Plotting out a glide path is the most important part of designing a target-date fund — not only does it take members on a roughly 40-year investing journey, but it also has the most significant impact on their retirement outcomes.
Glide paths must also address the key risks facing defined contribution plan members, said Satwick Misra (pictured left), director of business development and relationship management at SLGI Asset Management Inc., during Benefits Canada’s 2023 DC Investment Forum in late September.
These include market volatility, sequence risk of beginning to draw on retirement savings at the wrong time in the market, the risk of inflation eroding savings and the possibility of outliving retirement savings.
“If you speak to any investment manager, they will tell you that constructing a target-date fund — and specifically constructing the glide path — is a bit of an art and a bit of a science. You can . . . tackle each of these risks independently and surgically, but the art is really bringing that together.”
Each investment manager has its own approach, he said, charting the equity allocations of five sample industry glide paths as examples. While they had similar starting points of between 90 per cent and 100 per cent equity, they take significantly different approaches to decreasing that equity over time, with the belly of the curve sitting at between more than 50 per cent equity to less than 30 per cent. While some glide paths decreased equity to the point of retirement and then maintained a consistent level throughout, others kept slowly decreasing the equity allocation throughout the retirement years.
When it comes to addressing the four retirement risks, managers stress test the glide path in a variety of ways, said Misra. They evaluate how well a glide path balances risk and return and whether it supports wealth accumulation. To address near retirement drawdown sequence risk, they stress test the last few years of the glide path’s portfolio performance against a range of worst-case scenarios.
In addition, a retirement readiness analysis assesses both contributions and investment returns to determine whether plan members will be able to maintain their standard of living into retirement. Managers also perform a resilience test to determine the likelihood of plan members outliving their assets.
Jason Zhang (pictured right), portfolio manager at SLGI, said the investment manager evaluates glide paths against a target income replacement ratio of 60 per cent. That ratio includes both a plan member’s withdrawals from their DC plan alongside the income they expect to receive from the Canada Pension Plan and old-age security programs.
Looking at the five sample glide paths, he noted the impact of a too-conservative equity allocation can be severe for plan members: the most conservative glide path gave plan members just a 27.6 per cent chance of meeting that target income replacement ratio, in comparison to the other four, which had a 43 per cent or higher likelihood. The glide path with the highest equity allocation before and during retirement gave plan members 60.5 per cent chance of being retirement ready.
Glide paths are frequently evolving to accommodate changing plan member realities, said Misra, noting SLGI has started tweaking its glide paths over the past few years to include higher equity content during retirement as people are living longer. “Also, if you think about it, once a member retires, their contributions stop. The only thing that is driving retirement income and growth within these portfolios is the investment return.”
Research by SLGI has found the belly of the equity curve — and the speed at which the equity allocation decreased over plan members’ working lives — were between 80 per cent and 90 per cent responsible for a plan member’s final asset base level. However, that doesn’t necessarily mean the best course of action is keeping equity levels much higher at the belly and landing point.
Managers must strike the right balance between wealth accumulation and controlling for risk, he said, as well as guarding against plan members overreacting to down years and pulling funds from their portfolio out of fear. “Certainly, we want [the landing equity] to be high, but not too high. So again, it’s about striking that right balance between a focus on growth versus controlling downside risk.”
One important aspect to mitigating that downside risk is diversifying the asset base in a target-date fund by adding real assets, said Zhang. In a correlation table comparing listed U.S. equities, listed real estate investment trusts and listed infrastructure to direct real estate and liquid alternatives, SLGI found low correlation between the listed assets and the direct real assets.
“You can really reap significant benefits when it comes to [direct assets’] correlation to traditional assets,” he said. “We believe these are important building blocks when it comes to portfolio construction, as they are dependent not totally on the same set of return drivers as [listed assets].”
However, he noted alternatives shouldn’t be a significant allocation within the portfolio, given the changing macroeconomic environment in comparison to the last 10 to 15 years.
Read more coverage of the 2023 DC Investment Forum.