Target Date Funds (TDFs) have transformed retirement investing, but the static approach to the glidepath leaves many investors at risk. A more dynamic strategy is needed, and Glenn Dial says it all begins with defining what dynamic investing actually is.
TDFs: Better Outcomes, but Still Not Good Enough
Ever since 401(k) plans and their defined contribution peers, such as 403(b) and 457 plans, began to dominate the retirement plan landscape, the single biggest product advancement has been the launch of target date fund (TDFs) in 1993. These funds took the guesswork out of self-directed asset allocation by employees, which too often leads to a wildly inappropriate mix of investment choices and risk profiles.
A suitable allocation mix is based on sound reasoning—rooted in modern portfolio theory—of how an investor should be positioned among stocks and bonds during the various phases of life leading up to retirement. This asset mix, however, relies heavily on actuarial assumptions without managing for other critical factors such as market performance.
As employees transition from the investing phase to the spending phase of their retirement journey, TDFs with high equity exposure could leave employees vulnerable to too much risk. For those unfortunate employees who retire at a time of market stress, this could lead to significantly lower account balances at retirement. This outcome forces employees to choose between lower income throughout retirement or remaining in the workforce longer than anticipated.
Approaches to TDF Glidepath Implementation
Early entrants into the TDF market relied exclusively on diversification to mitigate against risk, and for many decades diversification was an effective enough tool. The idea that diversification alone can enhance returns and lower risk, however, hasn’t played out as planned. In times of market stress, asset classes once thought to be complementary have shown much closer correlations than in the past as stocks, bonds and even many alternatives such as real estate moved in lock-step direction on changing economic conditions.
The realities of retirement investing have changed, and with them the strategies on how to maximize return and minimize risk. TDFs have responded to meet these realities, evolving from a static glidepath approach to ones that incorporate a greater degree of flexibility. Here’s a closer look at three main strategies used in managing the glidepath:
Static – The first generation of TDFs was simplicity at its best: Establish a predetermined glidepath in which the asset mix would steadily and automatically shift from being predominantly equities to being more heavily weighted to fixed income the closer an employee got to retirement. Using this approach, employee asset allocations would be calculated and locked-in over 40 years in advance of retirement age.
Tactical – While a static glidepath seeks to provide the appropriate asset mix at any given point in time, the asset allocation never takes into account market conditions. An element of flexibility is needed and a tactical approach can deviate by 5-10% in either direction of the glidepath. However, these minimum bets are rarely meaningful enough to increase the reliability of achieving retirement income goals.
Dynamic – Starting with the idea of being tactical but adding much more flexibility to the glidepath is a dynamic approach. With the ability to deviate meaningfully from the strategic asset allocation, a dynamic approach has the potential to more fully participate in rising markets while preserving principal to a greater during periods of volatility. The ultimate goal is to significantly improve retirement outcomes by making the glidepath much more actionable.
Dynamic Means Decisive Action