In the first half of the 1990’s, the first target-date retirement funds were introduced by the asset management industry. Designed primarily for inclusion in Defined Contribution
(DC) retirement plans, they were intended to greatly simplify asset allocation decisions for the millions of workers suddenly responsible for constructing and managing their own retirement savings portfolios. The new funds offered institutional investment management concepts like broad asset diversification and portfolio risk reduction as the target date of retirement approached.

Today, there’s a growing chorus of academics and retirement planning experts insisting that Americans aren’t saving enough for retirement in the new world of DC plans.
In response to this problem, several prominent asset management companies have launched target-date products with very high equity allocations (sometimes close to 100%) throughout the investment horizon of the portfolios, even in the years just before and after retirement. Their justification for these higher equity portions goes something like this: People are living longer, health care costs are rising faster than inflation, and since many will still have 30 years of life ahead of them at retirement, time is still on their side, and much higher equity allocations are appropriate. Click here to download a copy of our LIVESTRONG™ Portfolios brochure

In our view, an overly aggressive equity allocation is a poor strategy for retirement planning success. This piece focuses on our investment thinking behind LIVESTRONG™ Portfolios. We take a different approach, designed to maximize the likelihood of a secure retirement for our investors without unnecessary risk-taking associated with high equity exposure.

The Risks of High Equity Exposure

Many future retirees face a daunting challenge if they have saved inadequately prior to the critical period five to ten years before retirement. But we reject the notion that “time is still on your side” at or near retirement and that high equity allocations represent the solution to this problem. While we agree that stocks can play a significant role in growing and preserving capital throughout retirement, the allocation decision must take into account the risk tolerance of investors nearing or just past retirement. With very high equity exposure, the road to retirement success can be pitted with potholes for the following reasons:

• Equity markets can be quite volatile 

The decades of the ‘80s and the ‘90s dulled investor awareness of volatility, because there were only two years of negative returns for the S&P 500 (1981 and 1990), and the annual total return with dividend re-investment averaged 17.9% over the twenty years from 1980 to 1999. “Volatility” in the minds of many investors became a question of whether the market return would be 7%, 17%, or even 37% (in 1995) for a given year. In stark contrast, market performance in the current decade — especially 2000 to 2002 when the cumulative S&P 500 return was -37.6% — has been a painful reminder that investing even in a broadly diversified large-cap portfolio like the S&P 500 has significant risks.

• Emotional investment horizons can be very short when confronted with losses

Studies in the behavioral psychology of investors confirm that they are prone to bailing out of portfolios that have incurred one or two years of losses, despite the reality that markets, especially equity markets, do mean-revert and often experience their best returns in the year just following the end of a slump. The painful decline in the S&P 500 between 2000 and 2002 was followed by a +28.7% return in 2003, but behavioral studies suggest many investors will run for safety at exactly the wrong time. In effect, investors’ emotional time horizons are much shorter than financial theory predicts based on a ‘rational investor’. And this emotional investment horizon becomes an especially powerful influence when losses are large in dollar terms and the perceived time to recover is short—as it is in the years just prior to and after retirement.

• Market volatility just prior to and after retirement can damage retirement success

The previous example highlights how critical investment performance timing is. At no time is it more important than in the years just before and after retirement. For example, the dollar impact of a substantial two- to three-year decline in equity markets (e.g. -37.6%) twenty years prior to retirement can be offset by many years of additional savings and the strong likelihood that market returns will mean-revert to long-term and positive values. But that’s not the case for a sixty-two-year-old investor with a much larger portfolio and only three more years to save before reaching retirement age. And losses become even greater for a sixty-six-year-old retired investor no longer saving but withdrawing money each year for living expenses.

Responsible Retirement Planning: Why LIVESTRONG Portfolios?

