Plan sponsors face many concerns in offering defined contribution plans. They want to offer a plan that attracts new hires but also serves the needs of their long-term employees who are nearing retirement. They strive to help participants accumulate retirement assets, encouraging broad-based participation in the plan and substantial savings rates. They offer investment programs that seek to help participants maximize results while minimizing risks. As participants near retirement, this typically involves making recommendations about protecting account balances and advice about withdrawing judiciously from retirement accounts.
These approaches are well intentioned and provide useful guidance for many participants. Yet, because these kinds of programs were instituted primarily in the past 10 years, they have not adequately helped many of their employees who are now approaching retirement age. As a result, participants are facing the daunting reality that they simply do not have enough funds to retire. This creates a significant workforce management issue for plan sponsors: employees are staying on the job past 65 years old – and in some cases past 70 years old – simply because they do not have ample savings to sustain them throughout retirement.
In our last paper, Taking the Next Step: A New Approach to Addressing Key Challenges Facing Today's Retirees and Plan Sponsors, we discussed why annuities are not a viable strategy for plan participants faced with this situation. The plan sponsor community has responded with concern, wondering what solutions will work for these employees who are nearing retirement but need more funds.
In this paper, we discuss innovative solutions that we believe can help participants in this situation. As we will show, a typical asset allocation strategy that defaults these participants to 60% equities and 40% bonds simply does not help minimize investment losses while still providing growth. Participants who face a cash shortfall cannot forego the chance for additional growth and sit passively on their dwindling assets. The industry must develop new investment strategies that help these participants protect their capital while enabling them to enjoy sufficient growth. Coordinating this effort with plan sponsors to provide more innovative investment solutions and plan designs, we expect, will help address the shortfalls of today's retirees and those approaching retirement in the future.
As plan sponsors know too well, the U.S. workforce is aging. During the baby boomer years, between 1946 and 1964, 76 million people were born, and this sizable generation is now in or approaching retirement age. From 2016 through 2029, 4 million baby boomers on average are expected to retire every year. The number of retirements is likely to peak in 2023 when 4.3 million are anticipated.1
Many of these baby boomers must face the fact that they lack sufficient funds to retire. This is partly because their careers spanned a time of significant change in retirement plans. Many started their working lives when defined benefit plans were the norm, and 401(k) plans and other supplemental plans were introduced when they were already halfway through their careers. Often, these employees were defaulted into defined contribution plans in their mid-40s at a 3% investment rate. They simply do not have the assets that would have accrued if they had saved 12% over a 30- or 40-year period.
This shortfall is substantial and worrisome. According to Fidelity, today's retirees hold an average of $87,000 in their 401(k) accounts. This account balance would supply participants with a meager $290/month in spending during their retirement years.2 Even if you incorporate their Social Security benefits, this would still only provide them with an additional $1,300/month for spending. Compare this to the average retiree's spending rate, which today is $3,800/month. This leaves these retirees with a shortfall of $2,210 every month!3
Today's participants who are approaching retirement are facing an additional uphill battle due to the market volatility over the past 10 years. Many were heavily invested in equities at the time of the 2008 global recession when the markets suffered extreme downturns. Events like these drastically affect portfolio balances. As shown in Exhibit 1, if a portfolio loses 10% in one year and then earns 4% in each subsequent year, it would take almost three years for it to get back to even, assuming the investor makes no withdrawals. More germane to the 2008 downturn, if a portfolio loses over 25% in one year and then earns 4% in each subsequent year, it will take more than seven years for that portfolio to return to even, assuming the investor makes no withdrawals. Given the amount of time it takes for investors to recover from such losses, plan participants need to have investment strategies that can help weather periods of severe market downturns.
It is important to note the consequences of such downturns because they are more common than most people think. As shown in Exhibit 2, over the past 55 years, the S&P 500® Index has experienced 72 occurrences of investment losses greater than 26%, which means that almost every plan participant will have to be prepared to withstand periods of severe losses.
Conventional Wisdom Has Failed To
Such sobering statistics require us to acknowledge that conventional investment advice has not addressed baby boomers' investment needs or significantly improved their outcomes. In fact, when we examine traditional retirement planning advice, we find three prominent myths that are not supported by the facts.
BELIEF: A portfolio that has a balance of bonds and equities is safe and protects investors from risk.
FACT: As shown in Exhibit 3, a portfolio that has 60% of its assets in equities and 40% of its assets in bonds, an allocation many target-date funds employ for participants nearing retirement, still has over 90% of its risk in stocks when you consider expected standard deviations and correlations. As a result, the portfolio's returns will depend upon the returns of the equity markets. This means that, though the portfolio will not benefit as much from strong equity returns when equity markets rally, it still faces significant risks from equity market downturns.
