Glide path construction: minimizing longevity risk in retirement

Target-date funds have become the investment vehicle of choice for U.S. retirement plans, with more than three quarters of plan sponsors now offering them as their qualified default investment alternative.¹ More than simply rebranded balanced funds, these strategies streamline what was once a complex series of continuous investment decisions into a single, professionally managed, objectives-based investment strategy.

While a detailed list of objectives for a target date fund could get quite exhaustive, they boil down to three simple goals that they seek to achieve:

• Assist the participant in accumulating assets for a successful retirement
• Increasingly protect these assets against potential drawdown risks and the risk of severe and sustained declines in asset values leading into and through retirement
•  Provide protection against running out of funds before the end of retirement (also known as longevity risk) that is otherwise lost as defined contribution plans increasingly replace defined benefit plans

Under the hood of every target-date fund is the glide path, the asset allocation adjustments that the fund is designed to make to balance growth potential with risk management as an investor approaches his or her anticipated retirement date.

The concept of a glide path is deceptively simple: a higher allocation to equities to maximize growth during the early to middle stages, which gradually tapers off to balance risk and return potential as retirement approaches. But in order to build—and protect—a level of savings necessary to fund a comfortable retirement, several key factors must be considered: How long will the participant need to contribute? What will the level of those contributions be? What’s the likely retirement date? How long will that retirement last and, perhaps most important, what constitutes an adequate and lasting retirement income?

Our aim with this paper is to provide an overview of the elements that shape our approach to glide path design. Central to this is the belief that most glide paths de-risk too quickly, thereby reducing growth potential before and after retirement. We’ll explore these elements in greater detail in subsequent papers.  

Our Lifetime Target-Date suite of funds seek to provide an adequate level of wealth in retirement through an investment process that carefully balances growth potential with risk management.

This process can be broken down into three steps:

1 The retirement challenge should be approached as a partnership between the participant and the asset manager, with both parties working together to accomplish a singular goal. There are several factors that contribute to the ability to achieve this goal, with the most important by far being the level of contributions made by the participant and the employer.

2 This is closely followed by glide path design, which drives much of the asset growth potential. Glide paths vary from provider to provider, and they’re the element through which the asset manager can make the biggest difference to the outcome.

3 Third is asset allocation. While the glide path determines the allocation shifts between equity and fixed income, we believe it’s the responsibility of the fund manager to make appropriate changes to the sub-asset class shifts based on expected return forecasting. This can also have a meaningful impact on the success of the target-date fund.

In this paper, we’ll consider each of these factors separately and assess how they can combine to create a successful target-date fund.  

No two participants follow the same pattern of behavior: In an ideal world, all participants would join the fund at 25 and retire at 65, but life’s not always so obliging. We have no way of knowing precisely when participants will enter the fund—some may join when they’re 20 years old and others at 40. Similarly, some participants will contribute at suboptimal levels for some if not all of the accumulation phase. In our experience, the participant’s contribution rate (including that of the employer) is the single most important factor in determining retirement success with a target date fund. Our goal is to design a preretirement glide path that can deliver the best accumulation while balancing risks, over a wide variety of personal circumstances.   

So, while participant behavior varies widely, it’s helpful to have an idea of how an average participant might act. A review of demographic data compiled from more than 2.8 million participants in John Hancock’s recordkeeping platform can help us gauge the actions of the average participant over the course of his or her career. Based on available data, we can say with some confidence that the average participant starts making contributions at age 25 on a salary of roughly $40,000, receives an annual salary increase of about 1.8% a year, and retires at age 65, earning roughly $84,000. The participant’s contribution rate, including a standard 3.0% company match, grows from 8.0% to 13.0% over that time, resulting in a retirement pot that will need to last between 25 and 30 years.

By feeding what we know about the average participant into our design process, we have the foundations we need to begin constructing an effective glide path: We know how long participants have to accumulate wealth, how long that wealth will likely need to last, a good sense of contribution levels, and what the portfolio needs to achieve to provide adequate retirement wealth.

How adequate wealth is defined is subjective, but based on our research, we believe an income replacement goal of 85% of final salary should be suitable. With 50% of participants’ final salary coming from their defined contribution plan, the remaining 35% typically comes from sources such as Social Security and other personal savings accounts.

There are several reasons we believe 85% of final salary is a suitable level for income replacement:

• Social Security in retirement is taxed at a lower rate than wages
•  Households are no longer saving for retirement
• Work-related expenses such as food and travel are no longer necessary

Based on these factors, our calculation shows that if participants begin contributing to a target-date fund at 25 years old at a rate of 5.0% (which, with 3.0% company matching, rises to 8%), increase that contribution rate throughout their working life to age 65 (or 13%, if we once again assume a 3.0% employer contribution), and factor in portfolio growth over the corresponding timeframe, participants should have a high likelihood of reaching retirement with an appropriate nest egg to make that sum last throughout retirement. The goal here is to maximize wealth during the accumulation phase while protecting against the risk of a drawdown so that the fund will be able to deliver an appropriate level of income over a retirement lasting 25 to 30 years. Taking John Hancock’s demographic data into consideration, we can strive to calculate the best path to get there, and the appropriate balance of growth and risk management necessary to meet our objectives.

