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Are Retirement-Fund Critics Off-Target?

Christine Benz

Christine Benz: Hi. I'm Christine Benz for Target retirement mutual funds have faced criticism on a number of different fronts over the past several years. I recently sat down with John Ameriks, who is head of investment counseling and research at Vanguard to discuss some of these issues.

John, thank you so much for being here.

John Ameriks: Always a pleasure, Christine. Good to see you.

Benz: John, you spend a lot of work on retirement planning, and specifically one thing that you've looked at is target-date plan glide paths. In the wake of the bear market many target-date funds come under assault. A lot of people said these really didn't do what they were supposed to do. A lot of people getting close to retirement saw big losses in their target-date portfolios. Let's talk about the category in the wake of what was a very trying market environment.

Ameriks: Yes. Part of me says, "Well, why would we want to go back and rehash things?" But the other part of me says, "Look, I think there were some things that we learned coming out of the market crisis, and also some things that we've learned subsequent to the market crisis about target retirement funds that are revealing, and I think maybe provide a little bit more support for my argument, which would be that target-date funds have in fact, throughout this cycle, done what we had hope they would do."

So, the first set of issues was just the losses in the portfolios that occurred at the end of 2008 and into 2009, and there was an awful lot of attention that was paid to that. All of it I think came with a premise that somehow these funds shouldn't have lost money or that there had been an implicit promise in the funds that they wouldn't lose money.

And I hope and I think we tried as best as we can at the time and we continue to try today to make sure that everyone understands that target-date funds are an investment. There is exposure to the market. So, I'll make a point that I made at the hearings that took place. They were the first-ever joint regulatory hearings that took place in 2008 around target-date fund performance. I made sure to say, "Look, the idea of a target-date fund isn't to get rid of market risk. It's to try to help people to put a portfolio together in a way that involves a sensible exposure to that risk over their lifetimes." So, a lot of work has been done subsequently just to make sure that nobody is confused and thinks that there is potentially some kind of a guarantee here. There isn't.

I've always said the one sort of reality check on that is while it makes for a splashy headline--people didn't get what they wanted out of target-date funds--we know the other anecdote that went around in 2008 were that there were a lot of individual plan participants that said, "I don't even want to open my statements in 2008." A lot of target-date fund shareholders may have said that, as well. And if you think about that--and I definitely understood that sentiment, a lot of our investors do--what it reveals is, they know there is a risk there, and they know that what they were going to see was not going to be something that they particularly would want to see at the time. And they knew enough, not to pay too much attention to it.

I think subsequently what has happened--and I want to be very humble about this because it did not have to happen in this way--but history would have led you to believe that what subsequently happened isn't unusual. The markets came back, and they came back very strongly. Steve Utkus [director of the Vanguard Center for Retirement Research] and I have done a lot of work as you know trying to look at how well people have done in their 401(k) plans through the financial crisis. The results there are encouraging. People in target-date funds did experience modest positive returns, single-digit positive annualized returns over the five-year period ended at the end of last year. And if you think about that and think about the market environment we lived through, it's really hard to say there could have been a worse test or a more rigorous test for the target-date fund as a concept and also--I suppose we could all expect better results; it would be great if we had twice that level of return--but it's certainly a decent level of return in that environment. And so I'd say we've really passed the test there.

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Benz: Another set of research recently has challenged the conventional wisdom about what target-date glide paths should look like, specifically they typically or invariably get more conservative as a person gets close to retirement date. This research actually turned that on its head and suggested that perhaps, in fact, target-date plans should get more equity-heavy and more aggressive toward the end of someone's career. What's your take on that question?

Ameriks: So, I've seen things that have been done like that. I mean I think this type of research and the questions that get raised around the optimal design of glide paths in target-date funds are great. We may have talked about this at one point before, but I think having that kind of an academic debate and a consideration of "Why does the structure look like it does and should the target-date fund glide path be changed?" is a really good thing. And that debate will take place between academics and providers and policymakers and everyone else. So the first thing is to sort of welcome the debate around the glide path. It's not a settled issue by any stretch of the imagination. We should continue to look at it.

The second thing is the notion that equity risk would increase as someone gets older is something that I do have a problem with, and I think the discussion we just had on 2008 reveals one sort of area where the problem comes from. We had funds that were down 20%-25% on average in 2008. With more equity exposure, those declines would have been even worse, and there were hearings and a lot of consternation around just that level of decline. So just first and foremost, if there's more risk in these funds closer to retirement, that doesn't seem like it would be something that would be easily accepted by a lot of people. But the other thing is not forgetting that the design of a target retirement fund is about managing risk through the lifecycle as I said earlier, and that means trying to gear the risk level in the portfolio to the point in life where investors tend to be and their ability to tolerate risk at different points in their lives.

Most of the academic research that's been done on this topic indicates that in aggregate and on average, younger people are in a better position to bear market risk in their retirement portfolios. And as they get older, their ability to bear that risk tends to decline. That's fundamentally why the glide path changes. It is not so much driven by more equities, less equities, or a stable amount of equities that will produce a better or worse set of outcomes over 40-year horizons, where people close their eyes and don't look at what's in their portfolio. It's about making a trade-off between what set of outcomes over 40 years is acceptable and reasonable, and then what level of risk at each point in time can be borne by the investor in order to get that set of outcomes.

