Foreward to:
[whitepaper]Four Things You May Not Know About TDF Glide Paths
By: Fred Barstein, Editor-in-Chief, 401kTV
401kTV Summary: Great article by industry thought leader Dorann Cafaro about how glide paths in target date funds (TDFs) work and what employers sponsoring a defined contribution plan like a 401(k) should be evaluating.
At their most basic, some TDFs “glide” to when a person is expected to retire (usually 65 years old) reaching its most conservative point which stays fixed. Though glide paths continue to be aggressive even when a person approaches retirement age trying to achieve better returns into a person’s retirement period.
What’s best? Depends on the profile of a company’s employees. Are they risk averse? Do they leave the money in the plan at retirement? High salaried?
TDFs are all about risk and return. Risk is not just about having more stocks than bonds. There’s a reason we call them junk bonds. Investing in IBM may be less risky than fixed income in Indonesia.
Investment can be hard particularly for HR professionals to understand but, if you’re not comfortable, imagine how your employees feel. If there’s one investment you should try to understand, it’s TDFs which 401kTV will cover extensively.
Four Things You May Not Know About TDF Glide Paths
By Dorann Cafaro
What you may know already is that a glide path in a target date fund (TDF) is the changing mix of investments over time inside the fund. Most articles refer to this as the change of the percentage of stocks, bonds and cash as it “glides” toward retirement and further they love to point out that this action usually falls into two categories:
- “to” glide paths where the allocation reaches the most conservative allocation at the time of retirement then stays fixed in retirement
- “through” glide paths where the allocation does not reach the most conservative level till later in retirement
Furthermore you may know that this “glide” may be done a little at a time in a steady gradual approach or it may be stepped down every so many years, often every 5 years, or it may take an aggressive approach retaining very high allocations to stocks until 20 years from retirement when it takes a sharp reduction perhaps more like a cliff than a glide.
But you may not know what different glide path features really mean to the evaluation of what is the most suitable choice for your plan participants. One you may not know that the glide path itself does not matter. Consider that a “glide path” is just a marketing term for the risk features allocated across the TDF investment over time.
Two you may not know that a glide path evaluation is all about risk! Risk is the comfort level we have to loss, the greater the chance to lose our savings the greater the risk. Does the glide path measure risk in a TDF? The short answer is no. To measure risk start with the basic facts of what are the holdings in the TDF that might be considered “risky”. Keep in mind that a portfolio with a large percentage in stocks could be less risky than one with more bonds if these bonds were high risk/junk bonds, so you must look at the specific holdings not just what percentage is held in the gross asset classes of stocks, bonds or cash across the TDF. A TDF with high exposure to emerging markets, to micro-cap equities, to securitized assets, and to derivatives could increase the TDF’s risk. Low quality credit quality fixed income or fixed income with long durations could increase the TDF’s risk. A concentration of investments in a few styles or a few geographic regions or a few economic sectors could all increase risk. If we started with looking at the actual holdings in the TDF then we can look at how these holdings are allocated over the entire life of the TDF from the earliest date one could have placed money in the fund to at least 15 years after retirement. Looking at the total exposure to higher risk investments over the TDF will provide an excellent view of the glide path risk and allows glide paths to be correctly compared.
Three you may not know that it is important to consider the stability of the glide path. What is a stable glide path? It is one that stays close to the published glide path. Many glide paths are not stable as the managers choose to use a tactical allocation methodology that purposely changes the glide path or the glide path changes due to the economic or market impacts. If the allocation is often changed than it is hard to evaluate and may make the glide path itself a high higher risk element. This higher risk feature, an unstable glide path, may increase returns and that will be a positive but it still increases risk and this needs to be recognized.
Four you may not know whether a gradual glide is better than a stepped or the “cliff” style. Many recent articles address what is called the optimization of the glide path but as noted the glide path is about risk exposure so does one of the glide path styles, gradual or stepped or aggressive, deliver less risk? Perhaps over a short time period a gradual glide path style may offer less volatility particularly in weak markets but a TDF needs to be considered over 30 to 40 years. Thus the evaluation needs to consider the glide path style, the percentage of equities, over the full TDF life, the 30 to 40 years. Recent analysis shows little to no difference over the long-term impact of these different glide path styles. Morningstar’s analysis of target date glide paths showed most should deliver similar results.
In summary, now you know that the role of glide path plays when evaluating what target date option best meets the needs of plan participants may not be as important as thought. Rather it is all about the consideration of how much risk is appropriate within the glide path. So the glide path itself may not be what is critical, rather think of it as the vehicle governing the percentages of risky assets. One must evaluate all the risk criteria in light of the glide path stability and this can be easily accomplished using the Bdellium QDIA Blue Book target date evaluation tool.