Defined Benefit Plan Source: Pensions & Investments Annual Survey of Defined Benefit Plans, January 2006

*The P&I Survey does not include TIPS as a separate asset class

Competitor Target-Date Fund Source: Information presented as of December 2007 at websites and in prospectuses

Competitors A, B, C and D are four large providers of target-date funds

While nearly all target-date funds incorporate a glide path to reduce equity allocation over time, some keep equity allocations very high as the investor approaches and enters retirement. As the graph below illustrates, the level of equity exposure in LIVESTRONG Portfolios changes in a substantial way — from over 80% for LIVESTRONG 2050 to approximately 45% for LIVESTRONG Income Portfolio. This helps protect investors from extreme swings in portfolio returns due to equity market volatility in the critical years just before and after retirement.

When we began our research into the design of LIVESTRONG Portfolios, our statistical models initially suggested very high equity allocations. It’s easy to become enamored with the sterile mathematical beauty and apparent precision of a sophisticated model, especially if you’ve built the model from scratch. But as we thought more about the impact of these portfolios on real peoples’ lives for the next 10, 20, 30, or even 40 years to come, we adjusted our model to account for two things:

1. Investors do not necessarily behave rationally. The emotional horizon of an investor is much shorter than the time horizon suggested by his future retirement date.

2. Mean-variance statistical models are notoriously input-sensitive. Past returns and correlations are not indicative of the future. Since we don’t know what will happen in the future, the more-diversified portfolio is the better choice between two statistically similar choices.

Our Approach to Designing LIVESTRONG Portfolios

We ultimately employed a methodology first based on numerical optimization techniques, then adjusted for real-world considerations. Consistent with our research regarding what truly defines retirement success, our objective function was to achieve at least a 90% probability that LIVESTRONG Portfolios would not decline to zero value in retirement, rather than an objective function based on maximizing net worth at retirement, regardless of risk. We utilized a lifecycle retirement model that incorporated all the key financial inputs (e.g. asset-class returns and correlations), cash-flow inputs (e.g. savings and spending rates pre- and post-retirement) and other critical inputs such as life expectancy and long-term inflation. Most importantly, we defined future expected values and realistic ranges for the key financial inputs and optimization constraints based on both historical relationships/trends and the long-term forecasts. These ranges and forecasts were developed by our LIVESTRONG portfolio management team using their long experience and real-world insights on how financial markets behave in reality.

Based on millions of numerical iterations — each simulating a single pre- and post-retirement lifetime for a real human being — we arrived at a solution that achieved our objective function of at least a 90% likelihood of not running out of money in the 30 years following retirement. From the perspective of mean-variance optimization, we were able to establish an efficient asset allocation frontier for maximizing retirement success based on our objective function — one that temporally migrates to lower risk (the glide path) based on optimal changes in the asset-class mix as the target date approaches. But because we believe it’s impossible to predict the future returns/risks/correlations of the asset classes with certainty, we adopted ranges for the key retirement model inputs. This led us to determine that this efficient frontier is more realistically represented as a band or range of efficient frontiers. As stated earlier, we believe the more-diversified portfolio is the better choice between two statistically similar choices. So we selected the portfolios with the greatest level of diversification across asset classes for each level of risk/return. Because of this, we believe LIVESTRONG Portfolios will perform more consistently in a wider variety of market environments than competing products.

The efficient frontier flattens dramatically as additional increments of risk exposure yield diminishing benefits of expected returns. This analysis is supported by historical experience: Between 1980 and 2007, a 60/40 mix of stocks and bonds generated approximately 85% of the returns of a 100% equity portfolio with only about two-thirds the risk. We recognize the value of equity market exposure (and returns) in achieving retirement success as we’ve defined it. But our analysis has demonstrated that the marginal benefits diminish while the marginal risks substantially increase as equity exposure increases.

This risk is most critical in the final five to ten years leading up to retirement, when the time available to smooth out periods of equity market downturns becomes compressed. The chart on the following page hypothetically illustrates — from age 40 to 65 — three retirement-networth outcomes for an investor who begins saving at age 25 with a $2,000 contribution and increases her annual contributions at 6% per year over the next 40 years. In the Base Case, she earns 8% per year on her savings, ending up with an attractive nest egg of over $1.3 million.

