What the Pandemic Taught Us About Target Date Funds
- Last year’s dramatic moves in markets highlight an often-overlooked risk to target date fund (TDF) investors – the risk that severe volatility could prompt rash selling that crystallizes losses.
- To mitigate this risk, TDFs should be designed to instill confidence in participants.
- Diversification and active management can help cushion volatility and enhance risk management, while dynamic communication programs can bolster participant confidence.
The ability to “set it and forget it” has long made target date funds (TDFs) an appealing investment for defined contribution (DC) participants. They can leave it to investment professionals to manage allocations and dial down risk as retirement nears. It’s inherently a long-term strategy.
Yet 2020 highlighted another type of risk to TDF investors – the risk that severe volatility could prompt rash selling that crystallizes losses. Such was the case last March, when the spreading COVID-19 pandemic spooked markets. The 12% plunge on March 16 was the third-biggest percentage loss ever for the S&P 500 Index, eclipsed only by Black Monday in October 1987 and October 1929 near the start of the Great Depression.
This underscores why it is important for TDFs to be designed to instill confidence in participants. Here are our lessons from the pandemic and three ideas to help advisors and sponsors keep participants invested.
Lessons from the COVID-19 crisis
March 2020 reminded us that financial markets can do the seemingly impossible. Based on a normal distribution of returns, historical data suggests a single-day decline of 12% in the equity market should almost never happen – yet it did on 16 March. That’s why factoring in these extremely rare events is imperative for defined contribution (DC) advisors and sponsors when selecting investment options, particularly as they relate to the qualified default investment alternative (QDIA) option – typically a TDF – for those nearest to, or in, retirement. Figure 1 illustrates why this is so critical for participants, especially those with the most to lose. In the first quarter of 2020 alone, net outflows from TDFs in retirement or within five years from retirement totaled $11.9 billion, almost 15 times greater than the 2018 quarterly average, and in sharp contrast to the net inflows seen in 2019. We saw a similar theme play out in 2008.
Importantly, as indicated by the continued outflows in the near-retirement vintages during the second quarter and the third quarter of 2020, some participants were slow to re-enter the market. They missed out on a remarkable recovery, effectively “crystallizing” their losses.
Figure 1: Individuals closest to retirement withdrew the most
For participants about to retire, cashing out or trying to time the markets can have disastrous results. Figure 2 shows three hypothetical participants, all of whom had planned to retire at the end of 2020. While we do not know exactly how many near retirees ended the year with less than they started, we can assume the number is meaningful based on the accelerated withdrawals reported by Morningstar. As you can see, participant 1, who stayed invested, gained 11% during the period, whereas the other two participants – even the one who re-entered the market – retired with a loss during 2020.
Figure 2: Rash selling can be costly
Keeping participants invested
While the markets cannot be controlled, advisors and sponsors can help guide participant behavior in times of uncertainty and volatility.
Here are three ideas to help keep participants invested amid challenging market environments:
1. Diversification remains the first line of defense
Dissecting the level and type of risks along the entire glide path is essential to understanding the degree to which a glide path is diversified. Early on, when equity allocations are highest, equity exposures are calibrated by market capitalization (e.g., small cap), geography (e.g., U.S., non-U.S. and emerging markets) and by the degree of equity-like substitutes (e.g., high yield bonds, real estate investment trusts, etc.). In our view, the glide path allocation among risk-seeking assets should be focused on maximizing returns per unit of risk. While this emphasis should persist throughout the glide path, it is most critical for younger participants who are most heavily invested in risk-seeking assets. The relative performance of TDFs during the 2020 drawdown showed that advisors and sponsors should pay special attention to so-called “through” glide paths for older age cohorts given the meaningfully higher equity allocations at retirement relative to “to” providers.