With traditional glide paths, a portfolio shifts gradually from equities to fixed income before reaching a final balanced portfolio allocation.
Ron Surz, president of Target Date Solutions in San Clemente, Calif., believes the typical glide path fails to address “sequence of returns risk” sufficiently. Instead, sequence of returns risk—the impact of significant portfolio declines in the years shortly before and after retirement—shapes Surz’s thinking about target date funds’, or TDFs,’ glide paths.
For younger participants, Surz’s patented “Safe Landing Glide Path” resembles the traditional model. But, assuming targeted retirement at aged 65, in his model participants’ allocation to risky assets start to drop off more rapidly around aged 50. The shift to safe assets like cash and Treasury inflation protected securities accelerates as the participant enters the risk zone, defined as the 15 years surrounding the retirement date. Risky assets’ allocation bottoms out in the 10 to 15 percent range at retirement; post-retirement, that allocation begins moving higher. The resulting V-shape allocation looks like a helicopter descending, hovering briefly and then resuming its climb.
The Risk Zone
Surz maintains that because the stock market has generated positive returns about 70 percent of the time historically, simulations of participants’ wealth using traditional TDFs’ portfolios forecast good average long-term results. But he notes that retirees get only one chance, not 1,000 iterations, and incurring large investment losses around the retirement date means funds will run out sooner or the retiree must cut spending significantly. Both solutions are unattractive, and he cites 2013 research by Pfau and Kitces and history to support his model. Participants’ choices are limited when bear markets occur, he argues: “You pretty much can’t go back into the workforce (so) your only course of action is to reduce your standard of living, spend less. People call that area the risk zone because your account balances are at their highest then—you have a lifetime of savings—and if you lose 30 percent, like people did in 2008, you’re toast.”
He believes traditional TDFs fail to sufficiently protect participants’ savings in the risk zone because the funds attempt to provide both growth and stability. His calculations show that his conservative TDF would have been much more stable during previous market corrections and its cumulative performance over the past decade only slightly underperformed traditional TDFs. (His analysis is available in a SeekingAlpha article.)
The Counterarguments
TDF portfolio managers recognize the sequence of returns risk, but say it’s only one factor they consider. Andrew Dierdorf, a Boston-based co-manager of Fidelity’s target date funds and 529 plans, also cites market risk over the shorter term and longevity risk for the long term. These two risks are competing with one another, he explains: “There are trade-offs in the investment decisions when you’re balancing short-term volatility with the long-term returns you need to achieve successful outcomes. So, I think any target date provider is making decisions about the trade-offs in those types of risks and certainly in our decision-making, we balance the risk and return for the investors at different ages along those lines.”
Basing a glide path primarily on sequence of returns risk is a fairly narrow view, according to Scott Donaldson, senior investment strategist in the Vanguard Investment Strategy Group in Malvern, Penn. TDFs work with horizon-based inputs to create reasonable asset allocations, he explains. In those circumstances, managing the portfolio from a human capital perspective makes sense. In human capital theory, younger participants usually have little financial capital compared to their human capital, which is the discounted present value of their future earnings. Human capital behaves more like a bond, so it makes sense to diversify that position with equities in the investment portfolio.
Older participants typically have more financial capital (savings) than human capital because their remaining careers are shorter, so it’s prudent to weight bonds more heavily. The reason almost all TDF glide paths “start aggressive and go more conservative (is) because most target date providers have set up their glide path based on this human capital argument of how people earn money over time and grow their financial capital over time by savings,” says Donaldson. “It’s basically risk-offset.”
Meeting the Needs of Many
TDFs must serve a wide range of participants, Donaldson points out, so there’s not necessarily “one silver bullet glide path” for everyone. “The idea of target date funds was to come up with a reasonable, appropriate asset allocation based on the one thing we do know about the participants—their time horizon—and to have an appropriate allocation based on some rational reason to have the level of equity that is being implemented,” he says. “That’s what target date funds do.”
To date, Surz has modest success in convincing plan sponsors to adopt his approach, which is available through a collective investment fund from Hand Benefits & Trust in Houston, Texas. He remains optimistic, though, and if we encounter another bear market like last decade’s, his glide path could attract a lot more attention.