Real Estate in Target Date Funds Solves Big 401k Problem

Sequencing risk looms large in 'late accumulation, early retirement'

Can real estate make target date funds more effective?Can real estate make target date funds more effective?

401k advisors know (and hate) sequence-of-return risk. Retiring into a down market means participants lose portfolio value at the exact time they begin drawing on assets for daily living expenses. Not only is their income diminished, but the assets aren’t there to benefit from the recovery to come. It’s a double whammy from which retirees will most likely never recover.

There might be a solution.

A new study by the Defined Contribution Real Estate Council (DCREC) examining the impact of a mix of public and private real estate in 401k target date lifecycle funds found that the addition of the asset class helped reduce volatility, mitigate “sequencing risk”, and improve overall outcomes, it was announced today.

“Sequencing risk looms large for plan participants in the late accumulation and early retirement phases of the investment lifecycle, generally between ages 55 and 75, as a result of the portfolio size effect (i.e. bigger portfolios equal bigger absolute gains and losses),” said Brian Velky, DCREC Research and Content co-chair. “Our research shows that an allocation to a mix of public and private real estate can make it easier to successfully navigate this challenge primarily by reducing volatility through the accumulation phase, ultimately leading to better retirement outcomes.”

The paper (Allocating to Real Estate Assets Across the Lifecycle: a Dynamic Approach), looked at three approaches to the challenge of asset allocation in DC plans through the target date lifecycle, considering the role of real estate across:

  • Deterministic asset allocation strategies (target date and balanced designs);
  • Dynamic asset allocation strategies (dynamic lifecycle funds); and,
  • Sub-allocation strategies (varying exposures to public and private real estate over time).

It further confirmed the results from an earlier DCREC study that found that adding as little as 10 percent public and private real estate exposure can enhance the risk-return profile of a DC plan portfolio throughout the retirement lifecycle, improving the probability of successfully achieving desired retirement outcomes.

In the most recent study, the 10 percent allocation was held steady across various portfolio strategies, while the public/private weighting was adjusted.  For most of the portfolios examined, adding real estate had a neutral to positive impact on performance, but increased the likelihood of success, defined by the authors as the ability to replace 70 percent of a plan member’s pre-retirement real income for life. This was due primarily to the reduction of volatility throughout the lifecycle, which in turn contributed to reduced sequencing risk.

In addition, the study found that managing the blend of public and private real estate over time might also have a positive impact on both terminal wealth and expected shortfall.  In this instance, the maximum benefit is likely to be achieved by overweighting exposure to public real estate early in the accumulation cycle as a source of diversified growth, and then moving towards greater exposure to private real estate late in the cycle for downside protection.

Lack of pooling transfers risk

The study notes that, in contrast to defined benefit (DB) plans, a key feature of DC plans is that sequence risk is transferred to plan participants, primarily by the lack of pooling of assets.

The authors point out that in a DB plan, the sponsor is responsible for setting aside sufficient resources to meet the needs of plan participants in retirement.  Participants don’t have to concern themselves with sequencing risk, which is spread over the pool of participants over all stages of the retirement lifecycle. In a DC plan the sequence of returns can have a major impact, with low or negative returns late in the accumulation phase making it more difficult for the plan participant to meet his or her goals.

“The sequencing of returns means that the behavior of participants is a key variable of the success or failure of a DC plan participant across the lifecycle,” said Cristina Hazday, DCREC research & content co-chair, who noted that timing strategies have generally delivered poor results for investors. “As such, we see a clear benefit to using real estate to deliver median outcomes that are similar to those of portfolios without exposure to the asset class, but with less volatility over time.”

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