The experts agree – charting the right glide path takes a skilled fund manager
This article and roundtable was produced in partnership with Fidelity Investments, MFS Investment Management, and Sun Life Global Investments.
THE COMPLEX interplay of economic factors, market dynamics, and regulatory changes has created a turbulent environ-ment, making it increasingly challenging for plan members and institutions alike to safeguard their financial futures. Target-date fund managers are actively reassessing their practices. Innovations such as behavioral finance and diversified asset classes have reshaped the landscape in recent years, leading to better risk-adjusted returns for DC plan members.
Not all target-date funds are created equal; they deploy a wide range of investment strategies. Experts Jason Zhang, portfolio manager with Sun Life Global Investments; Andrew Dierdorf, portfolio manager with Fidelity Investments; and Derek Beane, institutional portfolio manager with MFS Invest-ment Management delve into target-date fund portfolio construction and how it has evolved to place a greater emphasis on diversification. This includes employing multiple managers who each bring unique skills, insights, and return dynamics to portfolios.
Some interesting trends have started to form in the last few years around the interaction between employment and retirement. How might these themes change the retirement outlook for Canadian members? Is the allocation in a TDF portfolio for someone retiring today likely to be different for someone retiring in 30 or 40 years?
Dierdorf: With the benefit of hindsight, we can now reflect on a wealth of defined contribution [DC] experience, not only in Canada but worldwide. We’ve seen significant evolution, and anticipate this will continue, particularly regarding the changing nature of retirement. As people retire later and live longer, both savings and spending periods may be extended, necessitating careful navigation of these circumstances.
The intersection of plan member experiences with fluctuating capital markets is crucial. We’ve transitioned from a robust period in the capital markets to one marked by substantial global debt, rising inflation, and changing investment dynamics. As target- date funds adapt to these shifts, increased portfolio diversification will continue to play a pivotal role in our approach.
Zhang: We know that average contributions from plan members have remained steady at around 10 percent for decades, regardless of fluctuations in interest rates and inflation and the increase in longevity. Most plan members likely can’t bear the additional cost of funding their retirement, which puts more pressure on TDF managers to deliver greater retirement outcomes. This is why we have seen TDFs evolve in important ways, on both their glide path – incorporating more equity – and their strategic asset allocations – “DB-izing it” with more sophisticated asset classes. TDF managers will continue to play an important role in determining the retirement outcomes of Canadian members as they control members’ portfolio allocations over very long-term horizons. It has been important for TDF managers to evolve their portfolios continuously to keep pace with evolving capital market expectations, demographic shifts, and trends in savings and spending, as well as regulatory changes.
The industry is also increasingly embracing alternative asset classes, including real assets. These non-traditional asset classes provide powerful diversification benefits to portfolios that are usually dominated by systematic equity and interest rate risks. They also offer inflation-adjusted stable yield – nice characteristics to have when building retirement portfolios.
Do members feel that they have to be more aggressive in their investing to cope with that?
Beane: Your position in the retirement savings process greatly affects your strategy. In the early stages, most people are quite similar – beginning their careers with little capital and a long investment horizon. However, as retirement approaches, circumstances diverge. Some have saved diligently, while others haven’t.
Therefore, the closer people get to retirement, the more unique and tailored their situations become, moving away from a one-size-fits-all approach. Risk tolerance, too, varies significantly among people of the same age due to these factors.
What’s the most important consideration when constructing a TDF glide path?
Zhang: The design feature that most influences member outcomes is the glide path, which must align with the fund’s objective: providing a financial foundation to preserve retirees’ lifestyles. In our most recent simulated stress testing, we found that the landing equity point is the most important design feature in driving strong wealth accumulation: the higher the landing equity weight, the higher the asset level, all else being equal. However, stress testing results also clearly show that the more equity content you have, the higher the downside risks. While market exposure is unavoidable, managing drawdown risks and the potential for underfunding future liabilities is crucial in glide path design.
In the Canadian marketplace it’s interesting that starting equity weights are quite similar across the industry, but landing equity weights [at retirement] can differ significantly. Post-retirement stress testing shows us that running a low equity weight glidepath can jeopardize the goal of generating an acceptable retirement income. As there are no more contributions in retirement, both the pre-retirement and post-retirement equity allocations play an incredibly important role in the wealth creation needed to support retirement spending.
Beane: It’s a mosaic of decisions: What are your allocations? What underlying funds will you use? What’s your rolldown approach? What’s your rebalance approach? What’s your risk management framework?
Clients primarily focus on the end result, which is, has their chosen investment met their expectations? Ultimately, as we think about putting all these pieces together, everything that we do is based on the premise of growing wealth for members along their savings journey and helping minimize the likelihood of loss in that investment near retirement. Risks like sequencing and longevity are crucial aspects that we address diligently.
