Investing February 2, 2021

Understanding TDF Glide Paths

Glide paths aren’t just a change in equity and fixed income allocations, there are changes to investment types, too.
Reported by
Art by Chiara Brazzale

A target-date fund (TDF)’s glide path represents its changing mix of investments over time, Capital Group explains on its website. As a participant’s target retirement date nears, the fund “glides down” to a more conservative mix of investments.

Understanding how a TDF’s glide path works—how equities and fixed-income-type investments shift as investors age—is necessary for defined contribution (DC) plan sponsors to fulfill their fiduciary duties in fund selection and monitoring plan investments.

Never miss a story — sign up for PLANSPONSOR newsletters to keep up on the latest retirement plan benefits news.

Glide paths are designed to be gradual in investment portfolios, says John Doyle, senior retirement strategist at Capital Group/American Funds. Young workers who are just building their retirement savings will have a more aggressive risk level in their portfolios, with higher amounts of equities, but those investments will turn conservative, or shift to fixed-income investments, as they age, Doyle explains. “As the individual ages, their investment glide path matures to match their needs,” he says. “Some TDF glide paths will continue even after an individual retires.”

Randy Welch, managing director and portfolio manager at Principal, notes that investing in a TDF automates the management of investments for plan participants. Participants don’t have to be concerned with when to rebalance, shift and de-risk their portfolios, easing their path to retirement. “It’s a very easy and efficient way to get individuals to the proper asset allocation based on their age and time to retirement,” Welch says. “It handles that for them.”

While most individuals will begin investing between ages 22 to 25, some may start as early as 18 years old, Welch notes. Because these workers are just starting their savings journey, they should have very little invested in capital. Instead, they’ll have a higher exposure to equities to develop growth in their portfolios, because they have decades to accumulate, he says.

“Over time, we will de-risk what we think is appropriate, based on the goals that we are trying to achieve for them, and we gradually reduce at the easy level, from equities to fixed income,” Welch explains. “As a person gets closer to retirement, there is more sensitivity to inflation, so there may be [adjustments for that].”

Welch says the basic principle is to start an investor at 93% equities and 7% fixed income in their portfolios. Over time, equity is gradually reduced and fixed income is increased, but a proper percentage of equities is maintained for portfolio growth, based on the investor’s retirement age, he says.

Below is a basic example of a TDF glide path:

Source: Capital Group / American Funds.


Doyle says he believes there is a common misconception in how a glide path moves over the years. TDF managers don’t just change the percentage of stocks and bonds, they tactically manage them over time. It’s not just a pool of stocks that shrinks to a percentage of the participant’s portfolio over time and a pool of bonds that increases as the individual goes along their timeline, he says. “What you own in your stock portfolio at age 25 is very different than what you own when you’re 55 or 65 years old,” he says. “It’s not just a shift in percentage of stocks in the portfolio, it’s a real change in the types of stocks working in the portfolio.”

The same can be said about bond portfolios. Bonds play a different role at various ages along the glide path, therefore what a 25- or 35-year-old participant owns in bonds is different than what a 55-, 65- or even 75-year-old participant should own in their portfolio, Doyle says.

It’s integral to maintain the appropriate level of equity at each stage in the glide path, to ensure proper risk exposure and high growth, but this can differ depending on what the risk profile looks like for a specific investor, Doyle says. For example, at Capital Group/American Funds, a 65-year-old participant is still treated as a long-term investor with a 30-year time horizon for several assets in their portfolio.

Instead of looking at what percentage of the portfolio should be in stocks versus bonds, Doyle says, it’s important to understand what the investor’s risk profile should look like and how to get there. “I don’t know if there should be a specific answer on what percentage of stocks they should have at a certain age,” he notes. “It’s more about portfolio construction and the risk profile, and so the actual allocation is going to vary within guardrails. There’s no one right answer, it’s more about, ‘What does the risk profile look like for someone at that point in their timeline?’”

Welch expresses a similar view, explaining that appropriate levels of equity depend on the characteristics of an investor. At Principal, investors begin with 91% to 93% of equity exposure in the glide path. By the time they reach retirement age, the percentage of equity exposure down to 44% to 45%. When a retiree hits 15 years past retirement, this will decrease to 23% to 24% of equities.

