There is a “risk zone” in defined contribution investing for retirement. It's the period five to 10 years leading up to retirement and the five to 10 years immediately following retirement. Those are the years your account is most susceptible to lifestyle risk. This is the period generally when defined contribution accounts are at their highest level, and your only response to loss is a reduced standard of living since going back to work is generally not an option. It is the reason that the focus was on 2010 funds at last year's joint hearings on target-date funds by the Securities and Exchange Commission and the Department of Labor, because the market meltdown showed the dire impact of large equity allocations. It's also the reason the SEC's proposal issued June 16 would require incorporating the allocations at the target date into the target-date fund name.
Target-date funds have a wide range of equity exposures in the risk zone, ranging from a low of 20% to a high of 70%. They differ about the appropriate level of risk. Prior to this dangerous period or risk zone, most target-date funds are allocated in a narrow range, roughly 70% to 90% in equities. When viewed over the continuum of their lives, target-date funds look deceptively similar; their hidden risk is only visible when one examines the risk-zone allocations.
The risk zone is also critical from the plan sponsor's perspective. Older, more senior employees are more likely to sue, or at least make their voices heard, than are younger employees with smaller account balances. Employers should fear the risk zone for both its litigation threat and its importance to employee morale. Enlightened fiduciaries should focus on the risk zone in their target-date fund selection. Fiduciaries eventually will develop objectives for the risk zone, and it is likely to be safety first. Then the target-date fund industry will provide a consistently safer product. Until then, advisers can best help their clients by focusing on the level of equity allocation during the risk zone.
Fiduciaries need to choose between a glidepath that lands safely or the alternative of the current industry practice in the risk zone. A safe landing brings the participant to the target date in protected assets, like Treasury inflation-protected securities and Treasury bills. Critics say this landing is too conservative for those in retirement because life expectancies span decades. But most plan participants withdraw their accounts at retirement — they get off the plane. So this criticism is moot, a distinction without a difference.
In 2008, target-date funds with a 2010 target date were well within the risk zone. In that year, a 2010 target-date fund with a safe-landing flight plan would have held about 15% in equities with most of the balance in TIPS and T-bills and would have lost approximately 4% of value, in contrast to the 25% loss suffered by the typical 2010 fund. Even the low end of the current allocation range during the risk zone, 20% in equities, is too high for a safe landing. Flying 20 feet above the ground is not a landing and is certainly not safe. It's awfully risky for passengers who want to disembark.
Ronald J. Surz is president of PPCA Inc. and its Target Date Solutions, businesses specializing in target-date fund investment management and consulting and providing analytical tools for institutional investors. Both are based in San Clemente, Calif.
