Do Bond Allocations Along the Glide Path Align With Participant Objectives?

• Target date fund risk profiles should align with evolving participant objectives along the retirement savings journey and we believe fixed income plays a critical role in managing risk.
• In our view, glide path construction should focus on managing risk and the distribution of potential future returns, particularly for participants approaching retirement, as opposed to solely focusing on maximizing returns. This more balanced approach should increase the likelihood of participants attaining their desired outcomes.
• Target date fund managers allocate fixed income along a glide path in many ways. We highlight this data for sponsors and demonstrate how it can result in a wide variety of potential outcomes for participants.
• We encourage sponsors to take another look — this time through a fixed income lens — at the plan's target date glide path to ensure it aligns with the ultimate objectives of the retirement program.

We see the retirement savings journey as a framework that could help defined contribution (DC) plan sponsors explore the types of fixed income exposure offered to participants. Within each phase of the journey, there are key objectives for a participant's fixed income allocation which evolve as a participant ages, as outlined in Exhibit 1.

This paper takes the retirement savings journey from theory to practice by sharing our views on how fixed income should evolve across a glide path, exploring both the absolute level of the fixed income allocation and its composition in terms of fixed income sub-asset classes.

We encourage sponsors to consider the level of the fixed income allocation and how it evolves along the glide path when selecting and monitoring a target date fund.

A typical glide path illustration highlights the level of equity along the path, which reflects the DC industry's historical focus on the accumulation phase of the retirement savings journey. To shine a spotlight on the fixed income allocation within a glide path, we took the current glide path paradigm and turned it on its head. When viewed this way, we typically see an upward slope in the glide path as participants' fixed income exposure increases while the number of years until retirement declines.

In keeping with our theme of taking the retirement savings journey from theory to practice, the following are questions we hear from sponsors around how to structure fixed income exposure along a glide path in terms of level and composition.

As Exhibit 2 illustrates, there is a wide range of practices in the allocation to fixed income along glide paths. Depending on how much or how little fixed income a participant has at different points along the glide path, retirement outcomes can vary significantly. We encourage sponsors to consider the level of the fixed income allocation and how it evolves along the glide path when selecting and monitoring a target date fund.

Should early-career participants have exposure to fixed income?

The US Department of Labor's 2007 Qualified Default Investment Alternatives (QDIA) guidance states that for a fund to qualify as a QDIA it must provide a mix of equity and fixed income exposures.² Within this context, sponsors should consider just how much fixed income exposure early accumulation phase participants really need.

The average fixed income allocation for a participant invested in a 2050 target date fund is approximately 8.4%; however, the minimum and maximum allocations range between 1.9% and 21.2%, respectively. While a larger fixed income allocation in far-dated vintages might feel "conservative," and therefore more comfortable for some sponsors, it can potentially inhibit participants' ability to grow and compound their savings.

Participants in the accumulation phase should seek to maximize capital appreciation.

In the accumulation phase of the retirement savings journey, which includes participants in their early 20s through mid-40s, the most important objectives are to save as much as possible, maximize employer matching contributions and grow these savings through compounding investment returns. Accordingly, we believe participants in this phase should have minimal fixed income exposure and seek to maximize capital appreciation through the higher growth potential of equity and other higher-returning asset classes. With a long time horizon until retirement, these participants have time to recover from market downturns and can generally withstand the greater volatility associated with more risk exposure. A higher allocation to equities in this phase can help build a larger retirement account balance, which can allow for participants to potentially take less risk later.

By emphasizing capital appreciation through a relatively small fixed income allocation early in the glide path, we can also begin to address longevity risk, one of participants' greatest concerns in retirement. Longevity risk seems to be a topic most talked about as retirement approaches, but we believe this risk should be an explicit objective across the retirement savings journey. Growing capital early on is as important as growing it and protecting it later in life.

How much fixed income exposure should participants have in the later years of the consolidation phase and into the decumulation phase?

As discussed above, too much fixed income in the accumulation phase can inhibit a participant's ability to benefit from compounding investment returns. In the consolidation and decumulation phases, we believe too much equity exposes participants to excess drawdown and sequencing risk. We prioritize lowering the potential for capital losses above capital appreciation in the later years, which requires greater exposure to fixed income.

The range between the minimum and maximum fixed income allocations is significantly wider in near-dated vintages when a participant is close to retirement age, indicating less agreement among target date managers on how much to allocate to fixed income. While an analysis of the 2050 vintages shows a range of 19.3% between the minimum and maximum fixed income allocations, the 2020 vintages exhibit a range of 31.8%. These data illustrate the varying views of target date fund managers in determining an appropriate level of fixed income exposure.

