Another Aspect of Market Risk

Timing is everything, as the old saying goes, and that is especially true when timing retirement. In fact, although saving and investing for retirement is a long-term plan, the returns your portfolio receives in the last few years leading up to retirement can dramatically influence your portfolio and therefore replacement ratio. Alison Cooke Mintzer, Editor-in-Chief of PLANADVISER, spoke with Rich Weiss, Senior Vice President and Senior Portfolio Manager for the asset-allocation strategies at American Century Investments®, about the need to evaluate and consider sequence of returns risk when reviewing target-date funds (TDFs).

PA: What role do you see target-date funds playing in a retirement plan?

Weiss: A central role. Target-date funds have become the default vehicle in many if not most defined contribution (DC) plans, and for good reason. They offer prudent diversification and lifecycle investing. They are a critical part of a retirement plan no matter what the level of participant sophistication.

The participant’s level of investment sophistication, how their assets are split, how well or poorly they’ve saved over the years and therefore need to withdraw in retirement—these are all elements to help decide what type of asset allocations are appropriate. In a participant’s retirement plan, target-date funds could be the sole vehicle for investing. On the other hand, it could just be a small portion, depending on the participant’s other assets or inheritances, et cetera.

PA: What are the participant behaviors that are most beneficial to investing in target-date funds?

Weiss: The ideal behaviors that would be most beneficial are those that line up with the assumptions made in target-date funds or lifecycle investing in general, which are early and consistent contributions to your savings—in whatever plan you’re participating—and the “buy and hold” mentality, a “stick-to-itiveness.” Those are the behaviors that would be the most beneficial to investing in general, and it applies to target-date funds as well. Because target-date funds do have a process of de-risking in their asset allocation systematically over a lifetime, the best behavior would be one that allows the target-date fund to do what it was intended to do and to not second-guess it.

PA: How does a plan sponsor or adviser decide what target-date fund suite is right for a particular plan? What are those determinants?

Weiss: There are two main groups of determinants: those that are plan specific and those that are target-date fund specific. On the former, we’re talking about the demographics and characteristics of the participants in the plan themselves. Do they have a defined benefit (DB) plan? Are they professionals? Are they well-saved in general or high-income earning? Are their earnings variable or are they fairly steady and secure?

On the other hand, you have to match that information as best you can with the target-date fund specifics, and we compete on a number of different levels: glide path, fees, whether we’re active or passive or do tactical asset allocation, et cetera. No target-date fund is going to be able to address each and every individual participant’s needs, but you hope that you hit the broadest range of participants appropriately.

PA: What relationship does a glide path have on the potential fund return?

Weiss: The glide path design is probably the most critical element of a target-date fund. At least in theory, target-date funds are meant for the entire lifecycle. The glide path is the process of de-risking over a lifetime—presumably both through the accumulation phase and the decumulation or retirement phase. It is the main driver of the potential fund’s return.

Most target-date fund providers started only within the last decade. Even the longest-standing target-date fund providers go back less than 20 years, so it’s a fairly new concept.

The explosive growth in assets belies how new these strategies are, and unfortunately there’s not a lot of real-time data to use. There are new metrics coming out and a whole new language dealing with longevity risk, inflation risk, market risk, et cetera. We as an industry are now wrestling with how to best measure the success of different target-date fund providers and how they best match to different plans out there because it’s not just who gets the highest return for the lowest risk. It’s a lot more than that when you’re talking about investing for years if not decades at a time.

PA: Why is the sequence of returns in a target-date fund so important? What is this sequence of return risk and what do people need to know about it?

Weiss: There is more talk about the other risks in target-date fund investing: longevity risk, the risk of outliving your money; market risk, the risk that you have too much risk and you run out of money; and inflation risk, which is key to retirees. But a significant and major risk that is much less talked about is sequence of returns risk, otherwise known as path dependency.

It’s sort of the Rodney Dangerfield of risks because it doesn’t get much respect relative to the others. What it refers to is that, effectively, the sequence of returns that you personally experience are not necessarily the same that other participants in the plan—other people you work with—will experience because you start and retire at different times.

There are some well-known exhibits. We recently published a white paper that shows how well you would have done if you invested in the stock market over the last 30 years. But if you simply reverse the order in which you receive the monthly returns of the stock market, not changing the average return, there was a drastic difference in your wealth accumulation.

At the core of sequence of returns risk, if you have a bull market early on in your investing series, that’s good. But it’s not as good as if you have a bull market near your retirement when you’ve already built up most of your wealth. Similarly, if you have a bear market early on in your investing career, it hurts, but it doesn’t hurt nearly as much as if you hit the bear market when you are about to retire or in retirement, because that’s when you have your largest wealth bucket built up and the longest amount of time over which it has to cover your expenses. 

