For Target Date Funds (TDFs), the focus has always been on reaching retirement day. Now, on the brink of a baby boomer exodus from the workforce, Glenn Dial says TDFs should aim way past the target date to focus on retirement income, and lots of it.
Millennials and the mythic DB plan
For Millennials, Gen Xers, and even the tail-end of the baby boomers, the idea of a defined benefit (DB) plan seems too good to be true. The promise and expectation of lifetime income once retirement kicks in was once a cherished part of the American dream. And teams of actuaries, asset managers, accountants, benefits consultants and attorneys were left with the herculean task of sustaining it all.
The promise and expectation of lifetime retirement income was once a cherished part of the American dream
As the record shows, DB plans were in fact too good to be true over the long-term. In the face of mounting liabilities, DB plans have shrunk from covering nearly 40% of the private sector workforce at their height in 1979, to approximately 13% in recent years. And for the dwindling number of private DB plans still being offered to employees, the threat of insolvency is always top of mind.
DB vs. DC: Moving in opposite directions
% of US private sector workforce covered by plan type
Source: US Department of Labor as of 12/31/14
The dilemma of DC plans
With the future of DB in question, the void has increasingly been filled by defined contribution (DC) plans. However, the changeover has been far from smooth due to the decided differences between the two plans. The biggest difference being that DC plans fall short of providing the certainty of retirement income that DB plans offer.
For the dwindling number of DB plans still offered, the threat of insolvency is always top of mind
Helping to drive change is a shift away from thinking about DC as solely a savings and investment vehicle focused on reaching the 'magic number.' Increasingly, and by necessity, DC plans are also gaining recognition as retirement income generators. The DC industry, which in recent years has made great strides in investor education, would do well to expand their efforts to show employees how they can convert savings to income. Upon reaching their retirement date, an employee has any number of options for their DC savings, such as cashing out of the plan immediately, annuitizing or remaining in the plan.
TDFs: The transition to lifetime income
In an effort to help employees manage risk throughout the saving phase of their careers, DC plans took an innovative step forward with the launch of target date funds (TDFs) in 1993. Their goal was to provide a predetermined glidepath to keep pace with an employee's age and assumed risk tolerance. The concept proved so effective that TDFs were included as one of the three types of QDIA's in the Pension Protection Act of 2006. Still, without a plan for income after the retirement date, over 80% of participants take all of their savings out of a DC plan within three to five years after retirement.
Increasingly, and by necessity, DC plans are gaining recognition as retirement income providers
Many DC plan sponsors are now waking up to the fact that what happens after retirement is just as important as what happens before. To help retirees generate adequate income over their lifetimes, some plan sponsors are considering managed accounts or in-plan annuities. But these could bring unneeded complexity and oftentimes mixed results. A more efficient and effective way for DC plans to go about this is by ensuring their existing target date fund series contains a retirement income fund with the "actual" goal being to maximize income throughout a participant's retirement. This may sound logical, but many retirement income funds within a target date series don't expressly pay a targeted yield, instead they are simply a continuation of the glidepath.
DC plan sponsors are waking up to the fact that what happens after retirement is just as important as what happens before
Well-designed retirement income
A well designed retirement income fund can be an effective risk mitigation tool. Right off the bat, it eliminates transition risk and portability risk, which occur when plan participants are unsure what to do with their savings once retirement date rolls around. Then there's market risk, which innovative retirement income funds seek to mitigate via a dynamic glidepath. 'Dynamic' investing is essentially the ability to up-risk or de-risk the portfolio by strategically shifting the glidepath according to changing market conditions. The end result is to generate a relatively high and consistent stream of income while participating more fully in rising markets, and preserving capital to a greater degree in volatile ones.
DC plans need to ensure that their existing target date fund series also includes a retirement income fund
This kind of dynamic approach, with its built-in flexibility and responsiveness to changing market environments, is designed to better prepare employees for the uncertainty of retirement. By actively shifting the glidepath to get the best out of an appropriate mix of stocks, bonds and cash, dynamic investing positions an employee for better outcomes throughout retirement.
About Dialed In to Retirement
Each month, Dialed In to Retirement offers thoughtful insights from our US head of retirement strategy on ways to improve outcomes for plan participants, including analysis of emerging retirement trends, portfolio construction ideas, regulatory developments and behavioral finance research.
Glenn A. Dial
Target Date Funds (TDFs) have transformed retirement investing, but the static approach to the glidepath leaves many investors at risk. A more dynamic strategy is needed, and Glenn Dial says it all begins with defining what dynamic investing actually is.
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.
Since no standard definition of dynamic investing exists in the industry, its meaning gets murky
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.
Dynamic investing means to take action based on market realities by managing the glidepath accordingly
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.
A dynamic approach seeks to participate more fully in rising markets and preserve capital to a greater degree in declining ones
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 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.
The ultimate goal is to improve retirement outcomes by making the glidepath much more actionable
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.
About Dialed In to Retirement
Dialed In to Retirement offers thoughtful insights from our US head of retirement strategy on ways to improve outcomes for plan participants, including analysis of emerging retirement trends, portfolio construction ideas, regulatory developments and behavioral finance research.