Behavioral Finance Can Guide TDF Glide Paths

Investors are prone to risky behavior during market downturns and TDF glide paths should protect against these shifts, says a portfolio strategist with Charles Schwab.

Pulling assets out of a defined contribution (DC) plan during a severe market downturn is one of the worst actions a plan participant can take, says Jake Gilliam, senior multi-asset class portfolio strategist, Charles Schwab.

The firm recently released a white paper exploring how understanding behavioral finance among other factors can influence glide path design in target-date funds (TDFs), one of the most widely used default investments in the DC space.

Based on an analysis of its recordkeeping system as well as data from the Bureau of Labor Statistics and the Employee Benefit Research Institute (EBRI), Charles Schwab drew distinct investor profiles depicting how participants typically save at different age groups. For example, it found deferrals typically begin at 4% of salary per year for the youngest investors at around age 23 and steadily rise as salary, tenure, and age increase until a typical final deferral rate of 7% is reached.

Taking this and other data into consideration, the firm recommends plan sponsors selecting TDFs should thoroughly analyze their participants’ demographics and risk profiles to match them with the right TDF provider and glide path.

“Participants in general react very poorly to negative market events,” Gilliam explains. “They also are subject to performance chasing and overall inertia. Investors need to have a plan that helps them save for the long term and has the appropriate amount of risks, so they don’t abandon that plan at the absolute worst time.”

NEXT: Addressing down-side risk

To address these concerns, he says a glide path should focus on downside-risk protection and volatility control to defend against potentially negative behaviors investors may take during market downturns, especially near or in retirement when preservation of assets is crucial and time to recover is minimal.

Generally speaking, TDFs manage risk by becoming more conservative over time and devoting larger allocations to fixed income versus equity. But Gilliam argues that underlining securities deserve just as much scrutiny as the asset mix itself.

He says investors also need to be protected at “the sub-asset class level." Within stocks and bonds, there may be higher exposure to asset classes that might have more volatile events like emerging markets and international equity when participants can tolerate it earlier in their careers. "By the time you’re in retirement, we would have removed the direct exposure to emerging markets. Within fixed income, we’re blending active and passive exposures to make sure that we have a balanced approach to safe government and agency type securities as well as prudent exposure to credit. And we’re also introducing a dedicated allocation to TIPS 10 years prior to retirement. And we’re increasing our short duration and cash exposures to make sure we have an appropriate amount of interest-rate sensitivity and liquidity,” he adds.

To develop the glide path for its own TDFs, Charles Schwab used a proprietary metric called the risk-proxy. This outlines a projection of appropriate risk level at different age groups and investment phases: Initialization, accumulation, transition, and retirement. It also takes into account financial capability or a measure of the present value of existing accrued savings balances, and human capital or present value of future income and how that may translate to future contributions. All things being equal, low financial capital indicates higher risk tolerance. But this tends to increase with age presumably putting a higher account balance at risk as investors accumulate more.

Gilliam suggests that the glide path of a TDF should consider these evolving risk levels during retirement as well. Its research finds the typical retirement age to be 65 and life expectancy to be 85.

“We know the retirement needs of every investor will vary,” Gilliam notes. “What we’re assuming is a very conservative approach that there will be no post-retirement job. We’re looking at what people have accumulated through the glide path and how that could help them live in retirement under various withdrawal scenarios.” He says the right glide path should aim to prepare someone to withdrawal even 5% to 6%, adjusted for inflation, for decades into retirement.

He adds that the glide path needs to address the real dollar value that’s at risk and avoid exposing participants to what they can’t handle at the worse times. “Assume a 10% loss on retirement balances across the age range. For younger participants, say that’s on average a $600 loss. That will be minuscule in importance in the long term given the importance of contributions relative to volatility at that stage. Conversely, for someone who is nearing or in retirement, a 10% loss could be $40,000 to $50,000 or years lost in retirement savings.”

He says the glide path design needs to emphasize protection against downside events. “We want to encourage long-term savings behavior and not have a near retiree flee the market after a 2008-like event.” 

Instructions for downloading a copy of Behavior-Driven Glide Path Design can be found at Schwabfunds.com

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