Financial Glidepaths Impact Your Retirement

Financial Glidepaths Impact Your Retirement

Contents:
Approaching the tarmac (retirement)
The TDF Alternative
Setting the GlidePath
Savings and Critical Masses of Assets
What About Financial Engineering?
Why Are Glidepaths So Important?
What About Risk Tolerance?
The Risk Zone
Risky Alternatives
To and Through Investment Strategies
Glidepath Investments
The Prudent Investor
Glidepaths for Retirees
What About Custom Glidepaths?
What About GlidePath Wealth Management?

The most frequent definition for “glidepath” is the trajectory of an aircraft when it is landing. This is the line aircraft follow as they descend from their peak altitude to a safe landing on a runway. 

Another frequent definition of glidepaths is a series of events or actions that produce a particular outcome. For example, “we are on a glidepath to success”.

There is also a definition for a “financial glidepath”. In this case it is the gradual reduction of your exposure to risk as you age or approach a particular date, for example the year you plan to retire. You may have 80% of your assets invested in equities when you are younger and 40% when you are older and your tolerance for risk is lower. How you get from 80% to 40% is your financial glidepath.

Glidepaths have become extraordinarily popular since 2007 when Target Date Funds (TDFs) became an option in 401k retirement plans. In just 12 short years more than $2 trillion has been invested in TDFs that use glide paths to gradually reduce risk as people approach their retirement dates. This amount is expected to increase to more than $7 trillion by the late 2020’s. The impetus for the inclusion of TDFs in 401k’s was the Pension Protection Act of 2006 that designated them as Qualified Default Investment Alternatives (QDIAs).

Airplane landing on a runway

Approaching the tarmac (retirement)

It is said, airplane landings are successful if you don’t crash. The same can be said for retirement savings. In this case, a smooth landing is retiring when you want to with enough money to live comfortably for the rest of your life. 

A crash would be a significant market decline close to your retirement date and 60% of your assets are invested in the stock market. A recent example is 2008 when the stock market crashed and trillions of dollars of net worth evaporated. What if your retirement date was 12/31/08? This could have forced you to make a devastating decision: Defer retirement, take a part-time job, reduce your standard of living.

 

The TDF Alternative

A TDF is a mutual fund that pools assets for investment, therefore every investor in that fund has the exact same experience even though they may have individual differences.

Some investors may be comfortable with the fund’s final year asset allocation (the glidepath), while others may find the allocation excessively risky.

There is no regulation that protects investors from excess risk in a TDF. It is the responsibility of investors to protect their own financial interests – that is the nature of a 401k plan. If you believe the allocation of your TDF is too risky you can opt out of the fund and move the assets to a more conservative alternative.

Unlike airplanes, securities market crashes, based on global business cycles, are inevitable. The only question is when they occur. Everyone in the financial service industry knows that, but they don’t like to talk about it. It would be the equivalent of boarding a plane and being greeted by a person who talked about the probability of your plane crashing.

How Should I Allocate My Assets?

 

Setting the GlidePath

As the name implies a Target Date Fund is a mutual fund that has a glidepath to a certain destination – in this case the year you plan to retire. For example, you are 40 years old, it is 2030, and you plan to retire in 25 years so you invest in the XYZ 2055 TDF. The investment convention for most TDFs is to land in June of the indicated year. 

You might think a safe landing would be mandatory, but this is not the case. The average TDF lost 30% in 2008, and many glidepaths have become riskier since then. 

You might say you are entering a risk zone a few years before and after you retire. Your assets are their highest level, which makes you more vulnerable. You plan to retire in a particular year. You have no control over the performance of the securities markets immediately before, during, or after you enter your personal risk zone. The more dependent you are on the assets the less risk you can afford to take.   

The following chart shows examples of various glidepaths. All start in the same place, with high equity exposure for younger investors, but there is a wide range of end points. They all “land’ differently, that is to say they all have different exposures to equities at the target date.

Savings and Critical Masses of Assets

There is significant disagreement about performance versus safety at or near target dates. Most TDF providers believe performance is more important than safety because investors have not saved enough. People need to earn higher returns to compensate for inadequate savings.

