Target date funds are all the DC rage, keeping participants invested, allocated and consistent in good markets and bad.
It’s not to say they’re perfect; as behavioral economist Shlomo Benartzi and many others frequently note, if you get the glide path and altitude wrong it could all easily crash.
So how do advisors and plan sponsors know if the target date funds are, well …on target?
We asked Paul Root for insight. Root is a senior DC investment strategist with the Retirement Solutions group of Northern Trust Asset Management.
The firm’s done quite a bit of work and research to answer these very questions, and he had a lot to say about structure, measurements and the critical role of human capital in achieving successful target date outcomes.
Q: What do you think are the most important elements to sound glide path design?
A: We believe it’s the establishment of investor goals and ensuring that the resulting portfolio is built to efficiently fund the retirement liability without taking undue risk.
It’s critical that the portfolio construction process incorporates the anticipated consumption needs of investors and that the investments are calibrated using an asset-liability matching construct.
Too often, target date designs focus on maximizing relative return in the accumulation phase, and largely defer what constitutes meaningful retirement income to a separate discussion.
A DC investor’s liability can be calculated using a framework that estimates the required savings and an income target, with the goal of maintaining standards of living before and after retirement.
Among other specifics, taxes, social security, lifecycle expenses, and health care costs should be carefully considered, and regularly updated, in the framework to make the TDF objective sufficiently close to reality.
The framework should further accommodate specific situations for sponsors and participants, such as retirement plan provisions, worker earnings and demographics, and expected investment returns.
Q: Why is human capital so important?
A: Human capital is the most central rationale for an asset allocation that changes through time.
Within the context of a DC participant’s’ retirement savings, not only does the value of all future earnings need to be considered, but also how much of those earnings will be contributed to building the retirement funding over time.
As an investor ages and has fewer future earnings in front of him or her, the amount of human capital depletes. Consequently, this bond-like, non-financial asset needs to be replaced with similar risk-control assets.
Upon retirement, human capital is almost completely depleted, with a small amount remaining should the participant choose to re-enter the workforce.
When added to the investment portfolio, human capital is an important source of funding used for consumption needs throughout retirement and therefore needs to be considered within the overall portfolio context.
Q: Do you think glide paths should be strategic or tactical, or both?
A: We definitely believe glide paths should be strategic in nature.
Given the long-term nature of retirement investing, we believe a strategic approach is more closely aligned to the needs of the plan participants in helping them achieve their retirement goals.
Q: How do you measure glide path success?
A: The true measure of success when evaluating a glide path is whether it funded a participant’s retirement liability and thereby produced sufficient retirement income needed to maintain quality living standards.
We measure [it] by assessing both the historical performance relative to the objective and making a forward-looking assessment.
Understandably, discussions around DC investment performance typically address returns relative to a market index or peer average.
However, outperforming an index or other asset managers may not best represent the performance in the context of the ultimate objective of the portfolio.
Plan sponsors should look to their asset managers to deploy a number of metrics to more meaningfully assess the suitability and performance of the primary purpose of their glide paths, including liability-relative performance.
These metrics can ultimately be designed to measure how well participants are doing relative to what really matters: efficiently investing to fund their retirement goals.
Q: What is your view on appropriate risk allocation for younger participants?
A: The most academically sound portfolio based on long-term returns and the time to ride out negative performance periods points to a 100 percent allocation to risk-seeking asset classes, such as equities, real estate, and commodities.
However, such an aggressive portfolio may not best serve the empirical drop-out behavior we observe and also may not align with the risk-appetite of those younger investors.
Analysis by Northern Trust Asset Management, along with academic and industry reports, reveals an empirical pattern of participants dropping out of their plans—a reverse correlation with their account values. As a result, we believe it’s critical to build confidence and establish a strong savings commitment from participants.
We found that reaching a $10,000 account balance is very important from a mental perspective since it triggers a strong sense of accomplishment and thus incentivizes commitment. We wrote a research paper on this titled, “The $10,000 Hurdle.”
Given our research, we believe a rush to highly aggressive portfolios for younger participants may be counterproductive.
Large swings in account values could lead to the belief by individuals early in their saving careers that a $10,000 hurdle is insurmountable.
A target date solution that has a greater focus on capital preservation at the front end of the glide path helps participants stay calm and carry on through volatile markets.
Importantly, the optimization of the glide path through the incorporation of human capital, financial assets, and investor behavior does not negatively impact the retirement outcomes for participants.
By taking the right risk at the right time for individuals, plan sponsors have the ability address the negative impact investor behavior can have on an individual’s retirement outcome without sacrificing the growth required to achieve success.
Additionally, industry research suggests that the risk appetite of younger participants is far less than their own capacity to take on risk, and that this should be considered in the risk positioning within a QDIA glide path.
Cerulli Associates reports that, when asked about the risk within their investment portfolios, more than 80 percent of investors under age 40 said they would prefer “to protect my portfolio from significant losses, even if it means periods of underperforming the market.”
Given this, we believe that the most appropriate portfolio for younger DC participants is one that does not maximize risk, but rather takes a more balanced approach; to combat drop out behavior and better align the portfolio risk with the risk appetite of the investor.
Q: What do you believe are key elements necessary for increasing DC enrollment and reducing drop-out rates?
A: As previously noted, our analysis, along with academic and industry reports, reveals an empirical pattern of participants dropping out of their plans–a reverse correlation with their account values.
The peril of having as low as $1,000 saved for retirement within a plan, for instance, is that the asset pool is likely perceived as “play money.”
The paper notes that balances below $10,000 have a 60 percent to 84 percent cash-out rate. Such leakage risk is reduced when participants have an account balance greater than $5,000, but still remains elevated.
The leap to increasing that balance to greater than $10,000 makes a more noticeable milestone, slashing the drop-out rate by half. To emphasize again, the significance of crossing the $10,000 hurdle is that it mentally triggers a stronger sense of accomplishment and thus incentivizes commitment.
Q: What is the future of TDFs in DC plans?
A: Quite simply, [the] TDFs of the future will provide a personalized asset allocation at the participant level, in an automated fashion.
Given that every investor has different circumstances and different goals, the retirement liability is theoretically different for everyone, and therefore the investment portfolio at different stages in one’s life should require a unique portfolio for that individual.
Today, custom TDFs do not address the typical vast differences in participant circumstances within a single DC plan. Likewise, managed accounts do not have high adoption rates, given the relatively high fees and necessity for participant engagement.
However, with advances in technology, it is now possible to automatically pull critical information from a recordkeeper and/or plan sponsor system to formulate a personalized asset allocation at a price that’s much closer to today’s off-the-shelf TDFs.
We believe this new evolution of personalized target date solutions will be the QDIA for many plan sponsors, and an ultimate replacement for today’s off-the-shelf and custom TDFs.
With more than 20 years serving financial markets, John Sullivan is the former editor-in-chief of Investment Advisor magazine and retirement editor of ThinkAdvisor.com. Sullivan is also the former editor of Boomer Market Advisor and Bank Advisor magazines, and has a background in the insurance and investment industries in addition to his journalism roots.
