What the Pandemic is Revealing About Target Date Funds

The differences among target date funds (TDFs) can be hard for some plan sponsors and participants to immediately see, but it is moments like the one we’re in now that can reveal important distinctions between them.

The market volatility caused by the COVID-19 pandemic vividly demonstrates that while risk exposure is important at every point in a TDF’s glide path, it’s particularly impactful for people nearing retirement.

This is not a new point of view, but it’s newly relevant. Prior to the market declines we’ve seen since February, investors had enjoyed one of the longest-running bull cycles in U.S. history. That led to impressive equity returns, and with it a heightened focus on asset accumulation.

Subsequently, we believe too much embedded risk crept into many multi-asset class portfolios and remained hidden until now.

Of course, not everyone agrees. There are those who continue to make the case for keeping equity allocations at higher levels near and into retirement. And it’s worth looking at their arguments.  Here are two:

• It helps to support a multi-decade spending horizon – As retirement approaches, people move from generating an income and adding to their assets to having to spend their savings and make sure it lasts. The argument, therefore, is that higher equity allocations can help to fund those savings even after the threshold into retirement has passed. Yet, as we’re seeing today, this approach may risk exposing investors to too much volatility at a critical time, and can leave them vulnerable to emotional decisions such as panic selling. A more balanced approach is, in our view, beneficial on both the market and behavioral fronts – it may help to avoid the dramatic risk of panic flight and keeps investors in a position to participate in a potential market rebound over time.
• It helps people catch up — Research shows quite clearly that many people have saved too little for retirement. Therefore, some TDF allocations are designed to help make up for the shortfall. But doubling down on equities to offset poor savings behavior may not be a sound strategy since it carries with it the potential of backfiring, thus derailing savings even further.

Volatility, time horizons and cash flows

From our perspective, the two most critical factors for TDF portfolios during periods of volatility are time horizon and cash flow. As a result, they impact younger people on the front end of the glide path differently than older people nearing their retirement date.

Generally, TDF investors just starting their career with long time horizons and limited savings can benefit from significant volatility exposure, as this can help them accumulate wealth over time and benefit from the ups and downs of the market through dollar-cost averaging.

As investors accumulate wealth and approach and enter retirement, however, higher levels of equity exposure in volatile markets can work against them. It can cause them significant stress when balances fluctuate, given the larger dollar impact and shorter recovery times before investors need to tap into assets.

Consider how a hypothetical 20% portfolio loss might affect two TDF investors, one at age 25 and one at age 60.

Human emotion as a factor in glide path design

The pandemic has exposed more than just the importance of risk exposures within a TDF for people nearing retirement. It has also revealed how important human emotion is as a factor in glide path design.

Too often, glide paths are developed quantitatively “in the lab” and can ignore or underappreciate the fact that these are products that will ultimately be used by real people with real needs and emotions.

There’s an important takeaway for advisors and plan sponsors here.  When evaluating funds, keep participants in mind, and remember they’re human just like you. Ask your provider if their funds factor in participants’ emotions and behavioral biases into the investment process.

The range of threats to retirement savings include things such as market risk, longevity risk, sequence risk, inflation risk, tail risk, and interest rate risk. But human decision-making concerning those risks differs depending on the person’s stage of life. Those behavioral patterns can and should be factored into a TDF’s design to help drive toward successful outcomes for retirement savers.

Conclusion

We encourage advisors and their plan sponsor clients to consider the COVID-19 pandemic as a prompt to re-examine the TDFs they’re offering in their retirement plans.

To help evaluate portfolios, advisors and plan sponsors should:

• Make deliberate decisions for the workplace retirement plan as to appropriate exposure levels based on risk tolerance, time horizon, and investment objectives.
• Look beyond past investment performance and be prepared for the reality of volatility. A well-structured multi-asset-class portfolio that matches expected risk to goals and behaviors across a broad range of possible market scenarios can reduce the impact of volatility, offering a more positive overall investment experience and helping to optimize potential performance outcomes over full market cycles.

Questioning TDF equity exposures for near-retirees may not have been the most popular message even a few months ago. But just like so many other parts of our lives, we’re in a whole new world now.