Inadequate savings is true for a lot of people. However, these same people are more dependent on the assets in the TDF so they should be more risk averse.

One theory about inadequate savings is it is behavioral and cannot be solved by striving for growth with a risky portfolio. Investors need to be educated about the importance of savings as early as possible in their lives. When they save more, they achieve a critical mass of assets sooner and that is the best way to accelerate the growth of their assets. For example, a 10% return on $100,000 of assets produces $10,000. A 10% return on $500,000 produces $50,000. People can accumulate assets faster after they achieve critical mass.

Low savings rates increase dependence on assets that are being accumulated for retirement. This dependence reduces the risk tolerance of these people. Therefore, most TDFs should land safely with substantially reduced risk exposure.  

This is not a popular solution, but it is a harsh reality. People should not increase their exposure to risk due to low savings rates. They will have to adjust their lifestyles to their available assets. They cannot afford catastrophic losses near their retirement years.

 

What About Financial Engineering?

Financial engineering is the process that is used to assign various asset allocations to an investor’s time to a target date. There are two types of financial engineering. Both assign aggressive asset mixes to younger investors based on the theory they have more time to recover from big market declines. This aggressive asset mix declines over time as people age and approach their retirement dates. Conventional wisdom says the closer they get to their retirement dates the less recovery time they have.

The “Ibbotson Approach” combines human capital (their ability to earn money and save portions of it) with Investment Capital (investment earnings). The objective of this approach is to maintain constant total risk through time. As the production of Human Capital decreases as people near retirement, the production of Investment Capital increases as a portion of total Capital available for retirement. This is compatible with the critical mass (Investment Capital) theory described earlier.

The patented “Surz Approach” (U.S. Patent 8352349; January 8, 2013; patents.uspto.gov) combines two Nobel Prize winning theories with several precepts of modern finance, like liability-driven investing (LDI). The objective is to not lose money immediately before or after people reach their target dates.

 

Why Are Glidepaths So Important?

A TDF’s glidepath is the primary driver of the fund’s performance because asset allocation has the greatest impact on investment returns. It is the equivalent of being in the right place at the right time with your investments. For example, the stock market is producing positive returns and a significant percentage of your assets are invested in the stocks.

Understanding a TDF’s glidepath is essential to establishing goals, understanding exposure to risk, and evaluating investment results.

 

What About Risk Tolerance?

You have your own unique goals, circumstances, and concerns, so be wary of one-size-fits-all  glidepaths. Everyone in a TDF is invested the same regardless of any differences that may exist.  

A recent MassMutual Retirement Savings Risk Study examined risk preferences in 401(k) plans and found 85% prefer safety over growth as they near retirement. They want to be protected. By contrast, most young participants prefer growth for three reasons. They have longer investment horizons before they need the assets. They have more time to recover from a bad year or two. And, they expect to be rewarded for their higher exposure to risk.

Consultants agree. Pacific Investment Management Company (PIMCO) conducted a survey entitled the “2018 12th Annual DC Consulting Support & Trends Survey”, in which consultants report that they would not want to see people near retirement lose more than 10% of their assets, whereas 40% losses would be tolerable for younger people with higher risk tolerances and longer investment horizons.

 

The Risk Zone

The preference for safety near retirement has a lot to do with a special kind of risk that is present in the five years before and after retirement when savings are at their peak.

Losses during this Risk Zone can devastate lifestyles even if markets recover some years later. Using an extreme example, let’s assume you have $1,000,000 in your 401k and it declines in value to $500,000. You have experienced a 50% loss. Because you have a reduced asset base you need a 100% rate return to get back to the $1,000,000. And, this percentage does not account for distributions, inflation, or investment expenses. 

Out of Sequence: Is Sequence of Return Risk For Real?

Risky Alternatives

One TDF provider says people can afford to take more risk in the “Zone” if they take more risk in the years before they enter the Zone – for example, 5 years before and after retirement. That is not true if the people planned their retirements based on the amounts of assets they have before they entered their personal risk Zones.

The only exception would be people who have accumulated so much retirement money, that even if their account balances took a big hit while they were in the Zone there is no risk they will run out of money in their lifetimes. 

It stands to reason, when people get close to retirement, the prudent thing to do is to lock in the values by reducing their exposure to risk. 

