Not all target-date funds are the same, a point the Department of Labor has made in its most recent guidance to plan fiduciaries. One item the DOL stresses is whether a target date fund’s glide path, or the point at which it reaches its most conservative equity allocation, is pegged “to retirement” or “through retirement.”
The difference can be profound. Target-date funds that reach that point at a specific year of retirement, and then level off, can have very different return characteristics than those that continue to reduce equity exposure in the years after retirement.
It’s an important consideration that requires a trade-off, according to Joseph Martel, CFA, CAIA, a portfolio specialist in the asset allocation division of T. Rowe Price in Baltimore, Maryland. He describes the “art of glide path design” as balancing the objectives of accumulating sufficient retirement assets with moderating volatility.
“They tend to be competing objectives (because) the best way to ensure someone has enough assets to support themselves in retirement is to maintain a healthier equity allocation,” he says. “But, obviously, with that comes more volatility, more variability in the balance. If you focus on limiting the variability of the balance around retirement, that results in less equity, but what you’re doing is you’re sacrificing the portfolio’s ability to be successful at building wealth (and) supporting potentially long retirements.”
Plan consultants and sponsors got the DOL’s message and there’s been ongoing debate over which method to adopt; some industry participants strongly favor one approach over the other. BlackRock’s U.S. Retirement Group May 2014 white paper by Ted Daverman and Matthew O’Hara comes out in support of a “to-retirement” strategy, for instance. “Under any set of assumptions about investor risk preferences, capital markets or labor income characteristics, it is always optimal to have a flat post-retirement glide path.”
Not a Binary Choice
But the “to-or-through” definitions aren’t always the most relevant factor when examining target-date funds, says Martel. For example, Morningstar classifies funds that continue to reduce the equity allocation after the target date as “through-funds.” TDFs that reach and maintain their lowest equity exposure at the target date are “to-funds.” But relying solely on those categories can mask important underlying differences, Martel cautions. A fund could be defined as a “through” but still have a relatively low equity allocation and a greater focus on the balance’s stability around the target date.
Some target-date funds also vary their allocations in a way that blurs the definition. Shawn Sanderson, a senior investment consultant at Manning & Napier in Rochester, New York, believes the investment market environment should “dictate the actual asset allocation at any point in time.” Although the company technically uses a through-path with its funds, equity allocations around the retirement date can vary. In periods when the firm believes equity values and risks are elevated, exposure is reduced. “In contrast, there are environments where stocks are very attractive in terms of valuations and other indicators,” says Sanderson. “That suggests maybe you can be more aggressive and look like some of the more aggressive through-paths that are out there.”
Shifting the Focus
The to-or-though debate can be distracting for sponsors, Sanderson maintains. He believes a better approach is to focus on participants’ demographic considerations to gain an understanding of how they are saving and how they plan to use their funds after retirement. Sponsors need to understand participants’ distribution behavior and what’s going to happen near the retirement date, he says: “At what point will your participants begin to heavily rely on those assets to fund their retirement spending needs? That, in our opinion, really dictates when that glide path should reach its most conservative positioning.”
Martel agrees and says consultants can move sponsors beyond to-or-though by helping them review three key factors. First, what is the plan’s objective? If the goal is to maximize participants’ account balances at retirement to support long retirements, through-funds’ higher equity exposure are appropriate. Sponsors seeking to moderate market risk will be better off with to-funds’ lower equity allocations. Second, how does the sponsor wish to address inflation risk and longevity risk? There’s no single answer, but because plan sponsors effectively act as proxies for their participants, they must prioritize those risks.
The third factor is participants’ retirement preparedness. Martel says consultants and sponsors can estimate that status by evaluating retirement income sources, such as defined benefit plans, in conjunction with participants’ defined contribution account balances as a percentage of salary. T. Rowe Price’s research shows that a higher level of participant preparedness gives the sponsor more flexibility to focus on market risk. This can allow plans to “use a lower equity approach because the preparedness of your participants will help them reach their income replacement goals,” Martel adds.