Benz: And you noted, going back to the 2008 market environment that actually people who were closer to retirement were more likely to sell their equities than people who had longer time horizons?

Ameriks: Right. I want to first say that when we look at these issues of who abandoned the equity markets, we've always found that that's a very small fraction of the population. When you read a lot of popular press, you think that everybody called their 401(k) plan provider and moved assets. That didn't happen. In fact, we're talking about single-digit fractions of the population. On average about 3% of participants in 401(k) plans abandoned equities during the crisis. But when you slice that data by age and look at what the age distribution looks like, disproportionately more older people made that switch as opposed to younger people. I think getting a little bit at that risk-tolerance issue and how it varies overtime, as well. So, that's the real rationale for why the glide path has to change over time. 

The other thing that this research points out, though, is the value of equities, over long periods of time in particular, as a holding in a retirement plan. And we're very big believers in the equity risk premium, but we don't for a minute want to ever separate the return premium over long histories from the risk level that exists in the asset class, as well, and there is always that trade-off.

Benz: I'd like to cover with you, John, the "through versus to" question which I know is a hot question in target-date land. First, let's discuss what that distinction is and also, when you look at the research on that question, what is the right strategy and the right construction for a target-date fund?

Ameriks: Well, I'll do my best. I mean the "to versus through" debate has been all over the place in terms of what that actually means, so let me try to start. This refers to what happens at the end of the target retirement fund glide path. What happens to asset allocation when people reach the target date? And in a "to" design, what happens at the target date is the final location of the asset allocation at and after retirement. So that's the idea of "to."

Benz: Nothing changes. I hit it, and it stays there.

Ameriks: Yes, the asset allocation changes up until the point of retirement, to retirement and then, stays the same.

The "through" piece of that, the opposing strategy or differentiated strategy, is one that continues to change and evolve after the point of retirement.

So, the question is, is a strategy that stops changing at the retirement date right or one that continues to change through the target-date correct?

Our point of view and that of the dominant providers in the target-date fund space is that the asset allocation should follow a "through" glide path. It should continue to change after retirement. And that's based on the notion that as people enter retirement, their ability to cushion market shocks--by being able to work or having a spouse that's still working--essentially their sources of protection from risk still exist, but they tend to diminish over time. And by the time, someone settles into retirement perhaps several years after, they leave their last full-time job, at that point, that's when we think that the glide path ought to stop changing and ought to reach its most conservative point. For Vanguard that means seven years after the target date, our funds reach their final allocation of 30% equity and 70% fixed income, and then will stay that way throughout.

The "to" argument, I think the proponents of that would tell you, look, it seems to be a little simpler. At the target date here's what the asset allocation will be and then it doesn't change. I think that still requires you to understand what the glide path is, and as long as we're clear that you're getting a through path that shouldn't be a problem. I should also say that the discussion has morphed a little bit. Initially, the "to versus through" debate was all about whether there should be equities in the portfolio at or after the point of retirement. And so, really was this question almost of should you have stock in your portfolio to retirement or through retirement, and there were initially a number of advocates saying, "Nope, you should be totally out of the stock market, as of the retirement date."

Benz: With the understanding that the person would then go buy an annuity or something like that, that they'd literally need all that money on that day?

Ameriks: Exactly, they would cash it out or buy an annuity. Most of the folks who have worked with people and worked with investors, as they get to retirement and go through retirement, have seen and observed that there is a very, very small fraction of the population that behaves anything close to like that. Most people, while they may leave their retirement plan, are generally going to roll assets over and invest a significant portion of those assets for further growth or for income or for whatever purpose after the point of retirement. And so, you do run risks, when you ratchet a glide path down to cash or a very conservative portfolio and only then subsequently decide to take risk again. That time consistency introduces a little bit of risk around opportunities, and we don't think [that risk] should be there.

Really I think, as I said the debates morphed now. You have trouble finding someone who will really strongly advocate that it ought to be zero equity risk. And as we just talked about a minute ago now, you have people that are starting to take a look at "Well, what would be the value of actually increasing the equity exposure as people get older." I chuckle a little bit after three years of being attacked on all fronts about how much equity to have in the portfolio, and now to see somebody come out and say, "No, no, you actually got it wrong. There should be more equity."

I guess, all I can say is that we can't win. We're always going to be wrong one way or the other. It's either too much or too little. But hopefully, over long periods of time, people are going to see that what we're doing in these funds is reasonable. Again, on average and in aggregate for most people, it gives them a reliable reasonable way to approach saving for retirement.

I think, I've told you this before, that shouldn't in anyway diminish the value of taking a careful look at what you own, trying to decide what your individual circumstances are in tailoring a portfolio that best fits you, even if it looks a little different from the target-date fund, and/or working with an advisor to help you with that. Target-date funds are a great place to start and they could be a fine place to finish. And you don't have to do any of that, and I think you'll still get to a decent place. But I do believe in the value of financial advice, and there is some scope for improvement for a lot of people, if they take the time and energy to go through that exercise.

Benz: Well, John, thank you so much for sharing your insights on this very important topic.

Ameriks: Always good to talk with you, Christine. Thank you.