Selecting the appropriate investment default option for a defined contribution (DC) plan is likely to be the most important decision that plan sponsors will make. This is particularly true for the majority of DC plans that automatically enroll participants and invest their contributions into an investment default option – predominantly target-date strategies. Behavioral studies suggest that participants are most likely to remain invested in the default option rather than shift their allocations to other choices offered in the plan. Given this reality, the default selection should be appropriate for participants not only at the time of joining the plan, but also throughout their careers and even during retirement. That’s a tall order to fill, so where should a plan sponsor or fiduciary begin in selecting and evaluating appropriate default investment strategies?
Let’s begin by identifying the objective and success measure for most plans. Regardless of asset allocation structure, the investment default should maximize the likelihood that each plan participant will meet his or her retirement income needs. For most U.S. workers, that means replacing 40%-60% of final pay in inflation-adjusted dollars. Defining “success” for a DC plan as meeting a set income replacement goal also helps us understand and measure risk; that is, risk may be defined as the potential for shortfall relative to the retirement income replacement goal. One of the keys to meeting this goal is to understand how much plan participants can afford to lose at every age as they approach retirement, without jeopardizing their retirement plans. Based on our research, we believe participants’ capacity for loss may be much lower than many investment default options accept as tolerable. We have identified steps that plan sponsors can take to evaluate and select the investment default relative to this retirement income objective and participants’ capacity for loss.
As we consider the appropriate metrics to both select and evaluate investment defaults, we believe it is critical for DC plans to maximize the number of people likely to reach their retirement income goals. Participants have only one chance to get it right, so the asset allocation should be on target to get them to their goals within a set risk limit. What’s more, we believe investment default options should be evaluated relative to whether they are on track to meeting the income goal; we suggest evaluating the default’s tracking error to the outcome as a more appropriate metric than comparing performance relative to a peer group or an index composite, which, in our view, is misaligned to the objective of DC plans. Whether the investment default is outperforming other defaults that may have entirely different objectives or risk levels, is, we believe, both irrelevant and potentially dangerous.
To offer an analogy, our goal as a society cannot be that all fifth graders have higher reading scores than the average or median fifth grader. Rather, we should be seeking that they all are able to read at a particular level. The same is true for DC investment defaults. Our goal is not that the investment default is better than the average or median investment default; rather, we are seeking an investment default that is most likely to help each DC participant meet his retirement income goal.
Steps to selecting an investment default option
We have identified three steps in selecting or creating an investment default option appropriate for plan participants: identify a risk budget, work to maximize return and diversification, and guard against market shocks.
Identify a risk budget. The biggest “risk” in a DC plan may be failing to build sufficient purchasing power through inflation-adjusted returns to meet participants’ income needs in retirement. If the target income replacement for a plan is 50% of final pay, failure is falling short of this number. Understanding this risk allows plan sponsors to establish an appropriate risk budget. So the question becomes: How much can participants afford to lose at various ages as they approach retirement and still meet this income replacement need?
Based on the savings rate and match levels of your DC plan, you can mathematically derive the maximum 12-month loss workers can afford to incur, yet retain the likelihood of replacing at least 50% of final pay. This analysis provides the “risk budget” by age band or vintage for your plan. In PIMCO’s 2012 Defined Contribution Consulting Support and Trends Survey, we asked 39 consulting firms what they believe is the loss capacity for DC plan participants at various ages. You may be surprised by the loss capacity given by most consultants, especially for those over age 65: less than 5%, as shown in Figure 1.
Currently, most plans in the U.S. use target-date strategies as the investment default option. These strategies allocate assets based on an underlying glide path, shifting from more aggressive to more conservative assets as participants near their expected retirement date. Keeping in mind the loss capacity defined by the consultants, let’s take a look at the implied loss capacity embedded within the market average glide path constructed by MarketGlide, which is equally weighted across 37 target-date strategies in the marketplace today.
Figure 2 shows the market average glide path’s perceived loss capacity modeled as the maximum 12-month value at risk (VaR) at both the 99.5% and 95% confidence levels. Of particular note, while the consultants believe that participants at retirement date can tolerate no more than a 5% loss, the market average glide path may expose them to a 22% 12-month drawdown. This same analysis may be done comparing other types of asset allocation investment default options, including target-risk strategies, which may include a single or series of balanced portfolios differing by risk level, and managed account default allocations, which are diversified, often personally tailored portfolios.
But who’s right? The consultants or the average target-date strategy manager? At PIMCO, we believe the most instructive way to think about loss capacity is to ask how much a participant can afford to lose, yet still meet the retirement income goal. Based on a set of assumptions (a starting salary of $50,000; real annual wage increase of 1%; saving rate schedule of 6% in years 1-10, 7.3% in years 11-20, 7.9% in years 21-30, 9.8% for years 31-40; an employer match of 3.5%; and an annuity rate of 6%) about the typical starting salary, pay increases, contribution rates, and investment returns, we believe the consultants’ suggested loss capacity is about right for an “outcome-oriented” investment default option that seeks to replace 50% of a worker’s final pay. Based on PIMCO’s calculations, an outcome-based glide path can be designed to not exceed the “outcome-based” risk budget, and reduce the risk of plan participants’ failing to meet their income-replacement goals. Figure 3 shows an “outcome-based” glide path’s risk budget compared to that of the market average glide path and the consultant-defined loss capacity. You will note that the consultant suggested maximum loss capacity is significantly lower than the market average glide path and also lower than, yet much closer to, the outcome-based glide path.