Equities and fixed income portions of a TDF glide path might include different investment types. For example, some glide paths might use real assets that would be considered equities, but that vary in performance, Doyle notes. Real assets are investment vehicles such as commodities, public infrastructure and TIPS [Treasury inflation-protected securities] that provide a cushion to the portfolio should there be a shock in the markets, Welch says.

On the fixed-income side, high-yield bonds may be used. High yield bonds have a greater expected return but more volatility than government bonds, Welch explains. Those who are invested in high-yield accounts experience higher amounts of volatility because they’re investing in companies that are not investment-grade but that have the ability to earn excess return at additional risks, he adds.

Aside from real assets and high-yield accounts, Welch says Principal offers large-cap, big-cap and small-cap equity exposure within the U.S., and both developed and emerging equities in the non-U.S. markets. The company adds inputs to its models to manage expectations when investors are nervous about the market, like during the market swings of 2020 caused by the COVID-19 crisis.

“We give investors in TDFs exposure to many asset classes to help benefit them no matter where they are in the glide path,” Welch continues. “Most individual investors would not gravitate to or have an allocation to high-yield or emerging markets, so the TDF helps them do that.”

Investing January 26, 2021

Creating an Effective LDI Strategy for 2021

Defined benefit plan sponsors need to look at different tools for making their liability-driven investing strategies more efficient, and they should re-evaluate their glide path triggers.
Reported by
Art by Sarah Mazzetti

The volatile equity market, an expectation of lower future returns and the low interest rate environment have led many financial professionals to suggest the traditional 60/40 portfolio is no longer effective for retirement plans.

With their minds on improving the funded status of their plans, many defined benefit (DB) plan sponsors take the traditional 60/40 portfolio a step further and use liability-driven investing (LDI) strategies. Considering those market factors, are traditional LDI strategies no longer effective?

Get more!  Sign up for PLANSPONSOR newsletters.

Michael Clark, managing director and consulting actuary with River and Mercantile, says last year was an interesting year in terms of what it showed about what DB plan sponsors do with LDI glide paths in volatile markets.

“Most plans probably ended the year where they started [in terms of funded status], but there were a lot of ups and down in between. Those that rode the course probably ended the year slightly worse off,” he says. “After the market crash in the first quarter, those that put more money into growth assets probably are a little ahead of those that stuck with the status quo.”

Most DB plan sponsors are looking for a portfolio strategy that prevents them from going backward in funded status, Clark says. There is a trade-off between liability hedging and seeking returns. “Plan sponsors need an understanding of what risks they are taking on and where and how that should change over time to get them to where they want to be,” he says.

The broad thesis is that DB plan sponsors do need to think about restructuring their LDI portfolios, says Kevin McLaughlin, head of liability risk management, North America, at Insight Investment. He says plan sponsors should focus on two things: increasing the hedge ratio due to extreme volatility to make sure they have enough liquidity, and increasing returns to fill funding gaps.

More than ever, plan sponsors need a hedge for liabilities, McLaughlin says. “If they don’t hedge for interest rates and get it wrong, even small movements in interest rates will mean the return needed from growth assets will increase exponentially,” he explains. “Plan sponsors need to do more hedging now than in the past, particularly if they are underfunded.”

McLaughlin adds that plan sponsors need to hedge to control volatility. “We advise clients to try to keep problems solvable through investment returns. If interest rates decline, they will need assets to fill the funding gap,” he says. “The reason we think underfunded plans need hedging is we’re not sure we’ve seen the bottom for interest rates and there is so much market volatility.”

Components of an LDI Portfolio

Going beyond the traditional glide path, Clark suggests DB plans can use derivatives to decouple risk from growth. A derivative is a security with a price that is dependent on or derived from one or more underlying assets, according to Investopedia. Underlying assets could be stocks, bonds, commodities, currencies, interest rates or market indexes. The derivative is a contract between two or more parties based on the underlying assets, and its value is determined by fluctuations in the underlying assets. Futures, swaps and options are types of derivatives.

“With derivatives, plan sponsors can decide how much interest rate risk to take on or hedge and how much market risk to take on or not, and they can do that in a very controlled way,” Clark says. One way to do that with derivatives is by taking the assets in the portfolio and investing all of them in liability-matching vehicles, then accessing equity synthetically through puts, calls and options strategies to give equity a value the plan sponsor is comfortable with, he explains.

“This offers an optimized interest rate hedge and an equity exposure plan sponsors are comfortable with,” Clark says. “Sponsors get some downside protection, a range of returns they like and a bigger engine than what they have with just the physical assets in the portfolio.”