The aim of the John Hancock Lifetime Target-Date suite of funds is to seek to minimize longevity risk, or, put simply, the danger of running out of money in retirement. With that in mind, the John Hancock lifetime glide path favors a through retirement approach, which typically maintains a higher equity allocation for longer than the to retirement funds, gradually tapering off until they reach a static and more conservative final allocation 20 years past retirement.

The benefits of this approach are twofold: A through retirement approach allows participants to remain invested in growth assets for longer, thereby increasing the potential for continued accumulation within their portfolio. It also removes the danger of a cliff edge pension, in which the participants’ assets are transferred to cash or an annuity at age 65, regardless of market conditions.

A through approach also makes sense if we consider how people spend their retirement savings. It’s commonly assumed that people begin drawing on their retirement savings the moment they leave the workforce, but research into retirement spending suggests otherwise. Research found that between the ages of 60 and 69, only 7% of personal retirement account (PRA) holders take an annual distribution of more than 10% of their PRA balance in a typical year, and only 18% make any withdrawals at all. For these participants, annual withdrawals represent about 2% of account balances. At age 72 however, tax laws stipulate a specified required minimum distribution, which starts as a relatively low percentage and grows over time.  The research goes on to show that, rather than following an income replacement path, actual withdrawal patterns more closely follow these lower required minimums.²

So, even a modest income replacement goal may understate the withdrawal horizon of the majority of participants. And, if the majority of participants aren’t drawing down their savings for 5 to 10 years postretirement, it’s clear to us that the relatively long withdrawal horizon from a target-date fund is capable of continuing well beyond age 65.

Based on spending patterns in retirement, the benefits of maintaining an allocation to equities postretirement are clear, but we believe the greater benefit of a higher allocation to growth assets can be captured in the preretirement phase. Most glide paths begin to rapidly de-risk when participants are in their late 30s or early 40s, rebalancing the portfolio by reducing equity exposure in favor of bonds.

The rationale sounds reasonable: A steady move away from growth assets could, in theory, help shield the portfolio from sudden market turbulence as retirement inches closer. But we believe de-risking so quickly from such an early age is both unnecessarily conservative and potentially detrimental to participants’ ability to achieve their retirement goals.    

We believe a more gradual de-risking process offers a better balance of growth opportunity and risk management. At age 40, the average target-date fund participant will have another 25 working years in which to make contributions. Furthermore, as our demographic data shows, most participants will have been contributing to their fund for just 15 years by the time they reach 40—at a time when their salaries are at their lowest; conversely, the years between 40 and 65 are generally when an employee’s earning power is at its peak. To begin reducing equity exposure just as participants are in the best position to make larger contributions to their retirement fund is a missed opportunity.

The common view is that such a cautious approach is necessary as retirement approaches in order to minimize the risk of volatility in the markets denting your portfolio. We would argue that these fears are overdone. Recessions are a natural and fairly common market occurrence and can actually be a good thing for long-term investors making systematic contributions, such as pension plan holders. The bear market that typically follows a recession can be an opportunity for long-term investors, as shares suddenly become available at significantly reduced prices; furthermore, the majority of bear markets correct themselves reasonably quickly. If we look at the bear markets that have occurred over roughly the last 50 years, all but two had recovered within two years and the longest recovery was just over five years. As long as participants continue contributing to their 401(k)s prior to retirement, their cash contributions will go further in the market, thereby enhancing their overall savings. This is a complex subject and one we intend to discuss in greater detail in a later paper.

The target-date solutions managed by our asset allocation team begin with a firm understanding of the client’s risk and return objectives and constraints. The team maintains a fundamental core belief that the diversification of asset classes, investment styles, and strategies allows for the greatest probability of achieving superior risk-adjusted results that are consistent with the funds’ investment objective.

The asset allocation team seeks to provide broad diversification across a wide range of equity, fixed-income, and nontraditional exposures (e.g., alternatives) to drive attractive and consistent risk/return characteristics. From there, the team also attempts to diversify across a wide range of underlying funds managed by both affiliated and nonaffiliated managers. They use this approach to effectively implement their overall policy mix from an exposure perspective, to add alpha over time, and to help manage the overall consistency of returns.

We believe it’s necessary that advisors understand how glide paths are constructed if they’re to effectively measure a glide path’s ability to deliver sufficient income during the participant’s retirement. In our view, the vast majority of target-date fund glide paths begin de-risking far too early, thereby dramatically reducing the timeframe available to maximize the growth potential of a participant’s savings at a time when the earnings of the majority of savers are at their highest.

We believe the objectives of a through glide path should be twofold: to maximize wealth accumulation in the savings phase and to support an appropriate income replacement rate in the retirement phase for 25 to 30 years.

The process we‘ve shared in this paper has strengthened our conviction that a through retirement glide path that begins with a 95% allocation to equities, gradually tapers to 50% equity/50% fixed income at retirement, and continues to de-risk through retirement to reach a landing point of 25% equity/75% fixed income 20 years after retirement is more closely aligned with the earning and spending habits of most participants.

This approach, combined with a careful risk management strategy, can help participants secure an appropriate level of income to support them through retirement. 

1 Plan Sponsor Council of America’s 60^th Annual Survey of Profit Sharing and 401(k) Plans, December 2, 2018. 2 “The Drawdown of Personal Retirement Assets: Husbanding or Squandering?” National Bureau of Economic Research, MIT, Dartmouth College, Harvard University, January 2013; “Asset Decumulation or Asset Preservation? What Guides Retirement Spending?” Employee Benefit Research Institute, April 2018.