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Target Date Investing

A Different Perspective on Sequence-of-Returns Risk Around Retirement

Jerome Clark, Portfolio Manager, Multi-Asset
Kim DeDominicis, Portfolio Manager, Multi-Asset
Wyatt Lee, Portfolio Manager, Multi-Asset

Executive Summary

  • Investors saving for retirement must consider a range of factors, including the objectives they wish to achieve and the risks they are willing to take. One factor that often receives significant attention is sequence‑of‑returns (SoR) risk—the concern that portfolio losses around retirement could impact the ability to support postretirement income needs.
  • We recognize that investors may have different retirement objectives, resulting in different risk priorities. While some investors may rationally prefer a strategy that limits the variability of account balances around retirement, most are focused on achieving adequate, sustainable income streams during retirement.1
  • In target date investing, it is critical to align glide‑path design with investors’ objectives. To understand the potential trade‑offs, it is not only important to evaluate the magnitude of potential losses, but also to view that potential in the context of the full investment life cycle.
  • For investors with a longer‑term focus on longevity risk, the benefits of maintaining a growth‑oriented glide path in their accumulation phase could meaningfully outweigh the potential negative impact of a large market decline close to or soon after retirement.
  • Historically, equities have tended to generate higher intermediate‑ and long‑term returns compared with fixed income and cash assets. In our view, the benefits of capturing this equity risk premium outweigh the potential impact of SoR risk. Our analysis suggests that most investors could have achieved higher asset balances at and into retirement by following higher‑equity glide paths, even after experiencing large market declines close to retirement.

Investors saving for retirement must consider a range of factors, including the objectives they wish to achieve and the risks they must take to achieve their goals. One factor that often receives significant attention is the concern that portfolio losses around retirement may impact the ability to support postretirement income needs. This risk is often known as sequence‑of‑returns (SoR) risk.

We recognize that investors may have different retirement objectives, and differing objectives will result in different prioritization of investment risks. While some investors, given their individual circumstances, may prefer a strategy that limits the variability of account balances around retirement, the majority of retirement investors focus on achieving a durable, sustainable income stream to support their retirement needs.

Poor returns experienced close to retirement can impact the likelihood of premature exhaustion of portfolio assets. As a result, many investors understandably pay close attention to movements—particularly downward movements—in their account balances as they approach retirement. Some investors intuitively may gravitate toward strategies that prioritize stable portfolio balances around retirement.

However, a singular focus on the impact of market movements around retirement does not capture the complete picture when it comes to factors that potentially could lead to premature exhaustion of portfolio assets. One needs to consider the full range of risks and their impact on retirement outcomes over the entire investment life cycle.

Focusing solely on the potential for short‑term losses near retirement does not take into account an investor’s complete financial situation. Investors face other significant risks―including the risk that an overly conservative portfolio will not achieve the growth required to sustain a desired level of postretirement income. In our view, investors are more likely to achieve their goals by balancing these different risks, both before and after retirement. 

DEFINING SEQUENCE OF RETURNS RISK

SoR risk goes beyond simple volatility risk because it is a function of both the timing of market returns and the timing of portfolio contributions and withdrawals. When cash flows occur over an investment horizon, the sequence of returns―whether monthly, quarterly, or annually—may have a considerable impact on outcomes. While contributions before retirement and withdrawals after retirement both can produce SoR effects, withdrawals after retirement are typically of greater concern because they may “lock in” losses after a period of poor returns, ultimately leading to premature exhaustion of portfolio assets.

As a result, conventional wisdom assumes that in the event of a large drawdown near retirement, investors with relatively conservative asset allocations will be better off because a conservative portfolio will mitigate the impact of a negative portfolio shock. However, this discounts the possibility that following a more growth‑oriented strategy during the accumulation phase could provide a larger portfolio balance going into retirement (i.e., the distribution phase). 

In other words, the benefit of having a larger accumulated balance going into retirement may outweigh the negative impact of even a large market decline close to or soon after retirement. While a more growth‑oriented portfolio might experience a relatively larger percentage loss in a market downturn, it likely still will be worth more in dollar terms, even after that decline.

To put it another way, consider two newly retired investors: One suffers a 5% decline on a $900,000 portfolio, while the other experiences a 10% loss on a $1 million portfolio. A 5% decline would reduce the first investor’s portfolio to $855,000, while a 10% loss would leave the second investor with $900,000—or $45,000 more than his or her more conservative counterpart. The second scenario still results in a larger portfolio balance, even though the percentage loss is twice as large. This is why we believe retirement investment strategies should focus not only on the potential for loss in percentage terms, but on potential outcomes in dollar terms. 

SOR RISK IN TARGET DATE INVESTING

A key facet of target date design is the construction of asset allocation glide paths that evolve over time and are focused on achieving specific outcomes. It is critical to align those glide paths with the investment objectives that investors aim to achieve.

