Examining Risk Management in TDFs

A new research paper from J.P. Morgan Asset Management seeks to educate plan sponsors and advisers about the dynamic interplay of risks involved in target-date fund (TDF) investing.

Penned by a team of investing experts at J.P. Morgan, the paper evaluates the various risk management approaches utilized by different TDFs available in the defined contribution (DC) marketplace. Given the broad—and rapidly growing—adoption of these strategies in 401(k)s and other employer-sponsored retirement plans, the researchers argue now is clearly the time to get ahead of target-date risk trends.

“Today, these professionally managed multi-asset-class portfolios capture approximately 38% of 401(k) contributions, a figure projected to climb to 88% by 2019,” the paper warns, citing previous research from Cerulli Associates.

Daniel Oldroyd, a managing director for J.P. Morgan Asset Management and lead portfolio manager for the global multi-asset group, who also runs and helped to create the firm’s SmartRetirement TDF suite, says the complex interplay of risks in TDFs does not mean they are a poor investment choice for plan sponsors to offer.

“We continue to believe that target-date funds are the most prudent investment choice for the vast majority of participants,” he tells PLANSPONSOR. “However, we believe it is equally important to understand how differences in glide-path design may enhance or detract from expected retirement outcomes. We have received so many questions in recent years from plan sponsors wondering why their TDF is performing in a certain way, compared with the wider market.”

Oldroyd says most plan sponsors and participants are showing an improved understanding of what TDFs are, and how they are intended to function, especially in the wake of the 2008 financial crises, which brought more attention to disclosure and reporting. However, he says, one only needs to briefly peruse industry media for reports that tell a different story.

“To this day we have a small number of participants who believe TDFs are guaranteed income products, for example,” Oldroyd says. “And that’s not so unreasonable from the point of view of the participant. There is an implied social contract here, that if the sponsor chooses a good TDF as the default investment and they set up a good match and you set up a deferral that is sufficient, the portfolio manager is supposed to get you to the end of the glide path successfully.”

While many sponsors and participants can correctly identify the general strokes of a TDF program—that equity exposure will ramp down over time and the portfolio will automatically be rebalanced—there is a serious void when it comes to more sophisticated understanding of how to compare two different TDF suites.

“This is particularly true in terms of how each strategy handles risk management in its portfolio allocation and construction choices,” the paper notes. “Given the broad number of factors that go into securing retirement funding success, assessing a glide path’s risks entails more than evaluating standard deviations and downside volatility alone.”

Oldroyd says the new paper makes a clear case that DC risk is dynamic and multifaceted, so the risk-mitigation approach of a TDF also must be dynamic and multifaceted.

“Participants face an array of DC risks, some of which they can control with a high level of certainty, such as accumulation risk, participant-user risk and withdrawal risk,” he continues. “Other risks are driven more by what participants may experience, where the only degree of control they might have is through their saving and asset-allocation choices.”

These include market and event risk, longevity risk, inflation risk and interest rate risk, Oldroyd notes, adding that the magnitude of each risk changes over time and in response to different market climates. “This once again underscores the importance of taking a broad risk perspective in target-date fund design,” Oldroyd says.

But how does this thinking actually apply to portfolio construction and maintenance? Oldroyd again turns to the whack-a-mole analogy: You won’t win the game by focusing on one hole for the entire game. A TDF that focuses on one or two risks, say longevity risk and inflation risk, will leave participants exposed to other, equally important risks that are almost guaranteed to impact a TDF portfolio at some point along its glide path.

“The way I tend to think about all this during portfolio construction conversations, is just to point out that we know two things about the glide path of all participants,” Oldroyd explains. “First, we know participants are going to face all these types of risks over their working career. Over 40 or even 50 years, you can be pretty confident you’ll see bouts of inflation or low interest rates, or high interest rates. And you’ll see markets doing really well at some times and you’ll see markets doing really poorly. The other thing we know is that we don’t know when each risk will be most prevalent, or the magnitude of the risks and market reactions.”

Put these points together, Oldroyd says, and one can see there are some times when, as a DC plan participant, certain risks become the most prevalent and others take a back seat in terms of their ability to derail retirement readiness. 

“For example, the biggest risk at the beginning of the glide path would be accumulation risk—given that the younger investors will just be starting out and will be nowhere close to retirement readiness for a long time,” he says. “Given that they have little saved, this person probably doesn't have to worry as much about a strong downturn, or inflation. They're going to be focused on accumulation risk and getting the ball rolling.

“But as you move along the path, say to the end of the working career and near the retirement date, other risks become more prevalent,” Oldroyd says. “The biggest one during the late career or early retirement might be inflation risk or longevity risk, probably, for this group. Or it could be the risk of a major market loss.”

The paper suggests more dynamic risk approaches, which do not focus on one risk for the lifetime of the TDF and instead shift to address multiple risks that become more prevalent at different points along the glide path, will be more successful over time. 

“This is easy to see from recent history, when you consider a TDF for example that has a construct that seeks to mainly combat long-term inflation risk—which therefore will have more risky assets at the retirement date and will likely be called a through-retirement TDF,” Oldroyd says.  

As a through-fund, Oldroyd says, sponsors might expect the TDF to be riskier today and seek a higher return than many of its peers, “but being an inflation-fighting TDF, it would actually have lots of commodities and real estate and shorter duration fixed-income, even for someone who is 25 years old.­”

“There are TDFs in the marketplace that take just this approach,” he concludes. “But we know that since 2008 there has been relatively little inflation, so these strategies have lagged their peers and have led to some very disappointed plan sponsors, who wonder why their TDF didn’t follow the market up so sharply in 2013 or 2014.”

The full J.P. Morgan Asset Management paper is available for download here.