Clark says derivatives swap options (also known as swaptions) should be considered for the liability-matching side of LDI portfolios. “We’ve been talking to clients about the potential for interest rates to go up and liabilities to go down, but they don’t necessarily want to lock into a strategy,” he says. “This is where derivatives swaptions can be adjusted to protect the plan when rates fall.”

According to the Corporate Finance Institute, a swaption is an option contract that grants its holder the right, but not the obligation, to enter into a predetermined swap contract. In return for the right, the holder of the swaption must pay a premium to the issuer of the contract. Swaptions typically provide the rights to enter into interest rate swaps, but swaptions with other types of swaps can also be created.

“When you look at pension plan risk management in general, most DB plan portfolios have liability-matching and return-seeking assets, and they use funded status triggers to make portfolio changes. We’ve seen that’s effective to a point,” Clark says. “But for plan sponsors that want to make a meaningful difference in closing their funding gap, they need to look at different tools. Derivatives present good opportunities, especially in volatile markets like we’ve seen in the last 12 months.”

McLaughlin also points out that many plans are cash flow negative—paying more in outflows than they get in inflows. For this reason, they want to avoid a large shock to assets, especially large declines or drawdowns. “There’s a lot of focus now on the equity downside,” he says. “We see more focus on low volatility equities or volatility-control type strategies. There is much more interest in downside equity protection; there’s been a move from diversification to downside protection.”

For the growth part of an LDI portfolio, being well-diversified is still important, Clark says. “We saw quite a bit of disparity in asset classes in 2020,” he says. “Plan sponsors should understand what asset classes are available to them to create a well-diversified portfolio, and rebalancing is a tried and true principal.”

On the fixed income side of an LDI portfolio, there’s been interest in how to increase returns from fixed income assets, McLaughlin says. “We’ve seen more interest in private markets and illiquid securities such as structured credit and private loans,” he says. “The challenge is that more illiquid assets could potentially mean not enough liquidity to pay for outflows, which would make DB plan sponsors become forced sellers of equities. So they need to be careful when changing portfolio components on the fixed income side.”

McLaughlin says he has seen plan sponsors solve this conundrum by having more liquidity on the equity side of the LDI portfolio. Plan sponsors may do so synthetically via equity futures or equity return swaps.

“We would say two things: When hedging DB plan portfolios, be as capital efficient as you can to free up assets to pay benefits or buy private credit, and protect against large drawdowns in equity by having a strong hedge ratio to protect from volatility,” McLaughlin says.

Rethinking Glide Path Triggers

McLaughlin suggests DB plan sponsors should rethink their LDI portfolio glide path triggers. “Many [plan sponsors] are in a situation where they are a long way from the next glide path trigger on a funded status basis or on a market level basis—for example, a trigger of a 3% market rate on Treasurys,” he says. “A big focus in 2021 will be reassessing glide path triggers to make sure they are realistic.”

McLaughlin says Insight Investment’s broad advice would be for plan sponsors to have both a funded level trigger and an interest rate trigger. “Plan sponsors have to consider what could happen if equity markets decline and funded status declines. It’s better to have a combination of triggers so as not to miss hedging opportunities,” he says.

Interest rate triggers will signal a path for hedging, McLaughlin explains. “If interest rates go up by a certain amount of basis points, the plan sponsors can do more hedging,” he says. “If the interest rate trigger is less static and more dynamic—if plan sponsors think interest rates are range bound—there is more flexibility. Plan sponsors can take hedges off and on.” McLaughlin says he’s seen this strategy used a lot in the UK and he believes U.S. plan sponsors can take advantage of it.

Plan sponsors that adjusted their portfolios when they hit a funded-status trigger but fell below it due to a market downfall last year should look to their investment policy statement (IPS) for what to do, Clark says. It might require them to re-risk their portfolios. “Many who did that in the first quarter of 2020 came out ahead by the end of the year,” he says.

Clark says River and Mercantile would advise that, in light of 2020, which showed that market movements can happen quickly, plan sponsors should look at their governance structure. “If the IPS and governance structure don’t allow [plan sponsors] to take advantage of market movements quickly, they will miss out on market opportunities,” he says. “Having good consultants watching for opportunities and bringing ideas to the table while being able to act quickly will be key to making progress on funded status.”

«