TDFs: Better outcomes, but still not good enough
Ever since 401(k) plans and their defined contribution peers, such as 403(b) and 457 plans, began to dominate the retirement plan landscape, the single biggest product advancement has been the launch of target date fund (TDFs) in 1993. These funds took the guesswork out of self-directed asset allocation by employees, which too often leads to a wildly inappropriate mix of investment choices and risk profiles.
A suitable allocation mix is based on sound reasoning—rooted in modern portfolio theory—of how an investor should be positioned among stocks and bonds during the various phases of life leading up to retirement. This asset mix, however, relies heavily on actuarial assumptions without managing for other critical factors such as market performance.
As employees transition from the investing phase to the spending phase of their retirement journey, TDFs with high equity exposure could leave employees vulnerable to too much risk. For those unfortunate employees who retire at a time of market stress, this could lead to significantly lower account balances at retirement. This outcome forces employees to choose between lower income throughout retirement or remaining in the workforce longer than anticipated.
Approaches to TDF glidepath implementation
Early entrants into the TDF market relied exclusively on diversification to mitigate against risk, and for many decades diversification was an effective enough tool. The idea that diversification alone can enhance returns and lower risk, however, hasn't played out as planned. In times of market stress, asset classes once thought to be complementary have shown much closer correlations than in the past as stocks, bonds and even many alternatives such as real estate moved in lock-step direction on changing economic conditions.
The realities of retirement investing have changed, and with them the strategies on how to maximize return and minimize risk. TDFs have responded to meet these realities, evolving from a static glidepath approach to ones that incorporate a greater degree of flexibility. Here's a closer look at three main strategies used in managing the glidepath:
Static – The first generation of TDFs was simplicity at its best: Establish a predetermined glidepath in which the asset mix would steadily and automatically shift from being predominantly equities to being more heavily weighted to fixed income the closer an employee got to retirement. Using this approach, employee asset allocations would be calculated and locked-in over 40 years in advance of retirement age.
Tactical – While a static glidepath seeks to provide the appropriate asset mix at any given point in time, the asset allocation never takes into account market conditions. An element of flexibility is needed and a tactical approach can deviate by 5%-10% in either direction of the glidepath. However, these minimum bets are rarely meaningful enough to increase the reliability of achieving retirement income goals.
Dynamic – Starting with the idea of being tactical but adding much more flexibility to the glidepath is a dynamic approach. With the ability to deviate meaningfully from the strategic asset allocation, a dynamic approach has the potential to more fully participate in rising markets while preserving principal to a greater degree during periods of volatility. The ultimate goal is to significantly improve retirement outcomes by making the glidepath much more actionable.
Dynamic means decisive action
At its core, dynamic investing means to take action based on the realities of the markets and actively managing the glidepath in accordance with current market trends. The idea driving this approach is that asset classes exhibit both trending and mean-reverting return patterns, the cyclicality of which can be captured by a sophisticated blend of trend-following and mean-reverting allocation responses.
By combining these aspects together and actively managing them along a TDF glidepath, the resulting strategy seeks to balance as many return-seeking assets as possible with as many safe assets as necessary. And in the uncertain investment environment in which employees must contend, a dynamic approach could make all the difference in ensuring a rewarding retirement.
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About the Author Glenn Dial is Head of Retirement Strategy in the US with Allianz Global Investors, which he joined in 2011. He has 25 years of defined contribution experience. Mr. Dial is a co-inventor of the method and system for evaluating target-date funds, and is also credited with developing the target-date fund category system known as “to vs. through.”
Important Information The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Forecasts and estimates have certain inherent limitations, and are not intended to be relied upon as advice or interpreted as a recommendation.
Past performance of the markets is no guarantee of future results. This is not an offer or solicitation for the purchase or sale of any financial instrument. It is presented only to provide information on investment strategies and opportunities.
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