Retirement Strategies

12/11/09 - To or Through: Issues in Glide Slope Design for Target Date Funds or Portfolios

By: Frank Armstrong III, CFP®, AIFA®

Target date funds or portfolios are supposed to be a fool proof solution to the employee’s retirement investment planning inside or outside of a 401(k). But the melt down of the equity market in 2008 exposed widespread misunderstanding by participants and opened debate over their appropriate design. While there are many issues surrounding target date schemes, a central concern is whether target dates should be designed to or through retirement date.

Many participants believed that on retirement date, their portfolio contained zero risk, and that they would be immune to market fluctuations. In other words, they assumed that their account would be frozen at the high water mark. They were outraged to find that their accounts had decreased in value at or close to retirement. Congress and the press took up their cry. A lively and emotional debate ensued.

The Through Retirement Approach to Glide Slope Design

In fact, most target date funds are designed to position the participant in a portfolio properly allocated to provide income and growth for the rest of the participant’s life. Such a portfolio might commonly range from 40-60% equities, and carry a proportionate market risk. Ideally, we believe that the retirement portfolio should be established well before the target retirement date.

Notwithstanding the fluctuations the portfolio will endure as a result of an allocation to equities, I strongly feel that this is the appropriate and prudent solution. The participant never outgrows his need for some stocks in his portfolio. Without a lifetime commitment to equities, participants must abandon hope of meeting any reasonable financial objectives. The trick is not to avoid risk, but to manage risk as effectively as possible while taking no more risk than they can financially and emotionally afford.

The overarching problem with America’s retirement system is not the temporary loss in value caused by a market decline. Rather the real problem is that Americans approach retirement with far too few financial resources. If you don’t have enough capital in the first place, you certainly don’t want to see it decrease just before retirement.

However, taking pre-retirees entirely out of the market for an extended period of perhaps two to five years prior to retirement to eliminate fluctuations will only make the problem worse. The remaining portion of the glide slope will of necessity have to be dramatically steeper. The end result is that far too much capital will be out of play for much of the accumulation period.

A zero risk solution is a zero real growth solution. To arbitrarily freeze the account at some point prior to retirement precludes growth during the freeze, imposing an unacceptable lost opportunity cost. The effective time for the account to be properly invested during the accumulation phase to meet the goals of the retiree will have been cut catastrophically short, most likely leaving the participant with far fewer resources than if he had remained invested in an appropriate asset allocation plan.

The 40-60% allocation to equities is within the range of reasonable allocations we would recommend to our private clients. If they adopt a sustainable withdrawal rate, a balanced portfolio split between equities and fixed income gives them the highest probability of achieving a lifetime income along with inflation protection.
In the case of a properly designed and diversified portfolio within the participant’s 401(k) account, the participant need only transfer the assets in kind to an IRA and he acquires a professionally designed retirement portfolio without the need to re-invest the proceeds.
Even if the account is temporarily depressed as it would have been at the end of 2008, the asset allocation meets the needs of retirees and offers the highest probability of recovery within a reasonable time after retirement.

The To Retirement Approach to Glide Slope Design

On the other side of this discussion a group maintains that participants should be subject to zero risk as they approach retirement. In their view retirement plans of millions of people were destroyed by the decline of 2008, and retirement should not be subject to the vagaries of the stock market. They long for the good old days of defined benefit pensions.

All this makes great populist rhetoric, but flies in the face of reality. Americans haven’t and don’t save enough. Cutting down their real return to zero for any part of their lives only makes the problem worse.

Because the zero risk rate of return almost exactly matches the inflation rate the math looks like this: At zero real rate of return an individual that desires to retire after thirty years and then consume his retirement nest egg over the next 30 years but maintain his pre-retirement lifestyle would have to save 50% of his before tax pre-retirement income! Given that most of us pay tax, must eat, have children to educate and would like an occasional vacation, that’s not a realistic savings goal. Only the equity markets offer potential real returns sufficient to accumulate enough funds to retire with a 10-15 percent savings goal.

In the event that a zero risk landing spot on the glide slope is selected, the participant will be out of the market for some period of time which might be from two to five years. Then he is forced to reinvest the proceeds at retirement. If he has any concern about maintaining buying power, more than likely he will select an asset allocation plan somewhere in the range of 40-60% equities anyway.

It shouldn’t come as a big surprise that the most vocal and well organized proponents of the zero risk approach are folks that sell fixed annuities, or guaranteed accounts. One organization of annuity and insurance products salespeople are attempting to position themselves as the only true fiduciaries in the retirement field.

The advertised peace of mind doesn’t come cheap. In return for the insurance company guarantee, the participant gives up all hope of achieving real return and compounds his problem of accumulation during his working career.

Summary

Given that most Americans refused to save enough to meet their retirement needs, and then didn’t invest efficiently, most won’t have enough at their normal retirement date. Until they change their wasteful ways, there is no perfect solution to this problem. We can all understand their aversion to watching their retirement accounts fluctuate, especially close to retirement. But, on balance, a zero risk position as a glide slope landing point only makes matters worse.

It goes without saying that whatever the solution adopted by the plan, participants should fully understand the implications. We all need to do a far better job of explaining how our solutions might work in a variety of economic situations.