While many glide paths are based on age, is there a case for adjusting these based on account balance fluctuations or on a plan member’s risk aversion?
When it comes to optimal outcomes for members, considering risk aversion may be the most important factor, according to a new paper out of the Australian National University and the University of Copenhagen.
Using a dynamic strategy that responds to how the pension balance evolves, in addition to age, can lead to modest improvements, the paper found. Yet, it noted the most significant improvements can be tied to considering risk aversion in glide-path construction.
The paper modelled an investor with a pre-determined salary making contributions from age 25 to 65, assuming the individual is only concerned with the balance of the fund at retirement. It found there could be substantial utility loss if an investor uses a target-date fund strategy that doesn’t correspond to their level of risk aversion.
“If you have a situation where you just design one fund with one glide path and offer it to everybody, it’s going to be right for some people and it’s going to be wrong for others, and I think that’s the way the industry has tended to go with the lifecycle,” says Geoffrey Warren, associate professor at the Australian National University’s College of Business and Economics and one of the paper’s co-authors. “Whereas, when you’re in the balanced fund space, the industry’s already worked out that there’s people with different risk tolerances, so they provide a suite of the products to them. You have the conservative fund you could buy or the high growth fund or whatever. So what we’re saying is, you should do the same in lifecycle, ideally.”
He notes this doesn’t tend to be done in the U.K., Australia or U.S., but is done in Denmark.
Offering a range of products wouldn’t be that difficult because the target-date fund is a mix of underlying funds, notes Warren. “It’s not like it’s a big new product design. It’s just changing the weighting mix.”
Ultimately, it’s about acknowledging that risk aversion is an important part of the equation, he says. “I think that’s the main message: that risk aversion is an important player here and the industry probably needs to think a bit more deeply about whether the lifecycle products are designed properly to cater to people with different risk aversions.”
The paper does acknowledge the potential limitations in applying its findings to real life because it didn’t account for all factors, such what happens before and after the point of retirement.
In Canada, most target-date funds are constructed based on age, but other models are in development that look at alternative ways to de-risk, says Zaheed Jiwani, principal at Eckler Ltd.
“There are some providers out there that offer target-date funds with risk-based glide paths, so typically you’d have three different glide paths,” he says. “You’d have the main glide path and then one that might be a little bit higher risk and one that might be a little bit lower risk. So the members, in those cases, would be traditionally defaulted to the main glide path, but if members would like to make their own choice they could choose a higher-risk glide path or a lower-risk glide path.”
These haven’t tended to be very popular with plan sponsors or members and overall, these products have generally not gained as many assets, he adds.
As such, some providers have moved away from offering risk-based glide paths. And, if plan members want a different choice than the single glide path, they can choose a different vintage, says Jiwani. For example, if a member feels they can take more risk they can choose a longer-dated vintage. “It would still follow a glide path and it would still de-risk over time, but it would be at a higher risk level than what their expected risk would be for the typical vintage of their age.”
Challenges also exist in determining an individual’s risk level, notes Jiwani. In the retail sector, people fill out a questionnaire to find out what level of risk they’re willing to take. The same approach used to be common in the defined contribution space, but plan sponsors are moving away from it because it raises questions about accuracy and it only measures a person’s appetite for risk rather than how much risk they should be taking, he says.
Another approach that’s currently in development in Canada is considering the account balance in the target-date equation and re-risking or de-risking.
“It will be interesting to see how much traction those funds get. The concept intuitively makes sense, but I think a lot of work would have to be done, far more than is being done today, from . . . plan sponsors and providers to really understand how these products have been built and what’s the algorithm that’s being constructed to risk up and risk down. On a simple level, you may understand the concept, but if you don’t fully understand how it’s built you might be exposing your plan members to additional risks that you really didn’t intend to.”