Morningstar Advisor - October/November 2013 - (Page 67)

former generally has a lower allocation to equities than the latter in the year of retirement, that relationship often flips in the retirement years, as some “through” targetdate series glide paths quickly roll down their asset allocation, leading to a lower equity exposure than “to” glide paths in the retirement years. Fidelity, for example, continues its roll down many years past the retirement stage, but because its ultimate landing point (where allocations cease to roll down and become indefinitely static) is relatively low, its results share many of the same characteristics as a typical “to” glide path. Trading Longevity Risk for Market Risk Despite the apparent advantage displayed by higher-equity glide paths, more equities aren’t always the optimal choice. A lower allocation to equities corresponds to less market risk and uncertainty—those are nontrivial factors. Exhibit 6 shows the expected worst-case returns for the industry and specific glide paths at various ages, given each glide path’s allocations at those points as well as the Ibbotson capital market assumptions. “Worst case” means investors should have less than a 2.5% chance of experiencing a worse annual return than the figure at each given age. Using this viewpoint, the “to” glide paths measure up particularly well in the years leading up to retirement, as they were largely designed. American Century and BlackRock’s worst-case losses of 11.2% and 11.9% at age 55, respectively, are all less severe than the worst-case scenarios for any of the examined “through” glide paths. Meanwhile, Fidelity’s market-risk profile shines strongly in the in-retirement years, with a worst-case expected loss of 6.5% at age 95 that’s clearly lower than those of the rest of the group. An alternate view of risk could also examine the range of outcomes for each target-date glide path. Exhibit 7 shows the expected range of savings balances for 65-year-old workers invested in the industry average glide paths. The “to” glide path, which here corresponds to fewer equities, has a narrower range of results; its 95th percentile outcome also produces a higher ending balance than the equity-heavy counterparts. In other words, the worse-case scenario for investors in “to” series looks better than investors in “through” series. Those characteristics may appeal to more risk-averse investors. A more conservative glide path also makes sense for plan sponsors mindful of getting more of their workers across a minimum savings threshold rather than maximizing their workers’ retirement nest eggs. Comfort Isn’t Free Note that much of the divergence in results between “to” and “through” glide paths— and consequently glide paths with more versus fewer equities—comes on the upside. The more optimistic scenario may leave workers with the happy prospect of legacy planning. What’s more, a greater allocation to equities gives workers who have been less diligent about saving a higher probability of having enough retirement savings. The implications for the results essentially come down to a trade-off between taking more longevity risk or more market risk; one doesn’t happen without the other. While the difference in outcomes between the various glide paths may seem small, the relationships are stable and significant. Investors and plan sponsors choosing more-conservative target-date strategies may gain peace of mind that their savings balance will fluctuate less on a year-to-year basis than if they were invested in a more aggressive alternative. In exchange, they give up the potential for higher expected returns that can be as important in the years following retirement as they are in the years before, resulting in an increased risk that they’ll outlive their savings. As intuition would suggest, investors with high savings balances have more ability to take on more longevity risk. And while mortality considerations may prove uncomfortable for some, they also shed additional light on others who may be more able to take on increased longevity risk; they include investors and workers with certain family health histories (for example, heart disease), personal health issues (smoking), or occupations (construction jobs). The corollary take-away is that for workers with less savings or longer life expectancies, a more conservative glide path could reinforce or worsen an already tenuous retirement position. The shorter-term comfort provided by taking less market risk comes with the longer-term risk of outliving savings. Meanwhile, continuing improvements in health care, while probably welcome as a whole, will likely continue to exacerbate the situation by leading to longer life spans. With a more aggressive asset allocation, though, those workers could have a better shot at making up the savings gap through market gains. The obvious implication for plan sponsors is that they should keep their workforces’ demographics and overall pattern and level of savings in mind when choosing target-date funds. Companies with more-generous retirement-contribution plans, for example, have greater leeway to choose more-conservative options. As the results demonstrate, though, workers in other firms may need the long-term boost provided by more-aggressive options. That leads to a less apparent implication: Plan sponsors might consider increasing investor education around the trade-off between market risk and longevity risk. Particularly following the market volatility seen in 2008, market risk jumped to the forefront of investors’ minds, while longevity risk has since received relatively scant attention. As results here suggest, though, the two are inextricably linked, and lessening exposure to one means taking more of the other. Ultimately, plan sponsors—and their participants—weigh these risks as they choose and implement a target-date investment. K Janet Yang, CFA, is a senior fund analyst on the fundof-funds research team with Morningstar. MorningstarAdvisor.com 67 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