The global financial crisis is more than ten years in the rear-view mirror and equity markets have reached new highs. A spurt of volatility at the end of 2018 reminded us just how painful a 10% drawdown in one month can feel, especially to a participant who was set to retire on December 31. It leads us to ask the question: just how much equity risk is appropriate in the home stretch of retirement savings? And what can target date funds do to mitigate the effects of potential bear markets in those critical years?
From 8% to 65% and everything in between
Target date strategies form the backbone of many Americans’ retirement plans. But just because two funds have the same target date doesn’t mean their portfolios are alike. Asset managers take different approaches, particularly around the amount of equity that participants are exposed to at various points in their retirement savings life cycle. According to Morningstar:
• At age 25, equity exposure can range from 75 to 100%.
• At age 65, equity exposure can range from 8% to 65%.
The severity of the 2008–2009 bear market provided a wakeup call to the industry, so it is imperative that plan sponsors understand their glide path and how its equity exposure changes over time.
The lost decade for plan participants
The bear market that resulted from the piercing of the technology bubble in 2000 was only a prelude to the stock market declines suffered during 2008. Together, they rendered the 2000s a “lost decade” for equity investors in general, and knocked the stuffing out of the retirement savings of many new and near retirees.
Hardest hit were those invested in 2010 target date funds which lost an average of 22.78% during that year according to Morningstar. (The highest one-year loss was 41%.) Those investors likely found themselves facing harsh choices, as assumptions built into their target date funds did not live up to expectations.
The short reason: target date funds of the day had no flexibility to retreat from impending losses. The ability to reduce equity risk beyond a tactical allowance (usually +/-5% or +/-10%) is set by the fund’s prospectus—and regardless of whether they invested in active funds, passive funds, or a mix of both—those restrictions left them at the mercy of market forces.
The financial crisis also unearthed another risk: bonds weren’t necessarily a safe place to hide, either. Where some target date funds held short-term bond funds, others held riskier high-yield bond funds, which can move in the same direction as equities and therefore can carry the same risks as equity.
What have asset managers done to address the risk of loss in the intervening ten years?
While there is no crystal ball that can predict the degree and longevity of drawdowns in equity markets around the world, we believe there are indicators—global economic slowdown, credit concerns, heightened political tensions and everything in between—that if quantitatively analyzed together relative to historical patterns, may be able to signal that rocky roads lay ahead.
For example, specific and measurable indicators for market volatility, macro-economic cycles, credit, and liquidity can potentially be quantitatively combined to capture the pulse of several asset classes, acting as a barometric signal.
One such quantitative model, developed by Franklin Systematic™ (introduced in Franklin Templeton’s LifeSmart Target Date series earlier this year) combines several significant economic and market event measures to identify a pattern of heightened market risk.
Upon reading such a model signal, portfolio managers have the opportunity to reduce equity exposure for the duration of the “risk off” signal—in effect creating a “defensive” glide path that can reduce downside risk and protect the assets of older participants when they need it most.
Conversely, when those signals are no longer present, the model can flag for portfolio managers to return to the neutral glide path—business as usual.
(Click to view larger image.)
What can asset managers and plan sponsors do?
In Cerulli’s 2017 research study “Rethinking Risk for US Millennials”, 77% of investors surveyed want to protect their portfolios from significant losses, even if it means underperforming the market.
Given current market uncertainty, key lessons learned from the experience of target date funds in 2009 and changes in participant behavior and expectations, we still believe that the accumulation phase is best addressed by as much equity exposure as possible to fuel the engine for long-term growth. However, the flexibility to address and respond to bear markets for those participants in the home stretch of retirement is critical to protecting capital when it matters most.
Predicting the potential for increased market risk is one thing; having the built-in flexibility to do something about it—beyond an allowable tactical range—is another. In the latest prospectus, LifeSmart Retirement Target Date Funds have included a quantitative “risk off” indicator, giving portfolio managers the flexibility to switch to a more defensive glide path when the barometer indicates a potential storm in the offing.
For more information, visit franklintempleton.com/LifeSmartTDF
IMPORTANT INFORMATION
Unless otherwise noted, the views and opinions expressed are those of the author or individuals quoted, as of the date of the article, may change without notice, and will not be updated to reflect later developments. Such views and opinions do not necessarily represent those of Franklin Templeton. Views and opinions expressed by individuals who are Franklin Templeton employees may differ from those of other Franklin Templeton employees. Franklin Templeton does not endorse or recommend any views or opinions expressed in this article.
Statements of fact are from sources considered reliable, but no representation or warranty is made as to their accuracy, completeness or timeliness. FTI makes no warranties about information in this article or results obtained by its use, and disclaims any liability arising out of the use of, or any tax position taken in reliance on, such information.
This communication is general in nature and provided for educational and informational purposes only. It should not be considered or relied upon as legal, tax or investment advice or an investment recommendation, or as a substitute for legal or tax counsel. Any investment products or services named are for illustrative purposes only, and should not be considered an offer to buy or sell, or an investment recommendation for, any specific security, strategy or investment product or service. As a financial professional, only you can provide your customers with personalized advice and investment recommendations tailored to their specific goals, individual situation, and risk tolerance.
All financial decisions and investments involve risk, including possible loss of principal.