Morningstar Advisor - October/November 2013 - (Page 63)

Evaluating a glide path isn’t a straightforward exercise, however, especially considering the 60-plus-year investing horizon that some funds on the marketplace imply. Vanguard and Principal, for example, have already launched funds intended for those planning to retire in the year 2060. A 65-year-old retiree in 2060 would be 18 today, meaning he or she has 67 years to go before reaching age 85. Meanwhile, the industry’s oldest series, BlackRock LifePath (formerly Barclays LifePath), is less than 20 years old. There are also fewer than 90 years of market data by which to analyze these asset-allocation plans; even using annually rolling 60-year periods, that results in fewer than 30 observations. Exhibit 1 Equity Allocation of the Average Target-Date Glide Path Equity Allocation (%) 2012 Maximum 2012 Average 2012 Minumum 100 75 50 25 2060 2055 2050 2045 2040 2035 2030 2025 2020 2015 2010 2005 2000 1995 1990 1985 Data as of Dec. 31, 2012 Monte Carlo analysis provides one means of testing the likelihood that investors will be able to successfully retire using a particular glide path. Although markets and existing target-date series lack the history necessary to judge a glide path’s outcome, Monte Carlo analysis can simulate thousands of possible allocations that a glide path could take to calculate the probability of success (and failure) for investors. It is not a new technique, and it is one that many target-date providers already use. However, these models require many assumptions and inputs, so it is nearly impossible to compare one provider’s output with another’s (assuming that they even release the results, which is rare). Using Morningstar’s repository of glide-path and target-date series portfolio data, though, we conducted Monte Carlo simulations for some of the industry’s largest target-date providers, as well as the industry average glide path, using a uniform set of assumptions and inputs. Generally, we found that target-date investors in different series have very similar probabili- ties of having sufficient savings through age 85, the life expectancy of a typical 65-year-old woman. Beyond that age, though, the outcomes start to diverge, and series with more equities come with a higher likelihood of success through age 95. The results serve as a reminder that investors and plan sponsors choosing more-conservative target-date funds don’t just simply lower their market-risk exposure: They take on longevity risk—the possibility of outliving savings—in return. Morningstar’s results are by no means a final decree on any glide path’s merits. Investors have other ways (saving more, spending less) to help improve outcomes. The results do, however, provide indications of which glide paths may be the most appropriate for certain investors. Workers who have been diligent about saving may be well served by a conservative option, while those who have saved less may not be able to afford the comforts that come with a risk-averse strategy. Setting the Stage Basic glide-path testing requires two main inputs: risk and return assumptions for the asset classes underlying the glide paths, as well as a saving and spending profile for a typical target-date fund investor. For the former, we used Ibbotson Associates’ 2012 capital market assumptions.2 Ibbotson provides its asset-class return assumptions to pensions, foundations, endowments, and other institutional investors as an input for their investment policy decisions, so the forecasts are a reasonable starting point for this analysis. Next, we proportionately assigned the forecasted returns to the series’ strategic asset allocations to calculate annual expected returns for each series. We followed a similar process for the series’ annual expected standard deviation, though the formula is somewhat more complicated in order to take into account each asset class’ correlation with one another. Morningstar gleans 1 Invesco Balanced-Risk target-date series’ low equity allocation is an outlier within the industry, skewing the longer-dated end of Exhibit 1’s minimum boundary downward from year 2050 and on. Omitting the series, for example, would result in a minimum allocation for year 2050 that’s more similar to year 2055. Invesco’s target-date process amplifies the risk exposure for its fixed-income investments, serving as a reminder that equity exposure isn’t a comprehensive proxy for risk. Indeed, the SEC has also called for series to disclose their risks in ways other than equity exposure. 2 Ibbotson’s 2012 return and standard deviation assumptions, respectively, were 8% and 19.1% for U.S. equities, 8% and 21% for international equities, and 3.5% and 6.5% for fixed income. MorningstarAdvisor.com 63 http://www.MorningstarAdvisor.com

Table of Contents for the Digital Edition of Morningstar Advisor - October/November 2013

Morningstar Advisor - October/November 2013
Contents
Contributors
Letter From the Editor
How to Make Social Media Work for You
Do Mutual Funds Still Have a Role?
More Personal Than Finance
How to Handle Your TIPS Positions
A Real Estate Veteran Starts From Scratch
Investments á la Carte
Investment Briefs
When to Say No
Take a Guarded Approach to Homebuilders
Fund Distribution Has Been Turned on Its Head. Now What?
Winning the Distribution Battle
Active ETFs Wait for Their Heyday
A Fund Firm Defies Indexing Trend
Piloting New Channels
A Good Fit
The Predictive Power of Fair Value Estimates
Does Being Prudent Pay Off?
Utilizing Utilities’ Total Return
Stuck in the Middle Is Not a Bad Place to Be
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
The Good Guys Win

Morningstar Advisor - October/November 2013