Investors often differentiate target date funds based on their glide paths, which illustrate how allocations to equities, fixed income, and other assets change as investors age. However, a glide path is an imprecise way to compare a target date fund’s structure. Investors can gain greater insight by seeing how different types of equity, fixed-income, and other assets are used to construct the glide path.
Retirement portfolio construction requires balancing a complex set of interconnected risks. The strategy of shifting allocations along the glide path is based on the idea that a young investor with a long working career ahead can bear more equity risk, while future work income constitutes a type of fixed-income investment that economists refer to as human capital. The portfolio becomes more conservative with the passage of time because the investor’s capacity to assume risk changes. The declining exposure to the investor’s fixed-income-like human capital is replaced by fixed-income investments.
Investors can set the investing goal by targeting a retirement outcome
One measure of success when investing for retirement is based on accumulating the amount of money needed to buy an inflation-indexed immediate annuity, a conservative target that is easy to model, that replaces 60% of an investor’s pre-retirement income. With Social Security replacing an additional 20% of pre-retirement income, investors can reach a combined pre-retirement income replacement of 80%, which is a common goal of successful retirement investors.
Retirement investors must navigate a complicated and interconnected set of risks along the journey to the goal. Comprising the first risk layer are two primary risks:
- Longevity risk: Accumulating sufficient assets to last a lifetime.
- Market risk: The risk of loss as market conditions change.
For investors, understanding and addressing multi-dimensional risks can be essential steps toward achieving desired outcomes.
Understanding longevity risk
The risk of outliving one’s assets can be viewed in three different dimensions:
- Accumulation risk: The expected surplus at retirement relative to the targeted outcome. This is the amount of money beyond that which is necessary to purchase an inflation-adjusted immediate annuity to replace 60% of pre-retirement income at retirement.
- Success rate risk: The probability of falling short of the goal of having accumulated enough money to buy an inflation-adjusted immediate annuity at retirement.
- Shortfall risk: Assuming there is a shortfall, the expected shortfall of the targeted annuity value.
These three factors help to describe the distribution of potential retirement savings outcomes. The average expected surplus is the mean of the distribution of outcomes; the success rate is the frequency of positive outcomes; and the average shortfall is the entire left side of the distribution—importantly—including the left tail of the distribution.
Figure 1: Longevity risk’s three dimensions describe the distribution of potential retirement savings outcomes
Understanding market risk
Market risk affects all market investors. The severity of its impact on retirement investors depends when a market shock occurs relative to the targeted retirement date (age 65). A value at risk (VaR) approach is an informative way to measure market risk because it measures the effect of a market shock in terms of a portfolio’s dollar decline.
A market loss that occurs early in a retirement investor’s life, may not materially affect his or her potential of reaching the retirement investing goal. When the loss occurs, the investor likely will have a long sequence of contributions ahead to help recover, may have a relatively small VaR, and may enjoy relatively higher returns subsequent to a market shock than those that preceded the market shock.
An adverse market shock is potentially more complicated for an investor who is at or near age 65 when the loss occurs. There are fewer future contributions to help make up for the market shock’s portfolio drawdown, the VaR may be higher than that of the 25-year old investor, and the older investor does not have as much time to recover the lost assets through higher post-shock returns.
Different asset types may help balance longevity and market risk
Including different types of exposures to equity, fixed income, and other assets is essential to balancing longevity risk, including accumulation risk, success rate risk, and shortfall risk, and market risk, including drawdown risk occurring during market shocks.
Figure 2: A multifactor-based equity strategy compared with a traditional index strategy may have higher returns and lower risk over time
One way to address longevity risk and purchasing power risk is to add equity assets to a portfolio as shown on the left side of the illustration in an effort to help an investor’s nest egg grow faster or for longer. The flipside is that equity risk brings with it higher market risk and can be potentially devastating to retirement plans if a market shock reduces the VaR as retirement approaches or during retirement. As shown in the center of the illustration, increasing fixed-income exposure to the portfolio may lower market risk, although it also can increase longevity risk. Factor-based equity and fixed-income exposures may help balance the risks, as shown on the right side of the illustration. If you would like to know how this works, please take a look at these two previous posts, Factor-based equity strategies for retirement investing and Fixed-income factors in target date strategies.
What is an investor to do to untie this Gordian knot?
Different types of assets combined in new ways may address risks more completely
As shown in our previous papers and blog posts, factor-based equity and fixed-income investment approaches can deliver different risk-return experiences than traditional market capitalization-weighted approaches.
Focusing on equity factors such as momentum, volatility, quality, size, and value, among others, may offer the opportunity to better balance longevity risk and market risk than a market-cap weighted portfolio might. Focusing on fixed-income factors such as yield and quality may offer greater opportunity than a market-cap weighted approach to alter a portfolio’s interest rate, credit, and inflation sensitivity, create income, and shift to more inflation-sensitive assets through retirement.
