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Stacy Schaus, Ying Gao
Defined contribution lore suggests that participants do not worry too much about risk in target-date strategies, because these participants tend not to move their money, regardless of market volatility. What’s more, we have been told that, in order to meet their goals, participants need to accept the level of risk that’s typically embedded in target-date strategies. However, a careful look at the net flow activity into or out of target-date funds suggests that common DC lore may well be mistaken. According to the Plan Sponsor Council of America, over 76% of DC plans that automatically enroll participants into their plans use target-date strategies as the default. It’s not surprising then that, as the most prevalent default type, target-date mutual funds tracked by Morningstar as of 30 June 2012, have grown to over $440 billion, increasing from $75 billion since the Pension Protection Act of 2006 was enacted. [Note: Custom target-date strategies would add significantly to this asset value, but unfortunately cannot be tracked as readily.] Given the asset flow and the importance of the default strategy in meeting retirement income goals, we believe a close look at how participants are responding to the target-dates is critical. Our analysis of this data shows that the closer a target-date vintage comes to the stated retirement date, the more mutual fund net asset flows become correlated to market movements. This may indicate that participant risk tolerance is lower the closer one moves to retirement. Further, when we take a look at the risk of loss imbedded within the market-average glide path, we suggest that the loss potential embedded within this type of glide path exceeds the risk capacity of most workers. Our conclusion is that the market-average glide path may throw participants in over their heads, in terms of both their tolerance and their capacity for accepting risk. At PIMCO, we believe there is a better way to manage target-date assets: If we focus first on the risk capacity relative to meeting an income goal, target-date strategies may be more likely to meet the income needs of workers.
Appendix:Morningstar categoriesThe table shows the labels we use for each target-date vintage and the corresponding Morningstar universes.
It is not possible to invest directly in an unmanaged index.Starting time: January 2006 Starting age: 55 years oldStarting balance: $350,000Employee contribution rate: 12%Employer match rate: 3.5%Market-average glide path/stable value: Participants invested in market-average glide path at retirement starting at January 2006, then moved out in February 2009 and invested in stable value.Market-average glide path: Participants invested in the market-average glide path at retirement starting from January 2006 through June 2012.Returns for market-average glide path are back-tested and adjusted by inflation rate. Returns for stable value are from the Hueler Stable Value Index and are inflation-adjusted. End balance Market-average glide path: $490,864Market-average glide path/stable value: $371,262Bounce back to $350,000Market-average glide path/stable value: from February 2009 takes 17 months to bounce back in July 2010.Market-average glide path: takes three months to bounce back in May 2009.
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No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2014, PIMCO.
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