The Risks of DC Investing
Art by Carol Rollo
People face a long succession of risks in their lives, and while many of these possible threats never go away, some can be shifted around and compensated for. Some materialize all at once—damage from a car accident, home fire or bank failure. The insurance industry calls these discrete events “occurrences,” and they can be protected against by some sort of defined policy or coverage program.
The risks that face workers funding their own retirement through defined contribution (DC) plans are quite different: Rather than happening all at once, the risks are less distinct and evolve over a career. While difficult to measure, they are genuine nonetheless; however, plan sponsors and their advisers can take steps to ensure best possible outcomes through the design and implementation of the sponsor’s DC plan.
In a world of defined benefit (DB) pension plans, the complexity of retirement risks is borne by corporate plan sponsors or governments, which have fleets of actuaries, consultants and advisers to manage these plans. Participants just see periodic benefit statements and, ultimately, a stream of retirement income checks; the risks are largely invisible.
Under DC structures, however, participants are handed a bundle of risks. Retirement experts at J.P. Morgan Asset Management (JPM) had defined a structure they advanced in a March 2015 white paper—“Off Balance: The unintended consequences of prioritizing one risk in target-date fund [TDF] design”—that remains relevant today.
“There are a multitude of risks a participant will face; they’re all related, and you don’t know what the timing of those will be,” notes Dan Oldroyd, a managing director in the Manhattan office of JPM and an architect of its risk framework.
Some risks are incoming, or “participant experienced,” in that they are thrown at participants by the markets and the world at large—sharp falls in stock prices; shocks to the bond market when interest rates lurch higher; or a drop in portfolio purchasing power from the bite of inflation, all of which can be rolled into the longevity risk of outliving one’s savings.
Other risks are outgoing, or the result of the participant’s own doing, through low saving rates, poor investment choices or early withdrawals, all hampering accumulation of capital.
The spotlight most often falls on market and event risk, or the dramatic declines in stock prices, which make up the lion’s share of the potential risk in retirement portfolios. During the decade just passed, investors had few reminders of market risk, as the S&P 500 turned in solid gains in seven out of 10 years and only small losses in the rest.
But a look at the last 80 years of market history shows that patterns change. From 1939 through 2009, each decade saw, on average, two sell-offs of 10% or more in a calendar year. And, since the 1970s, the declines lasted an average of 42 months—i.e., measuring from the month end that the index crested to when it resumed that peak level. For retirees, the pain of the declines is compounded by the need to withdraw depreciated dollars to fund the cost of living.
Target-date fund managers and managed account providers control the looming risk of equity markets through portfolio construction. For younger participants in target-date funds, who might have a 40-year investment horizon, equity market drops matter less, says Jason Shapiro, director of investments with consultants Willis Towers Watson, in New York City. “If people are defaulted in, they stay invested for the most part, so the question of equity markets becomes more germane to those near retirement.”
Late 2018 provides an instructive laboratory experiment on the success of TDF portfolio design. For the fourth calendar quarter, the price level of the S&P 500 fell about 15%.
The late-2018 damage to TDF portfolios was limited by portfolio construction, but there were distinct differences in performance, Shapiro says. “At the 25th percentile, near-retirement funds were down 5.5%, and at the 95th percentile, about 8%. Two-and-a-half percent of someone’s wealth just before retirement is significant.”
But, Shapiro adds, those TDFs that fared better in late 2018, owing to greater diversification, also had underperformed in the long equity rally since 2009. “There’s no free lunch here,” he observes.
Few funds take a tactical approach to risk hedging. One, PIMCO’s RealPath Institutional series, included put options as a hedge against equity tail risk, alongside other heavy armor against inflation. But in a bull market, “the series received no joy for its relatively conservative stance [or] … its policy of protecting against stock market ‘tail risk,’ [which never arrived],” wrote John Rekenthaler of Morningstar in late 2018, on the announcement that the series would close this February.
“But even for the TDFs with less aggressive portfolios,” says Shapiro, “advisers and sponsors need to ask themselves, ‘Is that good enough? If we position ourselves conservatively, are our participants going to be set up for success against equity risk?’ Sponsors can do more, with customized asset allocations, so those who don’t need the risk can take more off the table than a TDF would.”
Rising rates hurting bond prices
Failure to
save enough
Participant Experienced Risks
Participant
Controlled Risks
Erosion of
principal by inflation
Drawdowns approaching retirement
Misusing
investment options
Withdrawals prior to retirement
Rising rates hurting bond prices
Failure to save enough
Participant Experienced Risks
Participant
Controlled Risks
Misusing investment options
Withdrawals prior to retirement
Erosion of principal by inflation
Drawdowns approaching retirement
Failure to
save enough
Participant
Controlled Risks
Withdrawals
prior to retirement
Misusing
investment options
Rising rates
hurting bond prices
Participant Experienced Risks
Drawdowns approaching retirement
Erosion of
principal by inflation
Failure to
save enough
Participant
Controlled Risks
Withdrawals
prior to retirement
Misusing
investment options
Rising rates
hurting bond prices
Participant Experienced Risks
Drawdowns approaching retirement
Erosion of
principal by inflation
Source: J.P. Morgan Asset Management, "Off Balance"
Resources Investment Advisors, in Overland Park, Kansas, provides participants with custom portfolios built from three assets, in the form of collective investment trusts (CITs). “Since the dawn of investing, there have been only three things to invest in—equity, fixed income and an uncorrelated asset,” says James Battmer, chief investment officer (CIO) at the firm. “We can create thousands of allocations based on data points for participant age, outside assets, a raise or another child, and deliver it in a way people can understand.”
Besides engaging outside asset managers for the equity and fixed-income components, the firm partners with the investment arm of the Chicago Boards Option Exchange (CBOE) for a low-cost uncorrelated asset, quantitatively managed and combining elements of equity, fixed income and cash. Battmer explains: “Over the long run, it has returned about 7% annually and has a standard deviation similar to fixed income.” Higher equity allocations and mitigation against equity risk are essential,” he adds, “because historical returns suggest that people will not reach their goals by investing in the fixed-income markets of the future.”
Battmer also emphasizes attention to noninvestment aspects of DC plans—the participant-controlled risks. “We get people to optimize their health benefits through an HSA [health savings account] and to use Roth accounts the right way, to avoid creating tax consequences out of thin air.”
“The softer issues [of] individual circumstances are an essential part of the 401(k) process,” says Randy Long, head of Sageview Advisory Group in Irvine, California.
“The biggest issue is that participants have to save more,” Long adds. “Following different risk strategies, and deciding when to rebalance, and diversifying alternative investments are all part of a sound retirement strategy, but there is so much to be said for saving a lot.”