Should Fixed Income Come First in Glide Path Discussions?

During a recent conversation with PLANADVISER, Joseph Flaherty, MFS chief investment risk officer and director of quantitative solutions, and Jessica Sclafani, defined contribution (DC) strategist, described the motivations behind their firm’s latest white paper.

The analysis is titled “Rethinking the Role of Fixed Income Along the Retirement Savings Journey: From Theory to Practice,” and it argues that target-date fund (TDF) risk profiles should align with evolving participant objectives along the retirement savings journey. As Sclafani and Flaherty explained, a big part of making this a reality will be doing a finer analysis of a TDF series’ fixed-income holdings.

With this in mind, Sclafani and Flaherty said, the MFS philosophy is to take an inverse approach relative to the normal way of discussing TDFs.

“A typical glide path illustration highlights the level of equity along the path, which reflects the defined contribution plan industry’s historical focus on the accumulation phase of the retirement savings journey,” Sclafani said. “To shine a spotlight on the fixed-income allocation within a glide path, we took the current glide path paradigm and turned it on its head. When viewed this way, we typically see an upward slope in the glide path as participants’ fixed-income exposure increases while the number of years until retirement declines.”

According to the MFS analysis, when “flipping the glide path” this way, it becomes much more apparent that there are wide dispersions in terms of any given TDF series’ fixed-income allocations at the start of the glide path—i.e., when participants are young and are just starting out. Indeed, the average fixed-income allocation for a participant invested in a 2050 target-date fund is approximately 9.1%; however, the minimum and maximum allocations range between 1.5% and 19.9%, respectively.

Flaherty noted that, while a larger fixed-income allocation in far-dated vintages might feel “conservative,” and therefore more comfortable for some sponsors, it can potentially inhibit participants’ ability to grow and compound their savings.

According to Sclafani and Flaherty, during the accumulation phase of the retirement savings journey, which includes participants in their early 20s through mid-40s, the most important objectives are to save as much as possible, maximize employer matching contributions and grow these savings through compounding investment returns. Accordingly, they argued, participants in this phase should have minimal fixed-income exposure and seek to maximize capital appreciation through the higher growth potential of equity and other higher-returning asset classes.

“With a long time horizon until retirement, these participants have time to recover from market downturns and can generally withstand the greater volatility associated with more risk exposure,” Flaherty said. “A higher allocation to equities in this phase can help build a larger retirement account balance, which can allow for participants to potentially take less risk later.”

After participants reach their mid-40s, Sclafani and Flaherty proposed, they enter what should be considered the “consolidation” phase, which is then followed by the decumulation phase at retirement. They said they often hear the argument that participants nearing and in retirement should continue to hold a significant allocation to return-seeking assets because they need a higher level of return for their savings to last through a longer lifespan. It is also commonly argued, they noted, that participants who have not saved enough must maintain a return-seeking posture, which implies that late-career and retired participants can invest their way out of suboptimal savings behavior.

“We believe that longevity risk can be managed in a number of different ways and that higher equity allocations are not necessarily the most effective way to accomplish this,” Sclafani said. “Furthermore, participants who have been unable to save enough are generally more financially fragile and have less ability to weather a market downturn, making a high-equity allocation late in the retirement savings journey potentially even less appropriate.”

After setting out this framework, the MFS analysis also explains the importance of carefully considering fixed income as the diverse and dynamic asset class that it is. Construction of the glide path should demarcate and define the relative roles of core bonds, global bonds, emerging market debt, high-yield bonds, short-term bonds and Treasury inflation-protected securities (TIPs), at the very least.

“While participants do not always have exposure to every building block and the relative size of the allocation depends on the participant’s position along the retirement savings journey, we feel that this diversified approach to fixed income exposure provides additional levers that can be employed to meet multiple objectives,” Flaherty said.