Target-date glidepaths must change, Mercer says

Defined contribution plan participants are burning through their retirement assets much faster than employers realize, which could have big implications for how much target-date funds invest in stocks, a consulting firm executive contends.

In a soon-to-be released research paper, Terry Dennison, worldwide partner and Mercer LLC's U.S. director of consulting, said the average participant withdraws more than 20% of his or her account balance per year at or soon after retirement, leaving the participant tapped out after five years.

The upshot: Glidepaths, which typically convert equity holdings to cash and bonds in target-date funds over a 15-year span, should cut the conversion period to five years so participants can better withstand stock-market volatility.

Mercer's research comes at a time when members of Congress have lambasted target-date funds — especially those with short horizons for people nearing retirement — for having stock-heavy allocations. The Securities and Exchange Commission and the Department of Labor, which held a joint hearing in June on target-date funds, are expected to impose new disclosure and fiduciary requirements on the funds (Pensions & Investments, June 29).

The problem, according to Mr. Dennison, is that typical participants in target-date funds attempt to maintain their previous lifestyles after retirement by drawing down their account balances more rapidly than is “actuarially sound” or that is considered in glidepath design.

“It seems clear the trend in glidepath development (the assumption that the long-term return advantage of equity over cash will provide a sufficient increment of wealth to compensate for short-term volatility) ignores critical asset balance and behavioral factors and is thus misguided,“ Mr. Dennison wrote. “Participants typically deplete their accounts so rapidly that long-term advantages are meaningless.”

Mr. Dennison cited data from J.P. Morgan Asset Management in his paper, showing target-date fund providers assume participants withdraw a consistent 4% to 5% annually during retirement. In reality, the average participant withdraws more than 20% per year, according to the J.P. Morgan data. Because of this high “burn rate,” participants are more sensitive to short-term volatility than once thought, Mr. Dennison wrote. As a result, this “unsustainable rate” of spending requires a shortening of the typical glidepath to little or no equity exposure by five years after retirement.

“We're finding many participants are not willing to give up their previous lifestyles, so if they happen to catch a bad period in those five years — even if they're not completely wiped out — no rebound will create enough wealth to keep them in the game, “ Mr. Dennison, who is based in Los Angeles, said in an interview.

Mr. Dennison also recommends there be a range of return/risk target-date funds to accommodate different participants' retirement goals. For example, he said, there could be low-, moderate- and high-risk funds for each target date. “This would add a second dimension to target-date funds,” he said.

Adding risk-related funds would be particularly important for participants who have other retirement assets. “There's a huge difference between someone that also has a defined benefit plan and someone that doesn't,” Mr. Dennison said in the interview. “The participant with the DB plan can take on higher risk for a higher expected return.”

Mr. Dennison said Old Mutual, Maxim Funds and ING Funds offer return/risk target-date funds, but wasn't aware of other major target-date providers offering these kinds of funds for retirement plans.

Ronald Surz, a principal with researcher Target Date Analytics Inc. and president of consultancy PPCA Inc., both in San Clemente, Calif., agreed that shortening the glidepath is best for participants, but would go even further than Mr. Dennison.

“Target-date funds that (maintain high equity exposures) through retirement are a mistake designed to benefit the fund companies at the expense of plan participants,” Mr. Surz said. “They've been sold to plan sponsors, who really should be more selective and at least consider target-date funds that end at the target date with no equities and require participants to act on their own.”

But most experts interviewed took issue with Mr. Dennison's paper.

Chris Lyon, a consultant at Rocaton Investment Advisors LLC, Norwalk, Conn., agreed plan sponsors should take participant behavior into account when selecting target-date funds, and said they largely do.

“We haven't seen plan sponsors picking heavier equity-allocated products,” he said. “But we also don't think they should cater to the lowest-common denominator. No target-date fund is designed for people to spend all their assets in three years.”

Thomas Fontaine, head of AllianceBernstein Defined Contribution Investments, New York, questioned the high “burn rate” cited in the paper, noting that record keepers can track money flowing out of plans, but can't account for where the money goes.

“Many participants could be rolling those withdrawals over into IRAs,” he said. Mr. Dennison acknowledged it is possible, “but probably uncommon,” that participants are rolling over a portion of their balances into individual retirement accounts. Participants tend to roll over their entire balances, he explained.

Mr. Fontaine also disagreed that shortening the glidepath is the solution. “We've never thought that target-date funds are a replacement for responsibility,” he said. “They're a default option, but participants still control the money. We believe participants should seek the help of an adviser.”

Josh Cohen, senior consultant based in Russell Investment Group's Chicago office, said his firm believes target-date funds should hit their most conservative asset allocation at retirement, and then remain static. “But asset allocation can only do so much,” he said. “If you're burning through your savings quickly, you can't asset allocate yourself out of the problem.”

Adding a range of return/risk funds to accommodate for different participants' goals, as suggested by Mr. Dennison, would be a “step backward” for the industry, he added: “Participants have a lot of trouble determining their own risk tolerances.”

Rod Bare, director of asset allocation strategies at Morningstar Inc., Chicago, said one solution is to annuitize a portion of the balance needed for essential expenses and put the rest in a target-date fund for discretionary expenses.

“There are enough target-date funds with enough glidepaths to find the appropriate one to roll into at retirement,” he said.