Return objectives in DC plans? Look inside a good target date fund to find out

 

At Russell, we see our role as being to help our clients earn the rate of return they require at a level of risk they can survive. In the past couple of blogs, I have looked at the required returns for non-profit organizations and for defined benefit pension plans but probably the cleanest application of this principle today is found in the world of defined contribution and, in particular, in the construction of target date funds (TDFs).

TDFs are the most common form of Qualified Default Investment Alternative (QDIA), which has been at the heart of the DC system ever since the Pension Protection Act of 2006 made “choice architecture” and “nudging” the keystones of plan design.

What makes TDFs special is the use of asset allocation glide paths: typically starting out with 90% in equities at young ages, falling to perhaps 30% by the time the plan participant reaches retirement. These glide paths are directly linked to how “a level of risk they can survive” evolves over a lifetime: a market decline that is unwelcome but survivable for a 30-year-old may be disastrous for someone who is two months from retirement. An asset allocation that is appropriate for one may be wrong for the other.

Good TDFs are based on an explicit targeted level of retirement income (usually expressed in terms of the replacement ratio compared to income whilst working) and it is this target that leads to the required rate of return and the asset allocation glide path. An example of the type of assumptions and analysis that go into a rigorous TDF construction methodology is found in Russell’s published approach. The resulting glide path is not set in stone—Russell’s is in the process of being revised to reflect updated modeling—and the return objective will depend to some extent on prevailing interest rates: pursuing an aggressive target of 8 or 9%, for example, is a riskier endeavor when interest rates are low than doing so when rates are high. At present, the return objective underpinning Russell’s TDFs is roughly 6-8½% (at the higher end of the range for longer-dated funds and at the lower end for shorter-dated funds).

The strength of the TDF approach—that they are a one-size-fits-all solution—is also its limitation. Designed for everyman, they are not necessarily the best solution for plan participants who do not fit the everyman profile. If an individual has a return objective or a risk tolerance that is markedly different from that built into the TDF, they may want to invest differently. That’s where the other levels of the choice architecture come in: TDFs are defaults, not requirements.

But when it comes to demonstrating the role of asset allocation in tying together investor goals with return objectives while keeping one eye on risk, target date funds are hard to beat.

Author’s note: One of the nice things about working at Russell is the sabbatical program – a chance to take a prolonged break after each ten years of service. As a result, I shall be away from the office from next week until late July. The Fiduciary Matters hot seat will be filled by guest authors over that period. Do make sure to provide comments in the space provided if you especially like or dislike anything we do or say. 


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