Mike Tyson famously said that “everybody has a plan until they get punched in the mouth.” That wisdom is oddly relevant even to retirement planning, because life and financial markets are constantly throwing punches at plan participants. Unfortunately, sometimes these punches connect – and all too often land on those who are in what we call the “transition risk zone.”
What is transition risk? Transition risk is the very real chance of a sudden or extreme change in a participant’s income level or retirement asset allocation during the 15-year window leading up to their planned retirement date. This is when participants most need protection from the potential to lock in losses. The risk is derived from unexpected/early retirement, panic selling/abandonment, or an ill-timed change in the retirement plan’s default investment alternative.
First-round knockout—nearly half of retirees stop working before their targeted retirement date
Perception doesn’t equal reality for many retirement plan investors. The assumption that plan participants “set and forget” their target-date fund (TDF) retirement allocation and stay fully invested on a smooth ride to retirement at age 65 is false. The reality is that many participants leave or are forced into retirement well before age 65.
One of the most jarring divergences between retirement perception and reality is how few plan participants make it to their anticipated retirement date. The latest Employee Benefit Research Institute survey data1 show that nearly half of all retirees retired earlier than expected. The catch is not just that these plan participants retired sooner than they’d planned. The issue is that they often unexpectedly retired early—an unforeseen punch in the financial mouth forced them to change course.
If that risk still seems merely theoretical, consider this: The COVID bear market has coincided with Depression-era levels of unemployment. According to the U.S. Department of Labor’s Bureau of Labor Statistics, by the close of October 2020, more than 11 million Americans were still unemployed, and nearly four million consider their job loss to be permanent. That is the worst possible one-two punch for those affected — retirement account balances took a beating and forced many into early retirement.
Heavyweight title bouts go 15 rounds—retirement investors slug it out for 15 crucial years
We believe this reality calls for looking at TDF risk differently. Rather than thinking of participants on a smooth journey to a single retirement date, we believe it makes more sense to think of a zone of transition risk in the 15 years before retirement. This better recognizes the fact that many workers never make it to their planned retirement date.
This zone also coincides with the period of greatest wealth accumulation for retirement plan participants. Under certain reasonable assumptions about retirement investing behavior, we find that a typical plan participant is going to accumulate fully two-thirds of their wealth at retirement in these final 15 years before the target date. A significant market downturn in this period can have lasting consequences for plan participants. As a result, it is crucial to consider this downside risk even before retirement. We think that’s an important break with the conventional wisdom that suggests downside risk is primarily an issue in the post-retirement period. Then there’s the additional risk that investors could unintentionally do themselves financial harm by moving out of equities/target dates into perceived “safe” investments or stop making contributions to their account.
Leading with your retirement chin—exposure to potential losses in the transition risk zone depends in part on TDF glide path equity allocation
Exposure to potential losses—and to transition risk—depend crucially on the TDF glide path in these final years before retirement. We see two issues—one is the level of equity exposure, and the other is the slope, or rate of change, in the equity allocation leading up to retirement. Glide paths with a high equity allocation and/or steep slope may exacerbate the risk of bad market returns in the transition risk zone. The level of equity allocation relates to the magnitude of loss, while the slope of the glide path relates to the ability to recover from such losses.
The premise of TDFs with comparatively high equity exposure is that investors require more equities for longer to fully fund retirement. But this calculus must account for the greater than 40% of participants who retire before age 65, including the sizable group who leave the workforce before age 60.
Knocking out transition risk
Clearly, no one wants to get punched in the financial face, but we believe that plan sponsors can mitigate transition risk through careful attention to the glide path in their default TDFs. Glide paths that are very risky and/or steep in the transition risk zone heighten downside risk and sequence-of-returns risk. In contrast, we believe a flatter, more risk-aware glide path in the important years before retirement may help minimize such risks.
Add it all up, and we think plan fiduciaries should thoroughly evaluate a TDF’s potential to manage downside risk in the transition risk zone. This likely better reflects the actual risks and horizon faced by many investors. Of course, we do not argue that there is one approach or plan for all occasions. Indeed, championship boxers famously tailor their approach to their opponent.
Similarly, the most appropriate and most suitable TDF selection is the one most closely aligned with the needs of each plan’s participant population and risk appetite. American Century’s Target-Date Blueprint is designed specifically to help advisors and plan sponsors narrow the TDF universe to focus on those whose investment profiles align with a plan’s demographics, risk profile and preferences.
1. 2020 Retirement Confidence Survey, Employee Benefit Research Institute and Greenwald & Associates.
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This material has been prepared for educational purposes only and is not intended as a personalized recommendation or fiduciary advice. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.
401(k) Specialist is not affiliated with American Century Investment Services, Inc.
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