In general, glide paths with greater emphasis on supporting long‑term income needs will have greater exposure to equities and other growth assets. Glide paths with greater emphasis on reducing balance variability around retirement will feature larger exposures to less volatile assets, such as fixed income and cash.

Target date glide paths typically begin with higher allocations to equities and then gradually rebalance into fixed income assets, so that the portfolio becomes more conservative over time. Because target date strategies are designed to span an investor’s entire life cycle, there typically is not a sharp transition from preretirement to postretirement positioning. A glide path that is more conservative at retirement typically will have been relatively conservative in the years leading up to retirement.

While concerns over SoR risk usually center on the risk of a large loss near retirement, investors cannot ignore the possibility that an overly conservative glide path will deliver low returns during the accumulation phase. This means that a conservative glide path ultimately could increase an investor’s risk at retirement by providing a long-term series of portfolio returns that are not adequate to support postretirement income needs.

Conversely, for investors focused on long-term income, the potential benefits of a growth-oriented glide path could outweigh the impact of even a large market decline close to retirement by allowing them to accumulate larger portfolio balances during the accumulation phase.

Historically, reductions in portfolio volatility typically have come at the expense of reductions in expected portfolio returns. Over shorter periods, equity returns have been more volatile relative to fixed income assets. However, the higher short-term volatility of equities also has been associated with higher long-term returns compared with fixed income assets. This equity risk premium has proven durable over long periods, facilitating wealth accumulation by retirement investors.

MANAGING SOR RISK REQUIRES GLIDE‑PATH TRADE‑OFFS

The implication of these long-term historical relationships is that any attempt to mitigate SoR risk by reducing equity exposure also will require target date investors to lower their postretirement income expectations. In fact, a more conservative glide path actually might increase the risk of premature portfolio exhaustion during the withdrawal phase if an investor is forced to take larger withdrawals from a smaller asset base to meet his or her income needs.

In this sense, asset allocation is a two-edged sword: While reducing portfolio volatility could mitigate SoR risk, the potential for lower expected returns introduces another risk to retirement income. What ultimately matters is the net effect of these two opposing forces as they are reflected in the glide path. To illustrate this point, consider two identical investors, H and L, who make exactly the same contributions to their retirement accounts over time; the difference being that H follows a higher-equity glide path while L follows a lower-equity glide path.

Should a severe equity bear market be encountered just before retirement, L is likely to experience a lower level of losses. Historically, however, investors with lower-equity glide paths have been more likely to have lower portfolio balances heading into a bear market. The relevant question, then, is which risk is more important: Would a smaller percentage decline leave L better off, or would having a larger portfolio value going into the bear market leave H better off, despite suffering a larger percentage loss?

EVALUATING THE IMPACT OF SOR RISK

To examine the trade‑offs required to manage SoR risk, we can measure possible outcomes using different glide paths. Our analysis here uses the benchmark glide paths represented in the S&P Target Date Indexes. This family of indexes is designed to reflect average asset allocations in the universe of glide paths currently available for different target dates, based on a survey of target date providers active in the market.

For each available target date, S&P also maintains two sub‑style indexes―the S&P Target Date To Indexes and the S&P Target Date Through Indexes:

  • The “To” glide path, which represents average exposures in glide paths that are generally designed to carry investors up to but not beyond the target date, has relatively lower equity allocations.
  • The “Through” glide path, which represents average exposures in glide paths that are generally intended to guide portfolio allocations through the withdrawal phase, maintains relatively higher equity allocations.2

As investors in 2020 target date funds are now fast approaching retirement, it is this cohort that will be most exposed to SoR risk over the next several years. Accordingly, we can compare the historical performance of the S&P Target Date To 2020 Index, which had approximately 42.5% invested in equities as of December 31, 2017, with the S&P Target Date Through 2020 Index, which had approximately 56.5% invested in equities.

Typical approaches to evaluating SoR risk focus solely on the potential magnitude of losses at specific points in time. Going into retirement, downside equity market volatility obviously could have a different impact on the two S&P indexes. Given that the To 2020 Index glide path has lower equity exposure, it seems reasonable to assume that it would outperform the Through 2020 Index in a down equity market.3 However, this approach does not consider the differences in portfolio balances that might accrue during the accumulation period.

To understand the potential trade‑offs, it is not only important to evaluate the potential magnitude of losses, but also to view that potential in the context of the full investment life cycle and the financial outcomes investors are seeking. This approach allows us to identify the point at which a rational investor might be indifferent between the outcomes of two different glide paths. In other words, given the potential performances of the S&P indexes in the accumulation phase, how big of an equity bear market would it take to equalize the values of two portfolios tracking those same indexes?

