The Retirement Purse

Art by Claire Merchlinsky

In the early days of target-date funds (TDFs), 10 or 15 years back, product designers for defined contribution (DC) plans were, maybe fittingly, focused on the early days of the retirement cycle—saving and investment during participants’ working lives—with little emphasis on the retirement years themselves.

But TDF managers still held differing views on how to fashion their funds’ glide paths in the later stage, which led the industry to develop a shorthand, placing TDFs into two categories: those that invested “to” participants’ retirement dates, progressively moving to a more conservative and static exposure to equities and other return-seeking assets, and others that invested “through” retirement, approaching the later years with a more aggressive posture and then gradually reducing equity exposure during retirement.

As a practical matter, though, for such complex products, “to” versus “through” is a distinction without much of a difference. “Early on, it was an easy way to classify funds,” notes Jeff Holt, an analyst of multi-asset funds at Morningstar in Chicago. “But there are so many decisions to be made in designing a portfolio and income distribution in retirement, and ‘to’ versus ‘through’ is just the tip of the iceberg.”

Treating a participant’s retirement as a watershed is, in actuality, fair: When a person stops working, the value of his human capital—receiving a salary in exchange for work—falls to zero. “You go from saving and investing—and being cash flow positive into your retirement account—to a point where you are cash flow negative,” observes David O’Meara, senior investment consultant at Willis Towers Watson, in New York City. “Because you’re no longer able to make contributions, your ability to bear risk changes meaningfully.”

How a target-date fund should react to that shift in risk is where the “to” vs. “through” debate originates, but consultants and fund managers say that the investment glide path decision should be drawn from more factors: longevity risk, or how long participants have to rely on their accumulated assets; behavioral risk, or how well they choose their investments; whether or not they will stay in their employer-sponsored plan; and when they are likely to start drawing down their retirement funds. A separate issue, but one that nonetheless is calling for answers, is a means for systematically distributing accumulated assets into retirement income streams.

“All of us who build glide paths look at a mosaic,” says John Croke, head of multi-asset product management at Vanguard Group, in Valley Forge, Pennsylvania. “One important piece everyone agrees on is the financial theory that there’s a return premium for investing in equities and that, for a retirement investor, it’s the right place to take risk throughout the life cycle. The second is the decline in human capital over time. That’s why glide paths are downward sloping.”

More meaningful, perhaps, than the nuance of whether allocations are changing by a few percentage points are the levels of those allocations. “At any point, the level of risk is more important than whether it is flat or declining,” O’Meara says. “A fund that holds 40% down to 30%. That’s very different from a fund that starts at 50% and stays there.”

At BlackRock in New York City, Matt O’Hara, global head of investments for the firm’s LifePath target-date offering, has rigorously modeled the question and advocates for steady allocations during retirement. “Put all of the uncertainties together, and it gets you to a constant allocation of return-seeking assets such as equities,” he says. “That will allow the highest spending at an appropriate risk over a lifetime. Some managers reduce their funds’ equity risk over time, but, in our framework, that reduces the ability to spend.

“In our research, we don’t see the “to” versus “through” distinction alone as an adequate way for choosing funds, so we don’t emphasize it,” says Holt. Morningstar took its last close look in 2016, and, he says, “One interesting point was that, with the ‘through’ funds, investors owned more in equities in the earlier years and less later on. But for both ‘to’ and ‘through’ funds, at 30 years after retirement, the average equity allocation was roughly the same.”

He also points out that an overall “to” or “through” measure of equity content just scratches the analytical surface: “Sponsors also need to look at the asset subclasses, because not all equity exposures are the same, and neither are bond exposures.”

Another consideration for investment allocations is the timing of withdrawals. Croke brings together his firm’s data on its own clients and government statistics, and finds that most retirees postpone withdrawals. “We see assets leaving DC plans and going to IRAs [individual retirement accounts], but we don’t see an increase in consumption from that wealth until people are in their early 70s. In building a glide path, because those assets are not being touched, we continue to take prudent levels of equity exposure, to 30% seven years out.”

“My view is that TDFs should invest through retirement,” says Martha Tejera, head of consulting firm Tejera & Associates in Seattle. “People rolling their accounts over to IRAs are not going to be out of the market very long, and most of them have to fund 25 or 30 years of spending, so why put them in an overly conservative asset allocation at the point of retirement?”

Implicit in the idea of a through TDF is an assumption that participants will keep their assets in employers’ plans once they retire. In turn, they will need some orderly way of drawing them down. Distribution is still on the drawing board, however, Holt says. “There have been attempts for several years to insert retirement income and distribution features into target-date funds, but the reality is they haven’t gotten widespread adoption.”

TIAA has built an annuity feature into its custom TDFs for about 50 of its clients. “The annuity is liquid to meet QDIA [qualified default investment alternative] requirements, and, for a typical 2020 fund, about 30% of assets would be in the annuity,” reports Timothy Walsh, senior managing director, in the firm’s New York City office. “Having income security through an annuity allows greater equity exposure in the rest of the portfolio for a longer period,” he explains.

T. Rowe Price Group, Baltimore, on the other hand, has brought to market a fund for retirement distribution, paying out about 5% of assets annually. So far, it is not part of a TDF structure, but the firm is exploring a TDF version.

“Distribution in retirement is not an investment product question, because TDFs are fully liquid,” says Tejera. “It’s more of an administrative question, making it easy for participants to take periodic distributions.”

“We think there will be a need for a set of solutions for distribution,” predicts Lorie Latham, senior DC strategist at T. Rowe Price. “Participants are solving for a variety of goals: longevity, secure income, structured paydowns or bequests. These would add complexity for sponsors, but if more retirees want to keep their assets in their plan, that might be where we end up.”

“The DC system is behind on distribution,” O’Meara concludes. “We need to find ways to engage with participants as they approach retirement. DC sponsors are missing an opportunity to play a critical role to provide them with choices and help them sort out those crucial decisions.”