Target date products (funds or automated portfolios) automatically reduce the exposure to equity and other risky assets of a DC member’s invested savings as he/she approaches retirement. But is this reduction in risk good for everyone?
Differences in current glide paths
Canadian target date glide paths tend to look alike. In fact, most stay within a +/-10% corridor around the median path, which starts from roughly 85% invested in equity when members are still far away from retirement (about 35 years) to 30% at retirement. Glide paths ending at the high end of this range are sometimes referred as having a “through retirement” approach.
Interestingly, even newer target date fund suites, based on complex methodologies and the latest research, present very similar paths (although with more sophisticated diversification in asset classes).
Some target date products can offer glide paths personalized to members’ risk tolerance—conservative, moderate or aggressive. A conservative glide path would hold about 10% less equity than a moderate one and an aggressive one would have about 10% more throughout the whole accumulation period.
In this case, members can usually determine their risk tolerance through a short questionnaire—generally the same used to help members choose the right asset allocation (in my opinion, this method is ill advised for target date funds as these questionnaires do not ask the right questions. But that’s another story for another day).
But is risk tolerance the best way to personalize a glide path? Does this approach provide sufficient immunization against the risks faced by a member getting close the converting savings into income?
A different approach
When a DC plan member retires, a number of retirement income options are available. Let’s focus on just a few.
Life income funds (LIFs) or registered retirement income funds (RRIFs)
With these vehicles, members need to continue to manage their investments and pay themselves a pension.
Under this scenario, someone retiring at age 65 would likely need to include some fairly dynamic investments in their immediate post-retirement portfolio to provide inflation and longevity risk protection.
Let’s assume a reasonable equity (or risky asset) exposure in this case is around 60% and the member is making withdrawals from the fixed income portion of the portfolio. Since even the most aggressive target date glide paths are down to roughly 40% in equity at maturity, the member would retire with his/her assets severely underinvested in equities.
Reducing the risky portion of that member’s portfolio prematurely would mean they are under-exposed to a potentially better-returning asset classes for a number of years prior to retirement and having to re-enter these asset classes at potentially the wrong time marketwise.
A glide path leading to a 60% equity exposure would be more reasonable and more likely to better support members’ transition from accumulation to spend-down when converting to LIFs and RRIFs.
This is where the member, upon retirement, needs to immediately cash in his/her investments to purchase an annuity with a life insurance company.
As life annuity prices are closely tied to long-term bond returns, it would seem logical that a member planning to convert to a life annuity transitions his/her DC plan assets to long-term bonds.
Yet the most conservative target glide paths still leave about 25% equity content in members’ portfolio (the fixed income portion including little or no long-term bonds).
A better solution here would be a glide path that leads almost exclusively to long-term bonds over the last 15 years of the accumulation phase. This is much like what DB plan sponsors are now doing through popular de-risking strategies. If this is good for DB plans, would it not make sense for DC members looking to annuitize?
Guaranteed minimum withdrawal benefit
These products have somewhat gone out of style, but the same reasoning could be applied to them: as DC providers guarantee the member a minimum income level based on past maximum attained savings values, there is no downside investment risk for members. In this case, the glide path should remain very aggressive right to retirement (note however that the insurance company offering the product might not allow this)—again, far from what current target date glide paths are doing.
More tweaks needed
Obviously, a strong underlying assumption here is that members would be able to decide early on what retirement income vehicles they would be using.
Since DC members tend to get more engaged about 15 years prior to retirement, the glide path could in fact be the same for every member, remaining at roughly 80% equity, which is how many European target date products are designed.
At that point, 15 years from retirement, with the right tools and education, members could determine how to split their savings into the various options offered. For example, 70% in life annuity category and 30% in the LIF or RRIF category, as required.
This new approach is in no way perfect and needs more refining. But it does hold promise, in that it would provide DC members with investment options that might better match a number of spend-down strategies.