Over the 10 years ended December 31, 2017, the S&P Target Date To 2020 Index posted an annualized return of 4.73%, while the S&P Target Date Through 2020 Index returned 5.60%. So a hypothetical investor who invested $100,000 in a portfolio that tracked the returns on the “Through” index over that same 10‑year period could have accumulated a portfolio worth $172,450 by the end of 2017. A hypothetical investor whose portfolio tracked the returns on the “To” index, meanwhile, could have ended up with a portfolio worth $158,720―a difference of $13,730, or 8.65%, in favor of the “Through” investor (Figure 1).4

FIGURE 1: A Strategically Higher Equity Glide Path Could Have Led to Better Outcomes Over the Last 10 Years
December 31, 2007, Through December 31, 2017

Sources: Standard & Poor’s and T. Rowe Price; all data analysis by T. Rowe Price.

FIGURE 2: Hypothetical Bear Market Outcomes in a Flat Fixed Income Market
As of December 31, 2017

Sources: T. Rowe Price and Standard & Poor’s; all data analysis by T. Rowe Price.

From this starting point, we can calculate the equity loss required to make the outcomes equal for both portfolios as they stood on December 31, 2017. If we assume that bond returns were flat following the 10-year accumulation phase, it could take an equity market decline of more than 45% to neutralize the advantage enjoyed by the “Through” portfolio (Figure 2). In this scenario, the “Through” portfolio could have declined by 25.34%, or $43,698, while the “To” portfolio could have lost 19.1% of its value, or $30,262, leaving both investors with portfolios worth slightly less than $129,000.

Even in an environment where bond allocations generated a 5% cumulative return during the bear market period, equity prices still might have to fall more than 40% to produce the same ending values for the two portfolios (Figure 3).

In this analysis, we focus on portfolio balances because as a simplifying assumption the current balance can be viewed as the present value of future retirement spending. If we assume that an individual has a set spending strategy, then, all else being equal, a higher balance potentially means that he or she could spend the same amount over a longer period (i.e., the stream of income would last longer) or spend more over a shorter horizon.

In both cases, the SoR risk resulting from market volatility near retirement could have a significant impact on retirement income. However, unless the equity decline were even larger than in the hypothetical scenarios outlined above, the more conservative “To” investor would not enjoy a withdrawal advantage over the more growth-oriented “Through” investor. From an outcome-oriented perspective, the benefit of capturing the equity risk premium over a long investment horizon potentially would outweigh the impact of SoR risk. 

FIGURE 3: Hypothetical Bear Market Outcomes in a Fixed Income Market That Appreciates by 5%
As of December 31, 2017

Sources: T. Rowe Price and Standard & Poor’s; all data analysis by T. Rowe Price.

In this analysis, we focus on portfolio balances because as a simplifying assumption the current balance can be viewed as the present value of future retirement spending. If we assume that an individual has a set spending strategy, then, all else being equal, a higher balance potentially means that he or she could spend the same amount over a longer period (i.e., the stream of income would last longer) or spend more over a shorter horizon.

In both cases, the SoR risk resulting from market volatility near retirement could have a significant impact on retirement income. However, unless the equity decline were even larger than in the hypothetical scenarios outlined above, the more conservative “To” investor would not enjoy a withdrawal advantage over the more growth-oriented “Through” investor. From an outcome-oriented perspective, the benefit of capturing the equity risk premium over a long investment horizon potentially would outweigh the impact of SoR risk. 


Price Perspective

Target Date Investing: A Different Perspective on Sequence-of-Returns Risk Around Retirement

1 T. Rowe Price recently surveyed almost 300 defined contribution plan sponsors to understand their views on these complex issues. Please see: Lorie Latham, Advancing the Way We Think About Perceptions of Risk and Achieving Outcomes, T. Rowe Price, July 2018. Available on the Web.
2 Equity allocations for the S&P “To” and “Through” glide paths are shown in Figure A1 in the appendix.
3 Given that both indexes continue to maintain meaningful equity exposure around the target date, it is important to recognize that neither a “To” or a “Through” strategy may be able to completely insulate an investor from loss.
4 The performances shown here do not reflect the deduction of investment fees or expenses. Past performance cannot guarantee future results. Figure 1 showsthe growth of USD 100,000 invested in portfolios tracking the S&P Target Date Through 2020 Index and the S&P Target Date To 2020 Index from December 31,2007, through December 31, 2017. Figures include changes in principal value, reinvested dividends, and capital gain distributions. All examples are for illustrativepurposes only and do not represent the performance of a particular investment. It is not possible to invest directly in an index.

Important Information

This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.

The views contained herein are those of the authors as of November 2018 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.

This information is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.

Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.

Past performance is not a reliable indicator of future performance. All investments are subject to market risk, including the possible loss of principal. All charts and tables are shown for illustrative purposes only.

T. Rowe Price Investment Services, Inc., distributor, and T. Rowe Price Associates, Inc., investment advisor.

© 2018 T. Rowe Price. All rights reserved. T. Rowe Price, INVEST WITH CONFIDENCE, and the bighorn sheep design are, collectively and/or apart, trademarks of T. Rowe Price Group, Inc.

201811-654171

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