not to say that short-term metrics―good or bad―cannot offer valuable insight into manager performance versus expectations; viewed in the context of prevailing market dynamics, even a quarter’s worth of data can reassure plan sponsors that their investment managers are behaving as expected or alert them that something may be amiss.
For example, an active manager with a history of outperformance in exuberant market environments and underperformance in sharply down markets should be evaluated regularly according to how well it meets these bogeys―theoretically, this performance is why the manager is included in the plan lineup.
However, such a track record also may raise larger plan-wide considerations, such as whether the volatility of this investment is in the best interest of participants and whether these performance characteristics over the long term will improve the probability of successful participant outcomes.
Rough roads may appear ahead
Just as challenging market environments will test the mettle of an investment manager, so too will they reveal a retirement plan’s fitness to withstand the rigors of market cycles. While there’s nothing sponsors can do to influence the direction of financial markets, thoughtful plan design and proactive communication can equip participants with the tools needed to build resilient, diversified portfolios that seek to 1) preserve invested principal, 2) grow both income and principal in defense against the ravages of inflation, and 3) generate a consistent stream of income in retirement.
With the 10-year-plus US equity bull market having come to an end, elevated volatility and economic uncertainty have become dominant investment themes. Advisors should capitalize on this environment while it still feels new; we suggest encouraging plan sponsors to evaluate their existing plan designs and investment menus and to confirm their retirement plans are prepared for what may prove to be a bumpy leg of the retirement journey.
Mike Rosenberg is Head of Retirement Investment Solutions and Joe Lee is Head of Retirement Platforms and Strategy with First Eagle Investment Management.
[1] Source: FactSet.
[2] Statman, Meir. “Behavioral Finance: The Second Generation,” CFA Institute Research Foundation, 2019.