One of the biggest risks you face when you're on the road is what's in your blind spot. What you don't see coming could hurt you. That's particularly true with respect to the hidden costs of surprise risks in DC investment portfolios. While DC plan sponsors and participants might recognize certain risks — the threat of losses in a market downturn or the possibility of outliving one's retirement savings — others aren't so visible.
The unexpected effects of volatility, short-term investing and illiquidity, along with other risks embedded within the fixed income and equity markets, can impact performance more than most plan participants, and even plan sponsors, may realize. This can jeopardize retirement outcomes.
Take volatility. Many investors know that it can have devastating short-term effects if you sell into or right after a big market downturn. What plan sponsors and participants may not realize, however, is that volatility can do more lasting damage — long after a market recovery. That's because it takes a bigger investment gain to make up the same magnitude of loss. So even if participant account values rebound as the market recovers, the growth of the account starts from a smaller balance because of the earlier loss. In short, volatility can knock some power out of compounding.
So what can DC sponsors and advisors do to avoid getting caught off guard by surprise risks? Keep a close eye on how the plan's options are managed. Now that we're more than six years into a bull market, this is an opportune time to take a close look at the durability of your DC investment options. Analyze how your managers fared in past periods of volatility, using characteristics such as rolling returns and downside capture ratio. But be sure to look beyond the typical 3- and 5-year time periods when analyzing risk metrics. That way, you'll be using risk/return data that covers full market cycles to see how the plan's investments performed in previous periods of volatility.
Like volatility's impact, many of the other hidden surprises in DC portfolios come from the way the strategies are managed. That might be due to lack of risk management or failure to adjust to changing liquidity conditions, among other reasons. But with robust, active risk management, it is possible to recognize hidden surprises and take measures to limit their threat. In the case of volatility, an active manager might choose to avoid the most volatile stocks as a means of mitigating risk.
We're not suggesting you can predict or avoid every hidden surprise risk in a DC portfolio. But in order to invest prudently, it's important to see them coming. Knowing what's in your blind spot and preparing for what could happen might do a lot more to improve retirement outcomes than simply looking in the rearview mirror.