The ability to “set it and forget it” has long made target date funds (TDFs) an appealing investment for defined contribution (DC) participants. They can leave it to investment professionals to manage allocations and dial down risk as retirement nears. It’s inherently a long-term strategy.
Yet 2020 highlighted another type of risk to TDF investors – the risk that severe volatility could prompt rash selling that crystallizes losses. Such was the case last March, when the spreading COVID-19 pandemic spooked markets. The 12% plunge on March 16 was the third-biggest percentage loss ever for the S&P 500 Index, eclipsed only by Black Monday in October 1987 and October 1929 near the start of the Great Depression.
This underscores why it is important for TDFs to be designed to instill confidence in participants. Here are our lessons from the pandemic and three ideas to help advisors and sponsors keep participants invested.
Lessons from the COVID-19 crisis
March 2020 reminded us that financial markets can do the seemingly impossible. Based on a normal distribution of returns, historical data suggests a single-day decline of 12% in the equity market should almost never happen – yet it did on 16 March. That’s why factoring in these extremely rare events is imperative for defined contribution (DC) advisors and sponsors when selecting investment options, particularly as they relate to the qualified default investment alternative (QDIA) option – typically a TDF – for those nearest to, or in, retirement. Figure 1 illustrates why this is so critical for participants, especially those with the most to lose. In the first quarter of 2020 alone, net outflows from TDFs in retirement or within five years from retirement totaled $11.9 billion, almost 15 times greater than the 2018 quarterly average, and in sharp contrast to the net inflows seen in 2019. We saw a similar theme play out in 2008.
Importantly, as indicated by the continued outflows in the near-retirement vintages during the second quarter and the third quarter of 2020, some participants were slow to re-enter the market. They missed out on a remarkable recovery, effectively “crystallizing” their losses.
Figure 1: Individuals closest to retirement withdrew the most
For participants about to retire, cashing out or trying to time the markets can have disastrous results. Figure 2 shows three hypothetical participants, all of whom had planned to retire at the end of 2020. While we do not know exactly how many near retirees ended the year with less than they started, we can assume the number is meaningful based on the accelerated withdrawals reported by Morningstar. As you can see, participant 1, who stayed invested, gained 11% during the period, whereas the other two participants – even the one who re-entered the market – retired with a loss during 2020.
Figure 2: Rash selling can be costly
Keeping participants invested
While the markets cannot be controlled, advisors and sponsors can help guide participant behavior in times of uncertainty and volatility.
Here are three ideas to help keep participants invested amid challenging market environments:
1. Diversification remains the first line of defense
Dissecting the level and type of risks along the entire glide path is essential to understanding the degree to which a glide path is diversified. Early on, when equity allocations are highest, equity exposures are calibrated by market capitalization (e.g., small cap), geography (e.g., U.S., non-U.S. and emerging markets) and by the degree of equity-like substitutes (e.g., high yield bonds, real estate investment trusts, etc.). In our view, the glide path allocation among risk-seeking assets should be focused on maximizing returns per unit of risk. While this emphasis should persist throughout the glide path, it is most critical for younger participants who are most heavily invested in risk-seeking assets. The relative performance of TDFs during the 2020 drawdown showed that advisors and sponsors should pay special attention to so-called “through” glide paths for older age cohorts given the meaningfully higher equity allocations at retirement relative to “to” providers.
Turning to fixed income, the most common allocation in the majority of glide paths is core bonds, or Bloomberg Barclays US Aggregate Bond Index (Agg) exposure. While glide paths may use other fixed income allocations such as Treasury Inflation-Protected Securities (TIPS) and high yield bonds, these allocations are typically so small that the average glide path yield essentially equals that of the Agg at 1%.Footnote1 Given that starting yields tend to be an accurate forecast of long-term expected returns, broadening fixed income diversification should not only help improve estimated risk-adjusted returns (Sharpe ratios), but also estimated returns, assuming such diversifiers can enhance the overall fixed income yield. For example, high yield currently offers roughly 3.3 percentage points of additional yield to core bonds (see Figure 3). We estimate well-diversified fixed income allocations in glide paths can enhance the yield of core bonds by anywhere from 0.5 to 1 percentage point in the current market environment. This added yield enhances estimated returns from fixed income and should further support improved participant outcomes. For more on our views, please see PIMCO’s December 2020 Asset Allocation Outlook, “Early Cycle Investing: Navigating the Growth Rebound.”
Figure 3: Active bond managers have out-yielded their passive peers
2. Active management can help cushion volatility and enhance risk management
Over a typical 40-year accumulation phase, a 1 percentage point boost to annual returns from the fixed income portion of a glide path can raise a participant’s balance at age 65 by $39,000 (a 7% improvement), resulting in seven additional years of expected retirement income.Footnote2
Of course, active management is accompanied by higher fees so considering the value proposition is essential. Ultimately, advisors and sponsors want to optimize participants’ fee dollars to active opportunities where enhanced returns are most likely to be achieved. We think a blend of active bonds and passive equities gives the best of both worlds, and this trend continues to gain momentum (see our Featured Solution from last year, “Blend Is the Trend”).
In response to the pandemic, yields across the globe have reached new lows. This creates a major headwind for income generation in DC plans. Fortunately, the track record of active managers out-yielding their respective benchmarks is strong and consistent. Figure 3 illustrates that for the top three bond categories in DC, roughly 90% of active bond managers meaningfully beat their benchmarks in yieldFootnote3 (represented by the blue portion of bars). Broadening the fixed income investment universe and employing active management may lead to a meaningful boost in income generation, and a greater number of participants achieving a successful retirement.
3. Strategic and tactical communication programs are essential to building participant confidence
While high quality and effective participant communications from sponsors are always needed, engagement is critical during uncertain and volatile periods. Here, we offer what we view as best practices for participant communications:
Building Resilient TDFs
There is a lot to reflect on from the past year. At PIMCO, we challenge ourselves to learn from market events and build a resilient TDF solution, one that gives participants the confidence to stay invested by offering a smoother ride into retirement. We hope these lessons and ideas help further your conversations about retirement investing as well.
The authors thank Erik Henrikson for his contributions to this paper.