Risk is a central concept in investing, particularly for retirement solutions in DC pension plans. However, the analysis of risk is potentially complicated, as the tolerance levels of individual plan members can vary considerably.

Most, if not all, individual plan members share the basic factors influencing risk tolerance. Virtually all members want to accumulate a solid nest egg that will last through retirement and beyond their lifetime. Furthermore, almost all plan members are looking for a solution that will generate a level of income adequate for their desired lifestyle.

However, several variables come into play that can result in different levels of risk tolerance. Portfolio size is one: a larger pool of assets may require more protection and result in a lower risk appetite. Moreover, a plan member’s time horizon is often a main determining factor. A member in her 20s, for example, will likely have a much longer time period between now and retirement, as opposed to members in their peak-earning 40s or near-retirement 50s and 60s. Matching the right asset mix to a plan member’s time horizon and resultant risk tolerance level is essential.

There are additional factors impacting risk tolerance that can’t be as easily calculated. Sometimes the factors are psychological: a survey of investors indicates that most are generally bullish on equities but comparatively few are actually investing.

Another dimension in risk tolerance is preference and attitude. Two investors could be the same age but have radically different views on risk.

Plan sponsors can access many different investment solutions to account for such wide ranges of risk tolerance levels among members. Two of the most common types are balanced funds and target date funds (TDFs). Each may have the same goal in mind, but the journey there can be substantially different. For example, according to a Franklin Templeton Investments simulation, over a 40-year period, a group of balanced funds can generate wider variations in performance compared to their target date counterparts and can carry a notably higher risk level in the critical decade before retirement.

The principal way TDFs manage risk is through an asset allocation glide path, which changes in lockstep with an investor’s march toward retirement. The target date approach can be further refined by providing target risk options—for aggressive, moderate or conservative investors, for example—that can help create a retirement glide path with the optimal combination of portfolio longevity and risk management.

With a significant proportion of plan members in their 40s and 50s, the target date/target risk glide path is a timely solution to address the risk tolerance and risk preference levels of this important segment.

Thomas Nelson is director of quantitative research with Franklin Templeton Institutional.

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Copyright © 2020 Transcontinental Media G.P. This article first appeared in Benefits Canada.

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