Target-date funds: Same destination, different (glide)paths

For plan participants, target-date funds simplify the complex task of investing for retirement by automatically allocating assets based on each individual's age and retirement date. This simplicity helps to explain why target-date funds have become one of the most popular investment options within defined contribution plans.

However, beneath the simplicity of target-date funds lie divergent investment methodologies. In particular, glidepath design should garner significant attention given that it is the primary determinant of risk and return in target-date funds throughout a lifecycle.

Given that each target-date manager uses a proprietary glidepath methodology, this has led to wide dispersion of equity allocations across the industry. For example, last year, the range of total equity allocations between the most aggressive and conservative glidepaths was more than 35 percentage points for participants aiming to retire in 2020. These significant differences in equity allocations can create wide dispersions in accumulated wealth, especially near retirement.

When evaluating a target-date fund's glidepath design, there are three key questions a plan sponsor should ask:

1. How are assets managed during the accumulation phase?
2. How are assets managed near and in retirement?
3. How is retirement success defined and measured?

Over the life of a target-date fund, a participant derives wealth from two sources: their labor income (or salaries) and their retirement account balance. As illustrated in the table below, the amount of wealth generated from these two sources shifts over time and, as a result, affects the shape of our glidepath.

Early in participants' careers, labor income is their greatest asset given that account balances are generally low because it takes years to build financial wealth. Labor income has bond-like characteristics that can help buffer market volatility. During market downturns, labor income allows the participant to make steady contributions that add to their holdings at a deep discount and can offset market losses given that contributions represent a large portion of total wealth. For these reasons, we believe it is appropriate for glidepaths to have aggressive equity allocations at the onset of a participant's career to help maximize expected return at a time when participants are well positioned to withstand expected market volatility.

In turn, we believe it is appropriate for glidepaths to have a conservative equity allocation near and at retirement to protect a career's worth of accumulated wealth. As retirement approaches, the present value of a participant's labor income rapidly declines on both an absolute basis and relative to the participant's projected retirement account balance. At retirement, labor income is discontinued and the retirement account balance becomes the participant's primary source of wealth. This means participants are far more vulnerable to market downturns as the ability to counter portfolio losses with future contributions is greatly limited especially given a short time horizon.

As a participant enters retirement, avoiding sequence-of-return risk should be a primary driver of glidepath design. Participants are the most vulnerable to sequence-of-return risk — the risk of selling during or immediately after periods of poor performance — the day they retire: It is at this period that wealth is likely at its highest as labor income has discontinued and withdrawals have begun. As a result, a significant market downturn in the early years of retirement has a far greater impact on the longevity of assets than at any other time in a participant's retirement. Given the heightened vulnerability to sequence-of-return risk, we believe a glidepath that reaches its most conservative equity allocation at the retirement date (known as a “to” approach) is the optimal structure to help participants meet their income needs through retirement.

A final aspect to consider is the overall objective of a glidepath. When it comes to retirement success, the investment goal of most retirement plan participants is a dual mandate: maintaining their lifestyle in retirement while not outliving their assets. Therefore, we believe it's important to examine the risk/reward tradeoffs of different glidepaths in an income replacement ratio framework. Income replacement ratio can be defined as the income generated from retirement assets as a percentage of the participant's last earned salary. This ratio reflects the participant's post-retirement relative purchasing power as well as their ability to meet their financial needs in retirement.

We believe a glidepath should optimally balance the risk/reward tradeoff of the income replacement ratio for a given risk aversion. To do so, we evaluate glidepaths based not only on the expected income replacement ratio, as defined by the median IRR over all possible outcomes, but also the shortfall risk, as defined by the average of the 5% of worst-case IRR outcomes. This approach takes into account that, at a certain point, higher levels of income replacement ratioa exhibit diminishing benefit relative to the additional risk that is assumed. Said simpler, there is a point where the incremental benefit of a higher level of median IRR is not worth the added risk an investor would need to take. We believe this approach to evaluating glidepaths allows for an optimal balance between key participant, plan and market assumptions. It also allows us to assess the likelihood of a successful retirement for plan participants taking into account their dual objectives; maintaining their lifestyle while not outliving their assets.

When it comes to evaluating and selecting the optimal glidepath, it is critical to take an in-depth look at each target-date manager's objective and approach to the accumulation and decumulation phases and how both align with a plan's unique objective, needs and participant characteristics.

Jody Hrazanek is managing director, senior portfolio manager and head of strategy design and implementation at Voya Investment Management, based in New York. This content represents the views of the author. It was submitted and edited under P&I guidelines, but is not a product of P&I's editorial team.