It is important to remember that when the basic building blocks used to construct a retirement portfolio change, the glide path should change as well. A glide path that was constructed using actively and passively managed market-capitalization weighted strategies may not be appropriate for factor-based strategies. The entire glide path may need to be reconstructed to take advantage fully of the potential benefits of factor-based investing.
For example, some glide paths maintain high equity exposure for the majority of the pre-retirement portion of the glide path then reduce that exposure quickly as the target date approaches. From a portfolio construction standpoint, this aggressive equity exposure reduction may have unintended consequences if it occurs at an inopportune time. In these circumstances, a portfolio might better balance longevity risk and market risk by replacing some of the equity exposure with equities characterized by a lower volatility factor, rather than by simply shifting to fixed income.
Additionally, it may be prudent to replace some of the fixed-income exposure with investments that are more sensitive to inflation, like Treasury Inflation Protected Securities and real estate investment trusts.
Can integrating asset allocation and asset selection improve retirement outcomes?
How can investors determine whether a glide path is designed to balance longevity risk’s three component risks: accumulation risk, success rate risk, and shortfall risk, along with market risk? We created a proprietary Glide Path Success (GPS) Score to evaluate whether a glide path balances these risks effectively to achieve desired retirement savings outcomes. Here’s how it works.
The GPS Score is based on an assumed salary trajectory, contribution rate assumptions, and market return assumptions.1 By conducting simulations using various return assumptions and applying them to a wide range of possible glide paths, we can score and rank glide paths. Converting the data for each component risk into z-scores relative to the glide path universe helps measure the divergence of an observation from the average. We can sort the z-scores into favorable and negative outcomes as they relate to the investor’s goal, which minimizes the impact of outliers and makes the scores more directly comparable with one another.
Figure 3: Four hypothetical glide paths were evaluated using the GPS Score methodology.
|Years until retirement||Years in retirement|
|Glide Path 4||99||99||99||99||96||92||82||72||62||52||40||40||40||40||40||40||40|
|Glide Path 3||86||86||86||86||86||86||81||76||70||62||54||29||29||29||29||29||29|
|Glide Path 2||90||90||90||90||90||90||90||80||65||59||55||43||34||24||24||24||24|
|Glide Path 1||90||90||90||90||90||85||80||70||60||50||40||35||30||30||30||30||30|
|Percent exposure to equity strategies|
Figure 3 illustrates the declining allocation to equity assets of four hypothetical target date glide paths. Based on the calculations described in this article, GPS Scores were generated for accumulation risk, market risk, shortfall risk, and success rate risk. The resulting scores are presented in Figure 4.
The charts below display the GPS Scores of each of the four hypothetical glide paths. Glide Path 1 includes factor-based equity and fixed-income portfolios while the other three are comprised of market-cap weighted portfolios.
Figure 4: GPS Scores of four glide paths were calculated
Of the four glide paths scored, the Glide Path 1 produces consistently positive longevity risk scores (accumulation risk, success rate risk, shortfall risk) and a positive market risk score suggesting that Glide Path 1 represents a healthy balancing of longevity and market risk.
When considering a retirement strategy, look beyond the glide path to these important considerations:
- What is the strategy’s goal? A conservative goal is to accumulate the amount of money needed to purchase an immediate inflation-adjusted annuity at retirement to replace 60% of the investor’s pre-retirement income.
- Does the glide path consider the multiple dimensions of risk in the selection and allocation of investments to the portfolio’s investments in equity, fixed-income, and other assets?
- Is the glide path constructed with consideration for the types of assets in the portfolio? Factor-based equity and fixed-income investments may enable portfolio allocations along the glide path that effectively address risk and the investor’s goals allowing them to invest for retirement with greater confidence.
1 For the purposes of this paper, we assume that retirement savers are using defined contribution (DC) plans (like a 401k plan) as their primary savings vehicle. A DC participant’s pre-retirement savings are a function of: 1) salary, 2) retirement saving rates (including participant and employer contributions), and 3) investment returns. In order to develop a salary assumption for the typical retirement saver, we used data from the US Census Bureau’s most recent survey of median income at various ages. This salary model is a conservative estimate of a typical plan participant’s salary trajectory. The US Census Bureau’s data includes new entrants to the workforce, who typically come into the workforce at a lower salary point than incumbent workers. Someone who stays continuously employed will typically enjoy a higher salary trajectory than that implied by the US Census Bureau data.
To develop a retirement savings rate assumption, we applied a DC savings model, which starts with a 9% contribution rate at age 25 (this includes both employee and employer contributions) and increases to 14.2% at age 65. We then multiplied our savings assumptions by our salary assumptions to create a series of annual DC contributions that approximate the savings pattern of a typical retirement investor. These numbers were a consensus figure from several sources. The main source was from the Employee Benefit Research Institute (EBRI)’s paper, “Plan Demographics, Participants’ Saving Behavior, and Target-Date Fund Investments,” by Youngkyun Park.
The target date represents the year in which investors may likely begin withdrawing assets. The funds gradually seek to reduce market risk as the target date approaches and after it arrives by decreasing equity exposure and increasing fixed-income exposure. The principal value is not guaranteed at any time, including at the target date.
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