BELIEF: Illiquid investments help protect investors from market downturns.
FACT: Looking at returns since 2008, illiquid investments have suffered alongside the broader market, and overall, they have not kept investors from losing capital, as shown in Exhibit 4. Some plan sponsors have tried to help their participants diversify by adding illiquid instruments, such as hedge funds to their plans. However, even when participants avail themselves of these opportunities with the hope of earning more upside, they typically end up losing significant assets when equity prices fall.
BELIEF: Index funds provide adequate return for retirement savings.
FACT: As Exhibit 5 shows, a portfolio that held 60% of its assets in the S&P 500® Index and 40% of its assets in the Bloomberg Barclays U.S. Aggregate Bond Index would have experienced significant periods of volatility from 1978 to 2016, having a potentially detrimental impact on account balances for individuals approaching or in retirement. Simply following an index does not guarantee adequate savings for participants.
In addition to the three standard pieces of investment advice, plan sponsors have sought to help participants by offering target-date funds, portfolios designed to automate certain investment decisions, like asset allocation. These funds provide an important tool for many participants, who are often too busy or too intimidated to actively manage their retirement assets. Target-date funds can help eliminate guesswork and enable participants to "set it and forget it."
However, even as target-date funds have helped address investor behavior issues, many are based on outdated investment principles. These funds presuppose that the only change participants need to make as they near retirement is to gradually shift their holdings from 90% in equities to 50-60% in equities. Yet, this single-focus strategy does not protect investors substantially from risk, and it has not provided the significant capital growth that today's retirees need. Remember, most baby boomers need to grow their capital during their retirement years, or they will face significant shortfalls. Therefore, participants who have placed their capital in target-date funds may very well decide to delay their retirement in order to grow their capital more and make up the gap.
Certainly, target-date funds have been a valuable innovation for retirement planning, but they are mostly managed exactly as they were when first introduced, almost 30 years ago, despite drastically changing market conditions and the evolving income needs of today's retirees. It is time to empower plan participants with better investment approaches that recognize their current savings shortfalls, as well as the challenging market environment in which they are investing.
One way to offer a new approach to retirement investing is to shift our focus onto what matters most to plan participants: the dollar amount of their portfolios, or what is known as "terminal value." Participants want their assets to grow over the long term with lower risk, and most importantly, they want to retire with enough money in their portfolios to last the rest of their lives.
Yet, the investment industry tends to evaluate portfolios based on more abstract measures, including beta and standard deviation (volatility). Such statistics basically evaluate portfolios as if people invest for only one quarter at a time, over and over again. But, of course, people in fact invest over a long period of time across drastically changing market conditions.
By focusing on increasing a portfolio's terminal value, a new component of risk becomes evident: time. After all, terminal value is the growth of assets over a given period of time, usually a decades-long amount of time. However, most investment models ignore risk over time and instead measure risk in an isolated moment. And indeed, in an isolated moment of time, it is of primary importance to diversify your capital across many asset classes, such as equities, bonds, commodities and cash. Yet, when we recognize that investing over time poses a distinct kind of risk, we can develop new investment approaches to manage for that.
In addition, ignoring how risk changes over time can have serious consequences for the terminal value of an investor's portfolio. We invest not in one single, repeatable period, but over a long time through many different market conditions. As advisors to plan participants, we need to move away from focusing on "average" performance and instead help participants take advantage of those times when they have the best chance to benefit from a market surge and to avoid the most significant periods of severe underperformance.
To serve plan participants more effectively, we need to set our sights on maximizing ending account balances. This must entail moving away from using volatility as the primary way to measure risk and instead redefining risk as the permanent loss of capital. Again, their ending account balance is what matters to plan participants and, by extension, to plan sponsors. Consider the hypothetical example in Exhibit 6, depicting two strategies that are both normally distributed. Using volatility as the risk measure, Strategy B is considered twice as "risky" as Strategy A. Yet, an investor in Strategy A has a 15.9% chance of losing capital, while an investor in Strategy B has only a 2.3% chance of losing capital. Therefore, in terms investors truly care about, Strategy A is almost seven times more risky. If we re-conceptualize risk as the likelihood of an investor losing capital, we can create strategies that protect account balances while enabling participants to significantly increase terminal value when possible. Such strategies will seek to decrease the amount of large losses investors incur, provide those who are near retirement enough returns to support withdrawals, and reduce retirees' risk of running out of money.