The exact sequence of your returns matters significantly and can alter your ending wealth ten-fold just because of whether you’re lucky or unlucky enough in how you personally experience the markets in your investing career. It’s a key risk for a target-date fund provider such as American Century because nobody can eliminate that risk. Nobody can forecast the market over 30 or 50 years, nor can you design a set of funds that ensures that there’s no variability from investor to investor. But there is a way when you’re designing a target-date fund to minimize the variability of outcomes across participants and across market environments.

You can’t eliminate it, but you can do your best to minimize the variability, and therefore ensure that most of your participants or employees retire successfully. That doesn’t necessarily mean you have the investors with the highest amount of money at retirement, but that the largest percentage of your employees will retire successfully.

The way to control sequence of returns risk is to, all else equal, have a flatter glide path—simply meaning that you don’t start very, very aggressive in equities or other risky assets and end with very, very little in your portfolio. The slope of your glide path, how much you change risk over your lifetime, has a definitive relationship with sequence of returns risk, and the flatter the better. The less variation the better.

That’s why the One Choice Portfolios from American Century Investments are one of the flattest, that is our variation. Risk is there, but it is definitely muted relative to the competition.

If you have a very steep glide path, if you start out at 100% in equities and then over your lifetime wind the equity exposure down to zero, by the time you retire with that kind of investment plan or glide path you really need the bull markets to hit early on when you have a heavy equity exposure. Having a bull market at retirement when you have 0% in equities does you no good. You’re much more dependent on the sequence of returns the steeper your glide path.

The flatness or steepness of the glide path has a direct relationship to sequence of returns risk, which is a key but sometimes unsung hero in target-date fund comparisons.

PA: How do plan sponsors and plan advisers then judge which funds will most benefit a set demographic of participants?

Weiss: You want to match your demographics as best you can to a target-date fund series, whether it’s very aggressive or relatively conservative, or whether it’s targeted to a very specific participant set, which may be the case for some plans and some companies.

If you think of a marathon, our goal with American Century’s One Choice Target Date Portfolios is not to have one person who finishes the fastest, which in this analogy would be the participant who has the most money at retirement. Our goal is to have the most people in the race cross the finish line, and they may on average be at a slower speed. 

PA: What if participant behavior differs from what’s expected?

Weiss: It’s great to have a target-date fund methodology that is theoretically correct and looks good on paper, but like communism, looking good on paper doesn’t necessarily help you in the real world.

The whole notion of behavioral finance was taken in to account, I’m proud to say, in the design of American Century’s product because two things are key behaviors that differ from what is theoretically expected in investing. One is that investors don’t necessarily hang on to riskier investments; they tend to abandon strategies which are too risky—generally at the exact wrong time. For example, in 2008 many sold out only to later go back in after the market recouped a good portion of its fall.

The whole notion of investor abandonment is well-documented in the academic literature. That’s a real world issue that providers need to take into account because the riskier your path of returns, the riskier your ride, the more abandonment you will show in your returns. Again, there have been studies done on this in the real world, too.

A mutual fund may report to return 10% over the last five years, but investors on average only received 7.5% of it. Why is that? Because they generally sold out at the bottoms and took time to get back in, and so the difference is the abandonment rate—that hair-cutter cost for people getting scared and bailing out of volatile strategies. It’s well-documented. In a target-date fund it’s important to focus as much, if not more, on risk control and volatility control than it is on return expectations because of that fact.

Then second, and just as importantly I think, the data shows that most participants do not stay in target-date funds post-retirement or very long post-retirement. They don’t stick with it. They take their money out of the plan, and they go elsewhere with it or have it customized or use an adviser or what have you, and so it’s important to recognize as a target-date fund provider that you cannot demand that the investor stick with it throughout the entire retirement phase. This speaks to the old “to” versus “through” dichotomy, the two types of glide path approaches. We’re firmly in the to approach as opposed to the through approach.

The through approaches are the ones that continue to de-risk and change their asset allocation post-retirement, and so in order to reap the full benefits of those approaches you need to stay in them until you’re 80, 90 years old, until the end of the lifecycle. Whereas a to approach does not demand an investor stick with it to receive the full benefits of the approach. It’s just a more realistic way of designing a target-date fund series. We believe we’ve captured that.

Note: A target-date is the approximate year when investors plan to retire or start withdrawing their money. The investment’s principal value is not guaranteed at any time, including at the target date. Each target-date portfolio seeks the highest total return consistent with its asset mix, which is adjusted to be more conservative over time. In general, as the target year approaches, the portfolio’s allocation becomes more conservative by decreasing the allocation to stocks and increasing the allocation to bonds and money market instruments.

You should consider the fund’s investment objectives, risks, charges and expenses carefully before you invest. The fund’s prospectus or summary prospectus, which can be obtained by visiting americancentury.com, contains this and other information about the fund, and should be read carefully before investing.

Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.

American Century Investment Services, Inc., Distributor. © 2013 American Century Propriety Holdings, Inc. All rights reserved.