Most Popular ArticlesNear Retirement?
August 25, 2009
Conclusion
The issue is measuring risk in target date funds. Few if any would recommend a 100% equity exposure at retirement, yet traditional risk and reward measures indicate that a glide path with increasing equities, rather than decreasing, results in greater wealth with about the same risk – a significant winner for those saving for retirement.
Our intuition tells us that retirees can’t “afford” taking that much risk, but traditional risk measures argue otherwise. We need an alternative risk measure that captures the importance of protecting account balances near retirement, because retirees have limited opportunities to make up losses by working longer.
Additionally, the pain of loss increases as retirement nears. 2008 is a good example. The recent joint hearings of the SEC and DOL focused on losses in 2010 funds rather than 2050 funds, even though losses were greater in 2050 funds. 2010 funds are intended for participants at or near retirement while 2050 funds are for those who are currently 25 years old.
If a retiree has $500,000 for five to 10 years as retirement approaches, he will get used to that and plan around that number. If the number is $600,000, the retiree will probably be not much happier because he hasn’t been assessing their situation relative to the $500,000 alternative path. Rather, he deals with the current reality, and adapts to it. But in either case a 20% loss is devastating, much more devastating than a 20% loss would have been 30 years earlier. The challenge is to create a risk measure that captures this spirit. Dollar-weighted downside deviation accomplishes this, because account balances are higher as retirement nears.
Here are details for the last three years of the 40-year paths that end in December, 2008.
This brings home the idea of wealth risk:
Ending wealth ($Thousands)
|
Decreasing Equities |
Increasing Equities |
2006 |
607 |
772 |
2007 |
640 |
812 |
2008 |
646 |
611 |
Yes, 2008 was an extreme, but it can teach us a lot. Both paths above end in about the same place, but I’d personally prefer the path on the left.
Comparisons of 40-Year Glide Paths: Decreasing (Forward) versus
Increasing (Backward) Equity Allocations
The columns in the following table are as follows:
Fwealth: Ending wealth when the glide path moves forward, ending at zero in risky assets
Bwealth: Ending wealth when the glide path moves backward, ending at 100% risky assets
Fret: Annualized return using the forward glide path
Bret: Annualized return using backward glide path
FDown: Equal-weighted downside deviation for forward path
BDown: Equal-weighted downside deviation for backward path
$Fdown: Dollar-weighted downside deviation for forward path
$Bdown: Dollar-weighted downside deviation for backward path
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