Back in the Great Recession of 2008-2009, participants experienced a dramatic stock market decline. The S&P 500 index had a “peak-to-trough” decline of 51 percent! Coincidentally, many retirees and near-retirees were gaining their initial experience with something called a Qualified Default Investment Alternative (QDIA). The QDIA is a “safe harbor” (Department of Labor Regulation 29 CFR §2550.404c-5, 72 FR 60452 (Oct. 24, 2007) for plan sponsors allowing an investment allocation even if a participant does not provide direction. QDIAs became much more prevalent after plan sponsors took advantage of provisions added by the Pension Protection Act of 2006 (Pub. L. 109-280) and the associated Treasury Regulations §§ 1.401(k)-1(j), (k) (proposed in 2007 and finalized in 2009) to adopt automatic features. Concurrently, on October 24, 2007, the Department of Labor provided regulatory relief to fiduciaries in selecting a QDIA (Department of Labor Regulation 29 CFR §2550.404c-5 (see above).
The most prevalent QDIA is a Target Date Fund (TDF). A TDF automatically rebalances its asset allocation to follow a predetermined pattern known as a glide path to ensure the participant’s account is allocated in an ever more conservative fashion. When used as a QDIA, a plan sponsor will typically select a TDF of the year ending in 0 or 5 that is closest to a participant’s 65th birthday. For example, someone born in 1960 might have a Target Date 2025. The TDF investment allocation is structured to anticipate benefit commencement in that target year or soon thereafter.
In 2008-2009, most participants at or near age 65 had a Target Date of 2010.
It turned out that every TDF had its own definition of more conservative, or what constitutes a lower-risk allocation. At that time, Morningstar found short-dated funds, like 2010 target date funds, had the widest range of allocations to equity investments that: “… span a startling range of equity allocations – from 72 percent to 26 percent. Unsurprisingly, series that had higher equity weightings typically trailed the more conservative offerings in 2008.” (See Morningstar, Inc. Target date Series Research Paper, 2009 Industry Survey, September 9, 2009)
The importance of such distinctions was often lost on plan sponsors, fiduciaries, and participants. Certainly, during the 2008-2009 Great Recession, Target Date 2010 fund performance varied dramatically from participant expectations, triggering hearings in the U.S. Senate Special Committee on Aging, and expert testimony to the Department of Labor, the Securities & Exchange Commission, plus representatives from the Senate Special Committee on Aging, June 18, 2009. Retirees and near retirees had experienced a drastic, abrupt decline in their account balance, sometimes in excess of 50 percent. That decline translated into a significant reduction in retirees’ and near retirees’ expectations about retirement income and consumption.
That dramatic result also helped expose a significant concern: To what extent can retirees or soon-to-retire workers rely on their Target Date Fund to be properly positioned for generating income (financing consumption)?
Since then, mutual fund providers have been analyzing alternatives that might reduce the volatility in retirement income/consumption. For example, S&P Dow Jones Indices and Dimensional Fund Advisors (Dimensional) completed a study that considered how many TDF strategies compare with a new index—STRIDE (Shift to Retirement Income and DEcumulation) Index Series. The study found that the index series is a fitting benchmark for TDF strategies that are designed to be used throughout both the accumulation and decumulation period, and that focus on reducing fluctuations in expected retirement income and consumption. STRIDE was compared against the average of 2010 Target Date funds. The period studied was 2003 – 2016, which includes the market decline during the Great Recession. Researchers identified the three main investment risks that drive uncertainty around future consumption in retirement: market risk, interest rate risk, and inflation.
These indices use a glide path that transitions from growth-seeking assets (40 years prior to the projected target date) to assets that can support a more stable level of inflation-adjusted, in-retirement income (for a 25-year period after the target date). The goal is to identify a retirement investment solution that manages uncertainty about how much in-retirement income a saver’s balance can generate.
STRIDE’s structure varies noticeably from that of the average 2010 TDF. The STRIDE glide path reduces equity allocations starting 20 years prior to the target date, where the goal allocation at the target date is 75 percent Treasury Inflation Protection Securities and 25 percent equities. Other Target Date fund allocations vary significantly, in part based on a fund’s strategy of either “to” or “through” retirement. Some TDFs have a “to” goal reflecting a higher degree of safety and liquidity – participants in these funds might use the funds to purchase an annuity. Other TDFs have a “through” goal anticipating investors will hold onto assets after age 65, reflecting a longer time horizon.
In regards to a “to” or “through” glide path – S&P Dow Jones Indices and Dimensional found that a STRIDE structure where the target date matches the anticipated commencement of payouts may result in less volatility in a participant’s expected income/consumption in retirement. Studies show a majority of plans now use TDFs (see above (GAO), see also: ICI Factbook, Figure 7.14 ). Alternatives that may avoid wide swings in estimated retirement income/consumption may be of interest to plan sponsors as more and more participants are leaving assets in the plan following separation/retirement.