Dierdorf: At every age, whether you are 25, 45, 65, or 85, you face unique uncertainties. Each target-date manager has a different perspective on the significance of these uncertainties, how to weigh them, and how to invest.
In our research frameworks, we prioritize diversification and flexibility to effectively navigate these uncertainties for our plan members. As life happens, individual circumstances change, and capital markets fluctuate. For instance, someone who experiences a booming market for a decade might need to consider a different saving or spending strategy than someone who endures a protracted downturn. We strive to manage uncertainties through thoughtful portfolio diversification that evolves over time.
The methods and timing of diversification – how to diversify, when to diversify, and how it evolves over time – vary among different fund managers. We apply unique and differentiated insights to inform our investment approach and decisions.
How do you balance the need to generate robust returns while providing smooth rides – i.e., the need to accumulate enough for retirement while trying to preserve wealth against the many risks plan members face?
Beane: The trade-offs involved in target-date fund design often represent opposing goals – growing wealth versus minimizing downside risk and volatility. It’s about taking risks when appropriate and reducing them when necessary, which ties back to our discussion on sequence risk – significant market downturns near or early in retirement can greatly affect outcomes.
When considering glide path design, there’s generally consensus that sequence risk is highest at or near retirement.
A lot of attention is paid to the slope of a glide path in terms of how quickly you are de-escalating the risk. There’s an idea that steeper glidepaths de-risk at a faster rate resulting in lower exposure to equi-ties when equity markets subsequently rebound. History in this case suggests that this concern is perhaps misunderstood or misplaced, as even the most severe market drawdowns are not long-duration events and therefore not a lot of glide path rolldown occurs during the actual market downturn.
What can be more significant is the shift in asset allocation due to the wide divergence in performance across asset classes. During an equity market downturn, the equity weight can drift meaningfully below the intended allocation.
Rather than focusing on the steepness of the glide path, plan sponsors and members may be better served by focusing on disciplined rebalancing, which can help ensure that equity levels are at their intended target when markets do rebound, helping to minimize volatility.
Dierdorf: Striking the right balance in trade-offs is crucial. Investment managers must reconcile investors’ or members’ need for returns with the various risks they face. These include both nominal and real drawdowns, with the latter being particularly relevant given the recent uptick in inflation.
Looking ahead, we need to consider the types of assets that can provide unique bene-fits in different capital market environments.
While stocks and bonds are foundational to most portfolios, diversifying asset types like inflation-protected securities or alterna-tives may play an important role as capital markets evolve in the future.
How important is communicating investment risk, and how did you get those messages across?
Beane: Education and clear communication are key to ensuring that plan members fully comprehend what a target-date fund is and what it isn’t. This is crucial because a major risk arises when the fund’s performance is not in line with the investor’s expectations, potentially compromising their ability to maintain their desired standard of living in retirement.
The risk profile changes based on age: If left to their own devices, younger individuals may actually be too conservative and not invest enough in capital markets, especially if they have experienced recessions early in their working life. Conversely, older individuals might take on too much risk trying to play catch-up if they have not built up sufficient retirement capital.
By providing clear, educational content, we can help individuals make informed decisions about target-date funds, ensuring they are used correctly. We often see people investing in multiple target-date funds, which is generally not recommended, since these funds are already diversified and tailored to the investor’s age.
Zhang: I think that’s a question that applies equally to both plan sponsors and plan members. I agree there’s a clear need for education around target-date funds to help plan members understand their purpose and how to use them correctly. We need to get that right for the funds to work as intended. Plan sponsors should consider how well aligned a target-date fund is to the intended member retirement outcomes of their plan, and I think that’s where we, as target-date fund managers, need to communicate what member retirement outcomes we’re targeting and how investment risk is being managed in pursuit of those goals.
How would you encourage plan sponsors to look at the “to vs. through” debate?
Dierdorf: From my perspective, it’s important to consider what the right portfolio is based on where I am in my life cycle. Should I have the same portfolio when I’m 55 as I do when I’m 65 or 85? The “to versus through” terminology has become shorthand for those questions, which I view as more pertinent and important.
In our investment process, we research, assess, and discuss the needs and sensitivities of plan members at each point in the life cycle. We consider multiple dimensions, including the risk tolerance as someone ages, how asset balances change, the future income or human capital associated with one’s ability or desire to continue to work, and the flexibility to adjust that individuals often demonstrate as experience emerges. In our view, some or all of these dimensions are different for investors at age 55, 65, and 85, which leads us to adjust the portfolio allocations and diversify appropriately based on these distinct attributes.