Lowering the potential for capital losses should be prioritized above capital appreciation in the later years of the retirement savings journey.

We often hear the argument that participants nearing and in retirement should continue to hold a significant allocation to return-seeking assets because they need a higher level of return for their savings to last through a long lifespan. It is also sometimes argued that participants who have not saved enough must maintain a return-seeking posture, which implies that late-career and retired participants can invest their way out of suboptimal savings behavior. We believe that longevity risk can be managed in a number of different ways and that higher equity allocations are not necessarily the most effective way to accomplish this. Furthermore, participants who have been unable to save enough are generally more financially fragile and have less ability to weather a market downturn, making a high-equity allocation late in the retirement savings journey potentially even less appropriate.

We believe that near-dated vintages should hold a relatively high allocation to fixed income, with the goal of lowering the potential for capital losses and managing sequence of returns risk. This can help to mitigate the impact of significant market declines as participants approach their retirement date, when there is less time to recover and a sharp drop in assets could have major implications, such as a postponement of retirement and/or a reduction of a participant’s standard of living in retirement. In other words, a larger fixed income allocation in near-dated vintages positions participants more conservatively at this crucial stage of the retirement savings journey.

A larger fixed income allocation in near-dated vintages positions participants more conservatively at this crucial stage of the retirement savings journey.

Theory to practice — The impact of fixed income allocations on participant outcomes

To explore this question of how much fixed income exposure participants approaching and in retirement should have, we analyzed the impact of differing fixed income allocations on potential retirement outcomes for two hypothetical participants under two hypothetical glide paths:

1. Glide Path 1, which starts with a fixed income allocation of 10%, reaches a 55% fixed income allocation at age 65 and continues to increase throughout retirement
2. Glide Path 2, which starts with a fixed income allocation of 5% and reaches a 70% fixed income allocation at age 65 that is held constant throughout retirement

Glide Path 2 begins with a lower level of fixed income exposure and a correspondingly higher level of equity exposure throughout the accumulation phase and into the consolidation phase. This relationship reverses midway through the consolidation phase and into the decumulation phase, with Glide Path 1 landing at 55% fixed income at age 65 versus 70% fixed income for Glide Path 2. All things being equal, Glide Path 2 should offer more opportunity for account growth in the accumulation phase while Glide Path 1 should offer the opportunity for asset growth in the later phases of the retirement journey, when account balances are typically larger and the effects of compounding investment returns more dramatic. Again, all things being equal, Glide Path 1 should offer reduced volatility in the accumulation phase while Glide Path 2 should lower the potential for capital losses in the consolidation phase, when account balances would typically be larger and the impact of drawdowns more dramatic.

Using the glide paths illustrated in Exhibit 5, we simulated the range of potential outcomes for two hypothetical participants — both age 45; with an initial account balance of $200,000; earning $80,000 per year and receiving annual increases of 2.5%; and saving 10% of their earnings per year to see how their account balance might look at age 65. In Exhibit 6 below, we show the results for each participant.³

We can see that Participant X has a slightly higher median account balance at retirement than Participant Y, which is a reflection of Participant X's higher allocation to return-seeking assets in the latter stages of the retirement journey. However, simply comparing account balances at age 65 does not tell the whole story.

What is value at risk (VaR) and why is it important?

Value at risk is calculated using account balance and asset allocation data for individual participants at a given point in time. Using this information, an expected return and standard deviation is calculated for the participant. The VaR represents the estimated loss at the first percentile of a normal distribution of outcomes, meaning that 1% of the time losses will be of this magnitude or greater.

VaR can be an instructive metric in discussing a participant's potential experience along the retirement savings journey and is particularly relevant for participants approaching retirement who are vulnerable to sequence of returns risk.

Looking at the results in Exhibit 6 from a risk perspective, Participant X has a value at risk4 approximately 55% greater than that of Participant Y, which is a result of Participant X having a larger equity allocation. Comparing the VaR of the participants reminds us that a glide path should not seek solely to maximize expected returns but also account for managing the distribution of potential future returns. In this scenario, Participant X’s annual retirement income is reduced by approximately $8,700 versus about $5,600 for Participant Y. While both participants experience a decline in their retirement income in this scenario, Participant X would see a larger impact in terms of standard of living during retirement.