Plan participants who may delay retirement for five or even 10 years due to their balance shortfalls create significant difficulties for themselves, as well as for plan sponsors. These participants could benefit from strategies that help them avoid times of extreme market downturns but still grow their assets during times when strong performance is likely.
As we have researched the factors that most affect a portfolio's terminal value, we have discovered that it is most significantly affected by short periods of extreme underperformance or extreme outperformance – or what investment professionals refer to as "tails." In a very short period of time, investors can lose a significant amount of capital, regardless of how that capital is allocated across asset classes. As the 2008 global recession powerfully demonstrated, traditional investment diversification tends to disappear during times of extreme market stress, and it can then take a considerable amount of time for a portfolio to recover from such a setback. If we can help protect participants' assets from those huge drops, they can maintain their balances even during difficult times. On the other hand, we can also help make sure that participants are not sitting on the sidelines when equity prices are surging.
These extreme events are even more important for those nearing retirement. After all, these participants have less time than their younger colleagues to participate in the markets, so significant events that occur near their retirement dates have the potential to greatly affect their accounts' terminal value. Consider how many employees had to delay retirement after the 2008 market downturn. As shown in Exhibit 7, participants nearing retirement in 2005 unsuspectingly subjected themselves to losses of over 20% by investing in 2015 target-date funds or income target-date funds. Conversely, how does only having 50% of assets in equities at times negatively impact current retirees' abilities to grow their account balance?
By focusing on the risks and opportunities posed by these "tails," plan sponsors can help participants avoid substantial losses while still enabling them to take advantage of periods of growth. In fact, our research indicates that the best way to protect against market downturns and enhance terminal value is to manage tail risk – stay out of the way of large losses and look to capture large gains.
It is important to emphasize that such an approach is not market timing. We are not advocating for strategies that attempt to predict the direction of interest rates or anticipate when the next market bubble will burst. Rather, we are calling for strategies that use quantitative measures and statistical models that will gauge the likelihood of tail events – periods of extreme losses or extreme gains. Such approaches can then be integrated into the target-date fund model so that instead of simply shifting portfolios from 90% equities to 50-60% equities, those funds could dynamically adjust for tail risk.
Given these conditions, what can plan sponsors do to help their most vulnerable participants? They can use target-date funds that focus on growing terminal value and managing risk over time, rather than offering funds that focus only on the equity/fixed income split. They can also offer standalone funds that seek to minimize investment losses instead of simply track a market index. Such vehicles draw upon innovative strategies that prioritize participants' primary goal: to maximize their assets before retirement. This goal is especially pressing to those approaching retirement age.
In particular, we recommend incorporating an adaptive asset allocation strategy into defined contribution plans. Adaptive asset allocation dynamically adjusts to changing risk levels and seeks to avoid substantial tail risks – namely, suffering losses during an extreme market downturn or failing to participate in a significant market surge. Whereas most investment approaches spend the majority of time and effort trying to produce the best average outcomes, adaptive asset allocation seeks to manage outcomes that have the most significant effects on terminal value. A target-date fund that uses such an approach will still allow participants to "set it and forget it."
By employing this type of approach, we believe participants will be well-positioned to minimize losses during difficult market conditions and participate in the upside when opportunities for growth are increasing. For participants nearing retirement, adaptive asset allocation could allow the protection of capital while still enabling capital growth.
Plan sponsors want participants to feel like retirement is something they choose, not something they must wait for until their retirement portfolios allow. Yet, clearly, many plan participants who are nearing retirement do not have sufficient account balances, and many more with small account balances are set to retire over the next 10 years, as the baby boomer generation transitions out of the workforce.
Traditional investment approaches do not adequately take into account today's volatile markets or the low portfolio balances of many participants. Plan sponsors need to look for strategies that define risk as a permanent loss of capital. Focusing on esoteric statistical measures or hypothetical averages, instead of terminal value, fails to recognize the priorities and realities today's participants face.
Plan sponsors have access to sophisticated investment options that are not typically offered through individual brokerage accounts and IRAs. A strong, innovative, and helpful defined contribution plan can help recruit top talent and can also help with workforce management. If a plan enables employees to earn enough money, they can retire when they want to, rather than waiting for sufficient funds to accrue in their retirement accounts. With good retirement planning – based on sound investment strategies – employees can retire between the ages of 55 and 65, rather than staying on the job in order to earn more income. It is time for the industry to recognize the need for new investment strategies that will increase terminal value while controlling for the real risks that threaten participants' capital.
Published November 2016