Zhang: That’s certainly a topic that has garnered a lot of attention in the industry, but we think broadly dividing the glide paths between “to” and “through” is missing the point to some degree. It is really a decision about where to allocate risk along the entire glide path.
We have strong social benefits programs here in Canada, and this may partly explain why a “to” glide path is more popular. If you opt for a “through” glidepath, be aware that it might expose members to higher levels of risk during the critical pre-retirement period and the first year of retirement.
It’s crucial that a glide path be designed with the plan members’ behavior in mind, carefully considering the specific points at which you want the rolldown in risk exposure to occur, as ill-timed member interventions have the potential to significantly alter the overall performance of the portfolio.
Beane: When we launched our suite in the early 2000s, there wasn’t a distinction between “to” or “through” retirement date funds. The vintage year simply marked when a fund reached its most conservative state. Over time, however, age-based defaults led to a division between “to” and “through” providers. Despite this, most members don’t stick with a single target date through retirement.
The debate over “to” versus “through” is largely irrelevant if people are altering their retirement assets soon after retiring. These approaches ultimately differ only in risk tolerance. “To” versus “through” is really a moot point if people aren’t experiencing the full rolldown that’s intended by a “through”- based approach. In essence, a “through”-based fund is implicitly a riskier “to”-based fund.
As people approach retirement, their financial profiles become more varied, and one single investment vehicle is unlikely to meet the unique and individualized needs of each investor. A personalized approach, considering individual risk tolerances and capital bases, is more appropriate.
When you launched these funds, were you aiming at any specific outcomes?
Beane: Our goal is to deliver performance in line with design and member expectations, focusing on capital appreciation in early stages and minimizing the downside as retirement approaches. In our design process, we conduct extensive stress testing and longevity analyses as part of our glide path design.
We acknowledge that investor circumstances vary widely and often differ from an average member profile. Our approach emphasizes the risk-return profiles of equity, fixed income, and non-traditional asset classes, rather than targeting a specific outcome. We advocate for a progressive glide path that seeks to maximize capital appreciation for younger investors, transitioning to a conservative allocation with a strong focus on downside mitigation and sufficient diversification as retirement nears.
This approach is designed to mitigate the impact of market sell-offs as members approach retirement, but it doesn’t target nominal outcomes. While one could create a solution based on a representative or “average” member profile, we recognize the diversity among investors, as most do not look like the “average.”
To use an analogy, if we were making shoes, we wouldn’t only produce size 9s, as that would only fit a minority of investors, even if nine were the average – for most it would be too big or too small. Similarly, our design is meant to align with the varied goals, objectives, and outcomes that people have for target-date funds. We prioritize the process over the outcome, avoiding overly precise objectives that may incentivize undesirable behavior. Ultimately, our process is tailored to serve most investors, not just the “average.”
Zhang: We recognize the importance of robust asset growth during the accumulation phase, as it lays the foundation for future retirement savings. It’s universally accepted that more money is preferable, given all other factors are equal. However, a major challenge today is the modest level of contributions – approximately 10 percent.
Additionally, behavioral factors such as recency bias and loss aversion can significantly affect decision-making, especially after a market downturn, leading some to abandon their plans and attempt to time the market.
Our modeling and stress testing of target-date funds along the glide path aim to enhance our understanding of how different exposures can affect plan members’ retirement readiness. We use the income-replacement ratio, considering government support programs like CPP and OAS in Canada, to optimize the probability of our plan members achieving a 60 percent income replacement ratio. This is a stringent standard, considering the longevity challenges and varying asset lifespan in target-fund accounts.
We also want to ensure members’ accumulated assets heading into retirement are sufficient to support a draw-down period that is broadly aligned with life expectancies, so we conduct comprehensive stress tests using different withdrawal rules, factoring in inflation adjustments, targeting the highest acceptable probability that members will have sufficient assets to draw upon throughout their retirement.
How do ESG/sustainability/NZ considerations factor into your TDFs?
Dierdorf: ESG is a rapidly evolving area, and our aim is to enhance transparency and foster conversations about its meaning with our clients, the industry, and plan members. Practically, our ESG research focuses primarily on identifying factors that are materially significant to financial outcomes for individual securities. Our stock and bond portfolio managers may consider both ESG and non-ESG research to assess the factors most likely to affect the future performance of various securities.
Beane: We have a long history of sustainability integration into our security selection process, along with other material factors, as it provides additional insight into the potential risks and opportunities that could influence a business’s long-term viability.
ESG integration is a natural part of our research and investment process – we don’t target a specific sustainability outcome or rating. There’s no need for an ESG overlay at the target-date fund level, as this is already incorporated organically through security selection in the underlying funds.