  

To and Through Investment Strategies

The Department of Labor advises people to begin their TDF decision making by deciding if they want a “To” fund or a “Through” fund. This is not very good advice. The words “To” and “Through” were coined at the June 2009 joint SEC & DOL hearings on Target Date Funds, when they examined the devastating losses of 2010 Funds in 2008.

The fund companies that testified at the hearings explained they take substantial risk at the target date because their glidepaths serve “Through” the retirement target date to death. This is in contrast to funds called “To” funds that end at the target date. The clear implication is that “To” funds are far less risky at the target date than “Through” funds, but this is not always true.

The common belief is that “To” funds hold less equity at the target date because they end there, as shown in this graph.  But the fact is that some “To” funds are riskier than many “Through” funds as shown in the graph below.

Glidepath Investments

Most glidepaths are comprised primarily of US stocks and bonds, even though there’s general recognition that increased diversification produces better returns over longer time periods. More sophisticated glidepaths are global and include real estate and commodities..

Some glidepaths are more prudent than others because they are more diversified in non-correlated asset classes.

What is Your Investment Strategy?

The Prudent Investor

A prudent glidepath TDF will invest in a global portfolio that maximizes diversification to reduce the risk of large losses. The TDF will also charge lower fees to increase investors’ net returns. 

Consequently, during some market conditions more aggressive TDFs will perform better than more conservative TDFs. During volatile periods and down markets the more conservative TDFs should outperform the more aggressive TDFs.

More prudent investors will put more emphasis on lower risk investment strategies.

 

Glidepaths for Retirees

Until recently, most of the focus on glidepaths, has been on the retirement date. That has been replaced by new strategies that are designed to manage longevity risk.

Increasing numbers of people are concerned about outliving their assets, in particular if one or both spouses require assisted living, skilled nursing, or memory care.

This concern is exacerbated by the 78 million baby boomers (1946-1964) who are entering their retirement years. Increasing numbers of boomers will live to be 100, which means their number of retirement years will rival their number of working years.

Most glidepaths during retirement average about 45% in equities, but recent groundbreaking research has identified an optimal glidepath that is substantially different. Dr. Wade Pfau and Michael Kitces have documented an optimal path that starts in the risk zone, with less than 20% in equities, and gradually increases this exposure to 50% equities over a 30 year time period. This creates a U-shaped glidepath when you combine working and retirement years. This U shape is not widely accepted and may be counter-intuitive, but more people will adopt it when they consider investment risk and rewards.

What About Custom Glidepaths?

The one-size-fits-all TDF is a mutual fund that has some serious deficiencies. There are superior alternatives that you should be aware of.

There are “Custom 401k TDFs” that purport to provide a glidepath that is based on the demographics of a company’s workforce. There are two problems with this approach. The result is still one-size-fits-all, and the best you can do with a diverse group is design for the “average” participant, whatever that may mean. A simpler, and more sensible, approach would be to recognize that there is one demographic that all defaulted participants have in common: They do not want to make any financial decisions. This demographic argues for safety over growth to protect investors who prefer a default alternative versus a more educated alternative.

Another approach is the “Hybrid TDFs” that move older investors off the glidepath and into a “managed account” where each investor receives personalized guidance. This approach would work if the personalized guidance were provided by a human advisor, but it is usually provided by an algorithm that generally doesn’t work well for less sophisticated investors.

The latest approach is to provide personalized Target Date Portfolios (TDPs) for each investor that are based on the investors’ goals, concerns, and tolerances for risk. This level of service requires each investor to have his or her own TDP. This service can also be used for asset inside or outside 401ks – for example, IRAs, rollovers, and personal accounts.

 

What About Glidepath Wealth Management

Glidepaths are an integral part of the GWM investment process that is used to manage assets that have a variety of purposes and general or specific target dates. For example, you may be accumulating assets to:

  •       Buy a second home in 2030
  •       Send a child to college in 2035
  •       Retire in 2050
  •       Live a secure, comfortable retirement to 2085

Most assets are being accumulated and preserved for a purpose and this purpose has a target date that is usually based on a financial plan. Smooth landings are paramount if you want to achieve your financial goals.

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