Are You an Average Investor?

Feeling old enough to worry about retirement, you have finally decided to check your 401k account to see how your money is invested.  You look at the investment options in your plan and they seem to be mostly mutual funds. Then you notice that there are a number of funds that look almost identical except that each one has a different date in the description. These funds most likely represent a target date suite, which offers multiple sleeves depending on the plan participant’s age. In other words, if you are interested in investing in a target date fund, you would pick one of those “sleeves” or “vintages” that would be suitable for you based on your expected retirement age. In many cases, if you are invested in one of these funds but don’t remember selecting it, the investment option may have been part of an auto-enrollment plan, where your plan sponsor has chosen a target date fund for you, as a default investment.

The “Date” in “Target Date”

Let’s assume you are 40 years old and you would like to retire around the time you turn 65, 25 years later. If it is 2020 now,  you would choose to invest in the fund with the 2045 date in its name because it coincides with your assumed retirement date (25 years later); hence the name “target date” fund. If you ended up in a target date fund through an auto-enrollment program, your employer checked your date of birth and most likely put you in the right sleeve. You should take a moment to double-check to make sure that is the case.

Risk Reduction

Saving for retirement is tricky business because people face different financial conditions, have different expectations, and more importantly, have different risk tolerances. The story is even more complicated when you consider that  the risk tolerance of an individual doesn’t always stay the same over time, often varying greatly from good times to turbulent times. In the midst of the financial crisis for example, when major financial institutions were on the brink of default, many investors were afraid to buy stocks (even though that may indeed have been a good time to buy), and in strongly up-trending markets in the maturity stage of a business cycle, many investors often feel much more courageous to invest in the riskier side of the markets (at a time when one might be prudent to be more cautious). Target date funds allow investors to “stay invested” across multiple market scenarios.

For every target date fund, there is an asset allocation methodology running in the background. This methodology is conventionally called a “glide path.” Glide paths are simply an expression of how risk should be reduced as plan participants age. Why does age matter? If you are 25 years old, the assumption is that you can take more risk because you have time on your side, therefore you should have more exposure to stocks (say, 90% or more of your portfolio) and less exposure to bonds. Even if the equity market drops 50% and it takes 12 years to recover from that loss, you can stay put and still have plenty of time to benefit from compounding effects of holding stocks over the long run. So, a strategic glide path is designed to move an investor from higher exposure to stocks to lower exposure to stocks over time. By the time you reach the age of 65, you will likely have an equity exposure that is roughly half of what you had when you were 25 years old, assuming you stick with the plan and never sell out of your target date fund.

Evolution

What is implied here is that most target date funds will appear riskier than a 60% equity and 40% bond portfolio (conventionally known as a balanced fund) for vintages that are far away from the retirement date. Conversely, most target date funds court less risk around the retirement date than the balanced funds do. Because target date funds more closely align with the actual ability for an investor to absorb risk based on their age, the industry overall has seen a natural evolution away from balanced and target risk funds as target date funds continue to gain popularity. If you hold the equity and bond split static throughout, then your glide path would not be gliding down, it would be simply flat.

A Balancing Act

Your required equity exposure at and around retirement is an important consideration and a component of glide path construction methodology. For example, your target date fund may allocate 45% to 55% to stocks right around your retirement. Why? Because the target date fund providers are attempting to optimize multiple retirement outcomes for you. Here are some questions that inform the glide path design:

1)     What if you live much longer than expected (longevity risk)

2)     What if inflation accelerates and erodes value of money (inflation risk)

3)     What if the equity markets crash before or during your retirement (market risk)

4)     What is the effect of your allocation schedule on the account value given potential market conditions (sequence of returns risk)?

All these assumptions are highly relevant to the design of a glide path and this is just the tip of the iceberg. Additionally, the provider makes a number of capital market assumptions. In simple terms, these assumptions are about long-term asset class risk/return forecasts. Depending on the time period analyzed, these forecasts can produce results with a wide dispersion. For example, the U.S. equity market returns since March 2009 looks very different than a 40-year average. When it is all said and done, all these assumptions lead to a strategic asset allocation methodology in the form of a glide path. The glide paths can differ from one another depending on those assumptions. The goal is the same though. Achieve an average investor’s retirement objectives.

Putting It All Together

If you think this is kind of complicated, you are not alone. Saving for retirement should be taken seriously and it makes a lot of sense to take charge and perform some due diligence on the investment options in your 401K plan. Understanding the glide path behind your target date fund will help you decide if “you” consider yourself an average investor as defined by your target date provider.