Keep in mind, even in calculating the risk budget with a 99.5% confidence level, actual losses may fall outside this confidence range. As we recently experienced with the financial crisis of 2008, the market average glide path for those 65 years of age (i.e., the 2010 vintage) lost 23% while some lost over 40% of their value, according to Morningstar.
Work to maximize return and diversification. Expected returns of an asset allocation should be maximized, but it is also essential that losses not exceed the maximum loss capacities or budgets at various ages. In addition, diversification should be evaluated not only on an asset class level, but more importantly in terms of what drives volatility. What matters is how an investment behaves, rather than what it is called. For instance, high-yield bonds are within the fixed income asset class, but they often move up and down in value with the equity markets. That is, high-yield bonds may behave more like equities than fixed income, especially during times of market stress when many asset class correlations tend to rise. At PIMCO, we identify these drivers of volatility as “risk factors.” Figure 4 compares the volatility of the market average glide path to PIMCO’s outcome-based glide path; the latter offers the potential for both a lower overall level of volatility and more diversified sources of risk as the retirement date approaches.
We believe it is also critical to evaluate how an asset allocation may fare during different economic environments, including: “normal,” when returns are proportionally aligned with volatility and higher risk means higher return; turbulent, when returns across a set of factors are unusually high or low; and inflationary, when the annualized monthly change in the CPI exceeds 3%. In our view, an allocation that is risk diversified is more likely to weather various markets more effectively, thus increasing the likelihood that participants will reach their retirement income goals.
Guard against market shocks. Market shocks occur far more frequently than many may think. These shocks may exceed the risk budget of the participants and thus require specific hedging. If we look at the equity market and rely on a normal probability distribution to determine the frequency and potential severity of market declines, we would expect that a market move of plus or minus 4.5% would have occurred seven times in the last century. Yet in fact, since 1916, the Dow Jones Industrial Average has had 414 such days, as shown in Figure 5. Unfortunately, diversification alone is often insufficient to cushion portfolios against such losses, so evaluating how an asset allocation structure may hedge against sudden drops is important. At PIMCO, we actively manage tail-risk hedges in an effort to guard participant assets against the potentially devastating impact of a sudden market loss – that is mitigating the loss of an extreme left tail event such as the market loss in 2008.
Comparing asset allocation strategies
Comparing one investment default option to another often leads to a simplistic evaluation of performance, either relative to the underlying benchmark (e.g., the composite of index allocations that make up a glide path) or to a peer group of similar strategies (e.g., all 2020 retirement date vintages). Unfortunately, a simple look at either a passive approach or a peer group tells us little of what we truly care about when managing a DC plan default: whether the investments are on track to help participants meet their retirement income needs. However, by focusing on the needed outcome and how much participants contribute to the plan (including the match), we can derive the necessary return to help reach the goal.
Let’s look at an example of a participant at age 65. First, we establish what account balance the participant should have had at age 55 to be on track to meet a 50% income replacement goal at age 65. In this example, about $350,000 should have accumulated in retirement savings at age 55. Given ongoing contributions, we then determine how the account must grow to generate the needed $612,000 account balance by age 65. Then we can compare asset allocations to this needed outcome.
As shown in Figure 6, investing in 10-year Treasury Inflation-Protected Securities (TIPS) would have failed to deliver the needed return based on the participant’s contribution rate. To succeed in reaching one’s income goals by investing in TIPS alone, the savings rate would have to increase. Note that given an increased savings rate, TIPS – Treasury bonds that contractually keep pace with CPI – offer potentially the lowest risk path to reaching one’s sustainable retirement income goals. By comparison, the market average glide path delivered more return than TIPS, but not enough to meet the goal, while the outcome-based glide path exceeded the needed income goal during this time frame.
All of these observations relate only to performance, which is just one part of the evaluation. What about the risk? Like other investment performance evaluations, in a DC plan we can look at tracking error – yet not to a peer group or index, rather to a more relevant measure – to the needed return to reach the 50% retirement income replacement objective. Calculating the tracking error of actual returns versus the needed return of 3.89% for the 55-year-old to meet the retirement goal at age 65, we can see that the outcome-based target date has significantly lower tracking error than both the market average glide path and the 10-year TIPS. To go one step further, we may ask whether the participant has been compensated for taking on this added risk, or tracking error, which can be measured by the information ratio (the ratio of excess return to risk). The outcome-based asset allocation has a positive information ratio, whereas both the market average glide path and the 10-year TIPS bond do not.
Conclusion
Evaluation and selection of DC investment default options – whether target-date, target-risk, or managed accounts – should start with a simple question: How much can participants afford to lose and still be able to meet their retirement income goals? The answer can allow the plan sponsor to establish the risk budget based on time to retirement, work to maximize the returns and risk diversification within this budget, and guard against market shocks beyond this risk budget.
Understanding what risk is in a DC plan (failing to meet participants’ income needs at retirement) also allows for benchmarking or evaluating strategies relative to this outcome goal. By setting the needed account growth path based on contributions and the desired account value at retirement, the plan sponsor can estimate how well different strategies may deliver and how much risk they may need to take. In our view, selecting an outcome-based target-date strategy as the investment default option for a plan may be most appropriate for plans that measure success by the percentage of participants likely to meet their income replacement goal. What’s more, once the investment default is selected, we believe evaluating whether it is on track to reach the income objective – that is, looking at tracking error relative to the needed return – is the most relevant and appropriate metric for most DC plans. Just as with teaching fifth graders to read, we want all of them to reach the goal and therefore we want to measure whether they are on track with their reading development. With DC plans, we want all participants to retire with sufficient savings to meet their income needs throughout retirement – thus, we want to know whether the investment default has them on track to meet this goal.
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