These hypothetical scenarios are intended to help sponsors explore how their plan's glide path aligns with the ultimate goals of their retirement program and how their unique participant population might view and understand risk. Behavioral finance studies show that the pain of a dollar lost often outweighs the benefit of a dollar gained. While the slightly greater upside potential of Glide Path 1 may be appealing, sponsors should ask whether the benefit of that upside is worth the pain of potential downside outcomes for their participants and the resulting impact on their ability to retire on time. The latter point also has an important impact on the sponsor's ability to rotate the workforce, maintain employee productivity and morale.

We believe in the broad diversification of fixed income throughout the glide path.

The retirement savings journey (Exhibit 1) illustrates the many objectives a participant's fixed income allocation must achieve. We believe participants' fixed income exposure should offer diversification from equities but also contribute to total return, lower the potential for capital losses, help manage inflation risk and ultimately support income generation. Meeting these objectives can be a tall order for plans that rely primarily on a core fixed income allocation for participants' exposure to bond markets. We encourage sponsors to explore how incorporating fixed income strategies beyond a core fixed income allocation can help meet participants' evolving needs.

What are the underlying strategies that could comprise the total fixed income allocation?

We believe in the broad diversification of fixed income throughout the glide path. Accordingly, we consider six fundamental building blocks when constructing fixed income allocations along that path (see Exhibit 7). The goal of constructing a diversified fixed income allocation is not to replace core bonds but rather to supplement the core bonds allocation, which acts as a foundation to address additional participant objectives.

While participants do not always have exposure to every building block and the relative size of the allocation depends on the participant's position along the retirement savings journey, we feel that this diversified approach to fixed income exposure provides additional levers that can be employed to meet multiple objectives.

Building a well-diversified fixed income allocation along a glide path

Many sponsors agree with the investment case for including exposures to fixed income strategies with higher risk and return profiles, such as emerging markets debt or high yield, but refrain from doing so on the core menu due to concerns that participants are not equipped to effectively allocate across these strategies. These concerns, however, are alleviated when the fixed income allocation is packaged within a target date fund glide path. We encourage sponsors to review the fixed income allocation within their target date fund and how it evolves across the glide path.

Do off-the-shelf target date managers offer diverse fixed income exposure for participants?

Some of the largest target date managers rely predominantly on core bonds allocations — especially in neardated vintages (e.g., a 2020 fund) when the fixed income allocation is approximately equal to or greater than half of the participant's total portfolio.

We encourage sponsors to review the fixed income allocation within their target date fund and how it evolves across the glide path.

When we analyze the fixed income allocations of the 2020 vintages of the 25 largest target date mutual fund series, we see that the number of underlying fixed income strategies employed ranges from three to thirteen strategies. Furthermore, ten target date fund managers have more than half of their total fixed income exposure invested in core bond strategies. Participants with high allocations to core bonds and limited exposure to other fixed income strategies are potentially missing out on the diversification that could be attained through broader access to the fixed income building blocks. We encourage sponsors to look at the fixed income exposure in the target date fund and determine if it is appropriately diversified.

We encourage sponsors to look at the fixed income exposure in the target date fund and determine if it is appropriately diversified.

We believe that target date fund risk profiles should align with evolving participant objectives along the retirement savings journey and that fixed income plays a critical role in managing risk. Glide path construction should focus on managing risk and the distribution of potential future returns, particularly for participants approaching retirement, as opposed to solely focusing on maximizing returns. This more balanced approach should increase the likelihood of participants attaining their desired outcomes.

Target date fund managers allocate fixed income along a glide path in many ways. We highlight that for sponsors and demonstrate how this can result in a wide variety of potential outcomes for participants. We encourage sponsors to take another look — this time through a fixed income lens — at the plan's target date glide path to ensure it aligns with the ultimate objectives of the retirement program.

Participant assumptions used in Exhibit 6

• The participant's retirement income need increases 2.5% annually.
• The participant has a starting balance of $200,000 at age 45.
• The participant earns $80,000 per year and receives a 2.5% raise annually, saving 10% of earnings per year (a combination of participant savings and employer match).
• The participant needs 70% income replacement at age 65. Life expectancy is 20 years from age 65. Social Security provides 27% of final pay prior to retirement, with 401(k) account providing the remaining 43%.

Investment returns were modeled using a Monte Carlo simulation generated by Oracle Crystal Ball software. Asset returns, risks (standard deviations) and correlations noted above were used to generate a normal distribution of outcomes for each asset class. 3,000 potential outcomes were generated to calculate the various percentiles of account balances.