Making Sense of TDFs

Essentials of target-date fund design and analysis
Rich Weiss

The popularity and widespread adoption of target-date funds (TDFs), a relatively new investment, by defined contribution (DC) plans, has been nearly unprecedented. Retirement plan sponsors and their advisers have greatly increased their understanding of issues around target-date design and analysis over the last few years, but the investments continue to evolve, so fund analysis must as well. Alison Cooke Mintzer, editor-in-chief PLANADVISER, spoke with Rich Weiss, senior vice president and senior portfolio manager within the asset-allocation group at American Century Investments®, to discuss the essential factors in target-date design and analysis for plan sponsors and retirement plan advisers.

PA: While plan participants should find target-date funds an “easy” investment, the investments themselves are fairly complex. What risks does American Century consider to be most important in the design of your funds?

Weiss: The goal of American Century’s target-date funds is to maximize the certainty of retirement outcomes for the greatest number of participants. This objective demands a balanced approach to weighing the risks associated with lifecycle investing.

Key among the risks in target-date funds are longevity and market risk: Longevity risk is the risk of outliving your money, and market risk is the risk of too much volatility in your portfolio eroding the accumulation of wealth.

There are a host of secondary and tertiary risk considerations as well, including inflation risk, interest-rate risk, tail risk, abandonment risk, and sequence of returns risk or path dependency, which is not often talked about.

American Century seeks to take a balanced approach. We do not emphasize any one risk over the other, the goal is to maximize the certainty of retirement outcomes and success for the broadest number of participants.

PA: What did the financial credit crisis and recession teach us about target-date funds and the risks of retirement timing?

Weiss: It highlighted a number of things, most notably sequence of returns risk, or the risk of losing a significant portion of assets at or near retirement, and the associated risk that most investors will just not hold on to a strategy that experiences a large loss close to retirement, which we call “abandonment risk.”

The financial crisis also highlighted the importance of recognizing the relationship between the appropriate level of risk and wealth level. Retirement day is, in financial terms, the riskiest day of your investment life. This is true because you’ve built up wealth, and now you’re entering decumulation mode, over which your wealth must last 20, 30 years or more. So, risk and wealth should be inversely related in your investment strategy. As someone grows wealthier, his risk aversion generally increases, demanding a lower risk investment strategy.

Risk should not naively be related to age, per se. It does investors no good to reach their minimum risk posture at 90 years old, when they presumably have little or no money left. The time to reach your minimum risk posture in asset allocation is by the time you retire.

The 2008 crisis also emphasized the advantages of the “to” approaches in glide path design—approaches which reach their minimum risk exposure in terms of asset allocation by the time one reaches retirement. The financial crisis proved the validity of that strategy, as opposed to the “through” approaches, which tend to exhibit much more aggressive asset allocations at the retirement date.

A flatter glide path may help minimize variations in retirement wealth caused by the sequence of investment returns.



Source: American Century Investments Data through December 31, 2011

Glide paths are divided between Stocks (S&P 500) and Bonds (intermediate Government). Several glide paths are examined, and are denoted by their beginning (year 0) and ending (year 30) Stock allocation. For example, the “50-50” glide path is flat; it begins and ends with 50% Stock allocation. The “100-0” glide path is steeply sloped, beginning with 100% Stock allocation and ending with no Stock allocation. Volatility of retirement wealth outcome for each set measured as the standard deviation of year-to-year change in 30-year cumulative return. Returns are simply compounded over 30-year rolling windows. This test was done for the overlapping 30-year windows from 1926-2011. IMPORTANT: The projections regarding the likelihood of various investment glide paths are hypothetical in nature. This hypothetical situation contains assumptions that are intended for illustrative purposes only and are not representative of the performance of any security. There is no assurance similar results can be achieved, and this information should not be relied upon as a specific recommendation to buy or sell securities.