A problem with target-date funds (TDFs) that was exposed during the Great Recession is their high exposure to equities. This can cause serious problems for near-retirees and retirees during periods of high volatility and market drops. Any losses are very real to those closest to retirement, and the drops can be painful.

“TDFs with higher equity exposure for older investors subject participants to deeper losses,” a recent PGIM Investments report says. “Because older participants sell out of their TDFs during market declines, these are not just paper losses. The deeper the loss, the more difficult the recovery, and the more imperiled the retirement outcome.”

Nonetheless, two researchers say they are confident that the glide path of age-appropriate TDFs can successfully automatically navigate investors through volatility and downturns, such as the latest one that occurred in March 2020, at the outset of the COVID-19 pandemic. Those who pulled their money out as the market plummeted took on steep losses, and many of these investors were reluctant to go back into the market, even as it has climbed to new highs.

The PGIM report lays out two hypothetical scenarios: one for a participant invested in a high-equity fund and one invested in a low-equity fund. It assumes that they remain invested in their TDFs and that the high-equity fund has a higher annual return throughout retirement than the low-equity fund (4% vs. 3.75%). It also assumes that both participants were forced into retirement after the COVID-19 decline and began taking annual retirement distributions. If both participants had the same annual income in retirement, according to the analysis, the high-equity fund participant would run out of savings two years early, despite a higher rate of return in retirement.

Christine Benz, director of personal finance at Morningstar, says she believes that if a plan sponsor relies on the expertise of a retirement plan adviser to communicate to participants the importance of remaining invested in an appropriate equity allocation fund, those participants—including near-retirees with the largest balances and the most to lose—are more likely to remain invested in their TDFs and reap the benefits.

“Research that Morningstar did last year found that older adults in professionally managed funds, as well as in TDFs, sold out” as the COVID-19 pandemic broke out across the nation, Benz tells PLANSPONSOR. Older investors in such professionally managed accounts, much more so than younger investors, were the most inclined to sell their holdings, Benz said.

“The issue is a communications challenge,” Benz says. People need to understand most TDFs have a “through-retirement” glide path, she says, explaining that they are not intended to be perfectly safe when someone approaches retirement. Instead, a “through-retirement” glide path focuses on maintaining an adequate income stream throughout retirement and reducing shortfall risk.

The question of whether and how much retirees in TDFs with high equity exposures are impacted when there is sharp volatility and downturns is also somewhat moot, Benz continues.

“When a person retires, they tend to move their assets [out of the TDFs] to some other account and spend them down at some reasonable rate,” she says. “Sure, they have some failures. They are not foolproof.” There are, certainly, problematic areas, she adds, such as overexposure in various market sectors. However, they also offer many benefits, such as the ability for an investor to consolidate their assets in one fund.

Ashley Dimayorca, vice president of product management at PGIM Investments, also says it’s crucial to communicate the importance of remaining invested in a “through-retirement” TDF, but says that the communication needs to be customized.

“At Prudential and PGIM, we recognize the importance of understanding participant behavior,” Dimayorca says. “Because the behavior of older participants differs so starkly from those of younger participants, if you want the best retirement outcomes for participants, you cannot paint TDF investors with a single brush. A high level of equity exposure for younger investors is a good thing—the tradeoff of higher volatility for higher returns makes sense, as they have a longer time horizon. But for older investors, it is a different story. Higher equity exposure near retirement, when participants have larger balances, can mean steeper losses in market declines and less time to recoup those losses before needing to make distributions from their accounts. Lower equity exposure near retirement—and a lower volatility profile in general—is the key to optimizing retirement outcomes for older participants.”