American Funds: ‘Not All Equity is Created Equal’

As an individual approaches and then enters retirement, the American Funds Target Date Retirement Series—“through retirement” funds with “dynamic glide paths”—lower their exposure to growth-oriented, high-beta equities, Bill Anderson, senior vice president, director of retirement business at American Funds, told PLANADVISER. The funds replace that with greater exposure to dividend-paying equities, he says.

The funds’ managers approach fixed income differently as well, Anderson said. “In the dynamic glide path, the fixed-income allocation changes from high yield to more of a core approach and, ultimately, U.S. government issues and then short-term bonds,” he says.

“Many target-date funds have a one-dimensional view of allocations in terms of mere percentages,” Anderson explains. “We have added another dimension by changing the types of equity and fixed income [in the portfolios] as an investor moves through their investing cycle.”

Ever since the target-date fund series launch in February 2007, shortly after the passing of the Pension Protection Act, American Funds decided to seek out “the best investment opportunities for investors and [treat] their objectives as our guiding light,” Anderson says. “An individual saving for retirement will go through three phases, the first being the accumulation period from when they put their first dollar in their account up until 20 years before they retire. The objective then is growth while protecting themselves against market risk, shortfall risk and concentration risk. 

“The next phase is the transition phase into retirement, where the primary goal is growth and stability to protect against market risk,” Anderson continued. “At retirement is the distribution phase, where the objective is to protect what they have saved while being mindful of market, inflation and longevity risk, as people could be living 10, 20 even 30 years in retirement.”

Thus, during the accumulation phase, the American Funds Target Date Retirement funds have a higher exposure to growth. The funds’ primary focus during the transition phase is growth and income, and in the distribution phase, the funds concentrate more heavily on equity income and bond funds.

“The end result is a higher allocation to all types of equity across all vintage—but less volatility as measured by standard deviation and higher income,” Anderson says. As a result, he says, the funds have consistently outperformed their Morningstar peer groups.

As American Funds puts it in “Capital Idea: Take a more  dynamic approach to managing volatility in target-date funds,” a recent white paper, “Not all equity is created equal when it comes to volatility. Dividend-paying equities have historically tended to be less volatile than higher beta emerging markets and small-cap equities. We believe that target-date funds should seek to lower equity volatility as participants age by gradually shifting the exposure toward historically less-volatile, income-oriented strategies and away from higher beta stocks—an approach we call recharacterization of equity. We believe plan sponsors and participants can benefit from this approach of essentially creating a ‘glidepath within a glidepath.’”

Adds Anderson: “As far as we know, we have not heard any other investment firm talking about this ‘recharacterization.’” The reaction from retirement plan advisers, he says, has been “very favorable. Because of the significant growth of target-date funds as an asset class, advisers are continually looking for ways to evaluate target-date offerings, and this gives them a new way to look at glide paths.”