What the Pandemic is Revealing About Target Date Funds – The 401(k) Specialist

The differences among target date funds (TDFs) can be hard for some plan sponsors and participants to immediately see, but it is moments like the one were in now that can reveal important distinctions between them.

The market volatility caused by the COVID-19 pandemic vividly demonstrates that while risk exposure is important at every point in a TDFs glide path, its particularly impactful for people nearing retirement.

This is not a new point of view, but its newly relevant. Prior to the market declines weve seen since February, investors had enjoyed one of the longest-running bull cycles in U.S. history. That led to impressive equity returns, and with it a heightened focus on asset accumulation.

Subsequently, we believe too much embedded risk crept into many multi-asset class portfolios and remained hidden until now.

Of course, not everyone agrees. There are those who continue to make the case for keeping equity allocations at higher levels near and into retirement. And its worth looking at their arguments. Here are two:

From our perspective, the two most critical factors for TDF portfolios during periods of volatility are time horizon and cash flow. As a result, they impact younger people on the front end of the glide path differently than older people nearing their retirement date.

Generally, TDF investors just starting their career with long time horizons and limited savings can benefit from significant volatility exposure, as this can help them accumulate wealth over time and benefit from the ups and downs of the market through dollar-cost averaging.

As investors accumulate wealth and approach and enter retirement, however, higher levels of equity exposure in volatile markets can work against them. It can cause them significant stress when balances fluctuate, given the larger dollar impact and shorter recovery times before investors need to tap into assets.

Consider how a hypothetical 20% portfolio loss might affect two TDF investors, one at age 25 and one at age 60.

The pandemic has exposed more than just the importance of risk exposures within a TDF for people nearing retirement. It has also revealed how important human emotion is as a factor in glide path design.

Too often, glide paths are developed quantitatively in the lab and can ignore or underappreciate the fact that these are products that will ultimately be used by real people with real needs and emotions.

Theres an important takeaway for advisors and plan sponsors here. When evaluating funds, keep participants in mind, and remember theyre human just like you. Ask your provider if their funds factor in participants emotions and behavioral biases into the investment process.

The range of threats to retirement savings include things such as market risk, longevity risk, sequence risk, inflation risk, tail risk, and interest rate risk. But human decision-making concerning those risks differs depending on the persons stage of life. Those behavioral patterns can and should be factored into a TDFs design to help drive toward successful outcomes for retirement savers.

We encourage advisors and their plan sponsor clients to consider the COVID-19 pandemic as a prompt to re-examine the TDFs theyre offering in their retirement plans.

To help evaluate portfolios, advisors and plan sponsors should:

Questioning TDF equity exposures for near-retirees may not have been the most popular message even a few months ago. But just like so many other parts of our lives, were in a whole new world now.

Omar Aguilar is Chief Investment Officer for Passive Equity and Multi-Asset Strategies andJake Gilliam is Head of Multi-Asset Portfolio Solutions with Charles Schwab Investment Management, Inc.

Read the rest here:
What the Pandemic is Revealing About Target Date Funds - The 401(k) Specialist