In both the hypothetical Scenarios 1 and 2, we change the annual rates of return on her retirement savings just in the final seven years before retirement (between ages 58 and 64).  Scenario 1 halves the annual return to 4% over these seven years. This results in a retirement net worth that is 25% lower than the Base Case ($1 million vs. $1.3 million). Scenario 2 uses an annual return of -2% in the final seven years. It results in a retirement net worth that is 52% lower than the Base Case ($641,000 vs. $1.3 million). Our investor continues to make annual contributions to her retirement savings in these final seven years for all three outcomes.

A situation such as Scenario 2 — where an investor is faced with retiring with less than half the savings she expected to have accumulated by age 65 — is a life-altering situation for someone about to retire. As we looked at this scenario, we asked ourselves whether an investor in this situation would just retire as planned and continue to keep her savings in a high-equity allocation portfolio. We thought it more likely that she would, in the face of such substantial losses in retirement net worth, shift all her money to a low-risk, low-return investment vehicle (with almost no equity exposure) and do one of two things: First, delay full retirement for some period of years in order to earn back more of the lost savings; or second, dramatically lower her spending plan throughout retirement to stretch out these deflated savings. Both options yield sub-optimal outcomes that can have a significant impact on her quality of life.

Given our philosophy and approach, we were not surprised when the U.S. Department of Labor issued its regulations for the use of target-date portfolios as Qualified Default Investment Alternatives (QDIAs) and specifically cited the requirement that these products not be 100% invested in equities. But we don’t think this simple and arbitrary rule goes far enough in reflecting the fiduciary responsibility and goal of plan sponsors who are genuinely seeking a target-date retirement solution that reflects the best interests of their employees: maximizing the likelihood of retirement success without taking undue risk along the way. LIVESTRONG Portfolios have been designed with this fiduciary goal of plan sponsors explicitly in mind.

Singular Focus

Over the past ten years there has been an explosion in the number and variety of target-date retirement products offered, accompanied by increased differentiation in the approach to equity allocations along the path to retirement. The result: An initial concept whose growth in popularity was driven by its simplicity — retirement savings based solely on choosing a target retirement date — has itself become a very complex and often confusing choice for plan sponsors and their participants. LIVESTRONG Portfolios have been designed with a single focus: maximizing the probability of a secure retirement. Their design is based on a disciplined process, philosophy, and approach to maximize the likelihood of a successful outcome by realistically balancing risk and return trade-offs over time.

Special Acknowledgements
Jeff Tyler, CFA, Senior Vice President and Senior Portfolio Manager; Irina Torelli, CFA,
Portfolio Manager; Scott Wilson, CFA, Quantitative Analyst; Matt Spain, CFA, Senior Portfolio
Advisory Analyst, Mark Fujii, Director Product Management; Lori Lucey, Product Manager;
Jim Finnegan, CFA, Investment Writer, Quantitative Equity and Asset Allocation; and Janan
Boehme, Financial Editor. 

American Century Investment Services, Inc. has entered into an agreement with the Lance Armstrong Foundation (LAF) for rights to use the LIVESTRONG™ name. LIVESTRONG is a trademark of the Lance Armstrong Foundation. For more information about the foundation, visit livestrong.org.

Material presented has been derived from sources considered to be reliable, but the accuracy and completeness cannot be guaranteed. All funds listed are target-date lifecycle funds with similar investment objectives. Other features of the funds may differ, including, but not limited to, sales and management fees, liquidity, safety, guarantees, insurance, fluctuation of principal and/or return, tax features and other characteristics not covered in this material. Each LIVESTRONG Portfolio’s performance and risk reflect the performance and risk of the underlying American Century fund in which it invests. The risks will vary according to each portfolio’s asset allocation, and a fund with a later target date is expected to be more volatile than one with an earlier date. Past performance is no guarantee of future results.

You should consider a fund’s investment objectives, risk, charges and expenses carefully before you invest. The fund’s prospectus, which can be obtained by calling 1-800-345-2021, contains this and other information about the fund, and should be read carefully before investing.

P.O. Box 419385
Kansas City, MO 64141-6385
1-800-345-2021
www.americancentury.com

American Century Investment Services, Inc., Distributor
©2008 American Century Proprietary Holdings Inc. All rights reserved.
IM-FLY-60820 0805

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