Challenges to the Traditional Glide Path

A paper published in The Journal of Retirement argues that asset-allocation glide paths popularized in target-date funds (TDFs) fail to deliver superior end-point wealth.

Traditional glide paths involve a portfolio-wide shift away from equities and into fixed income as an investor approaches a predetermined retirement date. The logic is that, when an investor is young, he can afford to take on additional risk to gain better returns. An investor approaching retirement, on the other hand, has less time to recover from equity losses and should therefore favor bonds and fixed-income investments.

In “The Glidepath Illusion … and Potential Solutions,” a team of authors from Research Affiliates say this approach, while intuitive, rarely plays out in the real investing arena.

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To demonstrate the point, researchers ran simulations for three different asset-allocation strategies, all assuming a 41-year career and a consistent, inflation-adjusted $1,000 annual contribution. The strategies include glide-path asset allocation, with investments shifting from 80% stocks and 20% bonds to the opposite upon retirement. Also tested were a static allocation rebalanced annually to maintain 50% each for stocks and bonds, as well as an inverse glide path shifting from fixed income to equities.  

To compare the strategies, the research team used 141 years of stock- and bond-market data to develop 101 different model investment experiences. The results show the typical glide path allocation resulted in lower ending retirement assets than either the balanced approach or the inverse glide path—even for the extreme bottom tail of the model portfolios’ distribution curves. The glide path approach consequently failed to provide a higher ending real annuity within the simulation.

Report authors explore a long list of explanations for the phenomenon. One interesting take is that, while all three asset-allocation strategies average a 50/50 stock to bond mix over an investor’s lifetime, the dollar-weighted average allocation is actually far more bond-centric within the classic glide path strategy.

The result is that, by the time investors using a target-date strategy have generated large account balances, they have already moved to fixed-income products and therefore miss the chance to put those additional dollars to work in the equity markets, where returns tend to outpace those in fixed-income markets. This is problematic when considering that stocks have significantly outperformed bonds over almost all historical periods.

Another explanation points out that any individual investor is just as likely to see good equity returns late in his career as he is to see them early. So an investor who enacts a traditional glide path during depressed equity markets may miss out on better returns later in his career, after he has already shifted towards fixed income.

A copy of the paper, authored by Rob Arnott, Katrina Sherrerd and Lillian Wu, can be downloaded here

Little Impact for Pension Accounting Change

A new research paper shows that the impact of using a mark-to-market accounting method for valuing pension liabilities will have a negligible effect on companies.

The paper from SEI, “Considering a Switch to Mark-to-Market Accounting? An Understanding of Potential Stakeholder Reactions,” examines the impact such an accounting method might have on companies’ investors, equity research, credit ratings and management compensation programs. Twenty-three major U.S. companies that implemented mark-to-market accounting for their defined benefit (DB) plans over the past two years were reviewed for the paper. The research findings show such a switch has resulted in little substantive change to these corporate constituencies.

“While there has been much discussion in the industry regarding the pros and cons of transitioning to mark-to-market accounting for pension plans, our research suggests that the reaction by key stakeholders and the subsequent impact on corporate finances is generally negligible,” says Thomas Harvey, director of advice for SEI’s institutional group. “Plan sponsors that might have previously been hesitant about such a change should potentially re-evaluate their pension accounting options.”

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The paper notes that many plan sponsors currently use a multiyear smoothing method in calculating their pension liabilities. This approach is designed to help decrease year-to-year volatility of pension expense but can create a drag on future earnings. Mark-to-market accounting removes this smoothing method and realizes gains or losses immediately as they occur, providing a more accurate view of the current results of the organization’s pension plan. The paper notes that mark-to-market accounting is used on a more global basis by International Accounting Standards.

Other findings from the paper include:

  • Returns on share price in the period surrounding the earnings announcement show no statistically significant abnormal return values;
  • Financial analysts’ reports and quarterly earnings calls show very few questions and no direct criticisms of the mark-to-market implementations by companies;
  • Ratings agencies such as Standard & Poor’s (S&P), Moody’s and Fitch already use mark-to-market accounting as part of their longstanding practices;
  • Internal management receives the benefit of removing drags on earnings, while ultimately gaining more favorable earnings per share without the penalty of past poor performance; and
  • Non-generally accepted accounting principles (GAAP) adjustments to earnings generally removes the mark-to-market effect in investor calls, analyst reports and management compensation programs.

The paper’s authors conclude, “Based on our research, a change to mark-to-market accounting can be made with the potential for little substantive change on the part of investors, analysts or managers as part of this implementation.”

The full text of the research paper can be found here.

SEI is a provider of investment processing, fund processing, and investment management business outsourcing solutions. Its institutional group provides outsourced fiduciary management investment services. The firm is based in Oaks, Pennsylvania.

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