Balancing Longevity and Market Risk in Enhanced TDFs

Target-date funds (TDFs) have become popular because they offer seemingly simple and logical solutions for retirement. The funds are designed to manage multiple, complex retirement risks, most notably longevity risk (outliving one’s savings) and market risk (losing substantial asset value), especially when it matters most—immediately before or shortly after retirement.

Most TDFs systematically reduce allocations to equities along a preset glide path. This is intended to reduce market risk, equities being historically volatile, and mitigate potential drawdown losses.

Yet, even as investors approach their typical retirement age—65 in the U.S.—TDFs often still allocate approximately 40% to 50% of their assets to equities. This means up to half of the assets that older plan participants are relying on for retirement are completely exposed to market downturns.

That may be too much equity exposure at the worst possible time.

Sudden market losses could devastate a participant’s ability to retire on time or with adequate assets. The typical investor may have to delay retirement, make higher catch-up contributions, if possible, or embrace a significantly lower standard of living than anticipated. Once individuals leave the workforce—and regular paychecks—and begin withdrawing capital from their retirement accounts, they reduce their base for recovery. This is referred to as sequence of returns (SOR) risk.

This risk hit traditional TDF plan participants who retired during the 2008 global financial crisis especially hard. Many TDFs, even those scheduled to retire in 2010—and that had already moved into “low risk” asset allocation—lost 25% to 40% of their value. Another such crisis could have devastating effects on participants nearing retirement.

To help protect older participants, plan sponsors may want to consider a managed volatility approach to TDFs. This can significantly enhance a TDF’s risk and return profile. Reduced volatility and less downside risk are always attractive to risk-averse investors. They can be just as important to those who are in or near retirement, when the sequence of returns can matter greatly.

Managed volatility strategies seek to capture broad equity market returns, as defined by market-cap-based indices, and dynamically adjust equity exposure to produce efficient portfolios with more stable stream of returns. Equity exposure can be adjusted by shorting—i.e., selling—equity futures to effectively reduce the size of the equity allocation.

Managed volatility strategies can limit upside capture; thus, it is prudent to limit their use to the capital preservation stages of investment life cycles.

More importantly, managed volatility strategies typically generate robust enhancements in tail risk reduction. Reduced downside risk potential can help investors prone to panicked selling—a behavioral bias known to be detrimental to portfolio performance—which generally increases in severe bear markets.

TDFs can be excellent vehicles for securing retirement—when volatility is actively managed. Otherwise, participants can risk losing big chunks of their retirement savings at the worst possible time. Plan sponsors that want to elevate the certainty that participants can confidently achieve their retirement goals should consider a managed volatility approach to TDFs.

Doug Sue is an asset class strategist at QS Investors, a subsidiary of Legg Mason. His opinions are not intended to be relied upon as a prediction or forecast of actual future events or performance, or a guarantee of future results, or investment advice. All investments involve risk, including loss of principal.