Taking a risk-based approach to evaluating target-date funds

Target-date funds seek to provide members of defined contribution pension plans with a straightforward experience, adjusting their asset mix in a set-it-and-forget-it option geared towards achieving acceptable retirement outcomes.

But the target-date fund world is diverse. There are differing features, including active and passive underlying funds, glide paths that go to or through a retirement date, tactical overlays and hybrid target-risk/target-date offerings. Even the underlying asset classes can vary dramatically by provider, with some including traditional equities and bonds, while others provide alternatives through either listed or direct offerings.

How can plan sponsors objectively assess the merits of a glide path and its affect on plan members? The once-popular method of comparing funds based on their equity percentage method doesn’t do justice to what really matters to plan members: retirement outcomes.

Read: More pension plans using target-date funds as default option

An objective way to compare the glide paths of target-date funds is to evaluate them in terms of the expectations for risk-adjusted returns. Using forward-looking asset class assumptions, it’s possible to review each point along a glide path and assign its own expected return and volatility. However, it’s important not to evaluate the two factors in isolation. Just looking at the expected return ignores the volatility a plan member might experience to achieve a certain return. Too much risk may bring large swings in account values and a greater probability of investment outcomes below expectations. And looking only at expected risk may ignore the level of return required for plan members to meet their retirement objectives.

It’s essential to consider risk and returns together for a number of reasons. First, higher volatility introduces a wider range of adverse investment outcomes. At the same time, large negative losses are more difficult to recuperate, since a 20 per cent loss is not equivalent to a subsequent 20 per cent gain. In addition, plan members would be more comfortable with a stable path to retirement therefore more likely to remain invested.

To illustrate the differences that can arise, we conducted an analysis of two types of glide paths. The traditional glide path includes only equities and fixed-income investments. The alternative glide path includes equities, fixed income, private debt, direct real estate and direct infrastructure, resulting in a more diversified target-date fund.

Read: The finer points of customizing target-date funds

Figure 1 plots the two hypothetical glide paths by expected risk and return. If we compare the 2055 funds, we see both glide paths have a similar expected return. More important is the different volatility required to achieve the expected return. For the 2055 fund, the traditional path has 40 per cent higher volatility than the alternative one.  

As Figure 1 illustrates, not all target-date funds are the same. They can vary dramatically in terms of how much risk is present in the glide path, a direct consequence of the underlying composition of the fund.

To take the analysis one step further, we can translate the expected results for risk and return into the retirement outcomes each fund could achieve for plan members.

In a best-case scenario, where we have 40 years of strong equity markets, a large percentage of members are likely to achieve their retirement objectives, regardless of the type of target-date fund they’ve invested in. But that best-case investment environment isn’t the scenario that’s keeping plan sponsors up at night.

Read: Comparing a ‘to’ and ‘through’ approach to target-date funds

Plan sponsors look more to median and worst-case scenarios as they can have an impact on plan members’ ability to retire on time and maintain their desired lifestyle in retirement. In those scenarios, a lower overall portfolio risk driven by diversification away from equities will provide better potential retirement outcomes for plan members. An approach with lower variability will come closer to objectives across more potential investment environments.

In evaluating target-date fund options, plan sponsors may wish to consider comparing funds and the variability of outcomes for plan members. Looking under the hood at the composition of target-date funds from the perspective of risk-adjusted returns provides an objective way to compare how they ultimately affect retirement outcomes.