Retirement Insights

Retirement Insights: Accounting for Changing Markets

Retirement Insights: Accounting for Changing Markets

The average American spends upwards of 40 years saving for retirement and another 25 plus years living on the income generated from their savings in retirement, a period that may span several different economic cycles and unexpected events. Retirement savers, whether they are just starting out in the workforce or approaching retirement, need access to differentiated investment options to help them accumulate, grow and protect wealth assets.

Over the past 15 years, target-date funds have become an investment of choice—or default—for many retirement plan participants1. This often considered one-size-fits-all approach is not without its shortcomings, however, particularly for retirement savers seeking a more personalized, holistic approach to their assets and retirement needs. Managed accounts, provided by fiduciary specialists, can help with the challenges facing this cohort of participants, but not without the partnership of plan sponsors, whose role as gatekeeper remains pivotal to retirement readiness.

To help participants—whether through target-date funds, managed accounts or an à la carte approach—plan sponsors should consider building investment menus that offer strategies appropriate for all types of market conditions and macroeconomic regimes. This requires not only close consideration of portfolios’ long-term track record of the potential for wealth accumulation—and that of their underlying components, in the case of packaged-allocation strategies—across different investment environments, but also sensitivity to changes in market risk, return and correlation characteristics.

Key Messages

  • Plan sponsors should consider providing a menu of investment choices that can meet the ever-changing needs of participants throughout their entire retirement journey.
  • The risk-return profiles of target-date funds, particularly those whose underlying investments are dominated by passive strategies, may not be well aligned with the needs of all retirement savers. Those with more complicated financial situations—or simply a desire for greater personalization—may benefit from the customization that comes with managed accounts, for an additional cost.
  • A well-designed menu of choices should include a range of investment strategies with complementary styles, philosophies, and goals that can be used to construct diversified portfolios focused on the steady compounding of potential wealth accumulation over time and the mitigation of downside risk.

Set It, but Don't Forget It

Target-date funds were introduced in retirement plans in the 1990s as a way to help make investing simpler for participants, many of whom lacked the experience or aptitude to effectively manage their own wealth. The popularity of target-date funds increased markedly following the passage of the Pension Protection Act of 2006 and a subsequent Department of Labor ruling that designated the vehicles as “qualified default investment alternatives” to which the assets of participants who have not made their own investment election could be directed. Today, approximately eight in 10 of all 401(k) plans offer target-date funds, and American investors have $3.3 trillion allocated to the strategies.3

Increasingly, target-date portfolios are composed of passive investments—typically mutual funds or collective investment trusts (CITs). A recent survey by investment consultant Mercer found that 58% of target-date assets under management were in passive strategies compared to 33% active (with the remainder in active/passive hybrids)4. With an average expense ratio of 0.06%5 , index funds are a lower cost way to track the performance of a benchmark—but should benchmark tracking be the goal of retirement portfolios intended to grow and protect wealth over long time periods?

Given the many twists and turns that plan participants might encounter on their retirement journey, we believe that investors need to consider how well their investment strategies protect capital in challenging investment environments while participating in market upside. Passive strategies have no mechanisms to mitigate systemic risks likely to emerge periodically over a participant’s lifecycle, such as inflation, market gyrations, exogenous shocks and geopolitical uncertainty. And while the programmatic glidepaths that govern target-date fund allocations over time provide a degree of risk management at the asset class level, this positioning typically is based on backward-looking risk-return assumptions that may not be representative of future experience. Further, the actual risks of these portfolios may be greater than commonly thought; a Morningstar report found that the equity beta—or sensitivity to market movements—of the average target data fund was higher than the average equity allocation across the glidepath.6

Take the current environment, for example. Though equity investors over the past decade-plus have benefitted from beta exposure, the market’s success has led to a number of distortions. The valuation of many stock indexes, particularly in the US, appear rich, even after 2022’s shaky start; as of March 31, 2022, the S&P 500 Index’s price-to-book ratio was about two standard deviations above its 10-year average value, while the MSCI World Index’s was less than half a standard deviation from average7. Recent dynamics also have culminated in extremely top-heavy US indexes, suggesting that index funds carry both significant single-stock and sector risk. For example, the information technology sector represents about 28% of the S&P 500 Index, or 37.3% if you include tech-adjacent companies Amazon, Facebook and Google.8

Portfolios benchmarked against the most popular investment grade bond indexes, meanwhile, face their own set of concerns, as ultralow interest rates and massive sovereign and corporate bond issuance have skewed allocations toward markedly different risk-return profiles. The Bloomberg US Aggregate Index, a popular proxy for domestic bonds, has seen its effective duration rise to historical highs as yield collapsed to all-time lows. Long durations and a slim yield cushions suggest an unfavorably asymmetric risk-return profile for core bond investments going forward, particularly as the US Federal Reserve embarks upon a new tightening cycle.

Plan participants nearing or in retirement and needing income may be particularly vexed by the performance of bond indexes of late. Fixed income assets have been caught in a vise of persistent and increasing inflation expectations combined with heightened concerns about restrictive monetary policy, including more aggressive rate hikes and earlier and deeper balance sheet rationalization. We saw the impact of these dynamics clearly in first quarter 2022, particularly on duration-sensitive assets, as the high-grade Bloomberg Barclays US Aggregate Bond Index and Bloomberg Barclays Global Aggregate Index fell 5.9% and 6.2%, respectively.9 Interest rate and spread volatility seem likely to persist, in our view, as the benign financial conditions that provided an unprecedented tailwind for risky assets in general may have begun to unwind.

One Size Fits Some

While target-date funds have helped countless Americans achieve their retirement goals, we believe may not be the best solution for all savers. Designed to meet the needs of a broad swath of participants that share an anticipated retirement date—and potentially little else—these portfolios operate in isolation from an individual’s personal financial circumstances, whether it’s outside assets, future spending needs, potential sources of wealth or many other considerations. Given their inability to account for an individual’s assets and goals holistically, target-date funds can be suboptimal savings vehicles for those with more complicated financial circumstances, particularly as participants accumulate greater wealth and near retirement.

As a result of these challenges, sponsors increasingly are offering managed accounts in their retirement plans. Managed accounts offer fee-based advisory services tailored to needs of individual participants based on their age, income, contribution rates, risk tolerance and goals, while also accounting for assets held outside the plan. Often, these accounts are discretionary, giving the advisor the ability to transact on behalf of the account owner. Furthermore, managed accounts will adjust allocations as conditions and needs change over time.

While managed accounts offer what appears to be a compelling solution to retirement savers who are unable to self-direct their investments or have more complex needs that cannot be met with target-date funds, managed accounts do have some drawbacks. The most distinct drawback are fees, which can vary from a few basis points to more than 1% depending on a number of factors, the degree of human interaction versus Artificial Intelligence-driven advice most notably. While fees have been a deterrent to managed account adoption, innovations by industry participants are making the fee hurdle less challenging. Accordingly, plan participants should consider performing the difficult task of ascertaining if their risk-adjusted returns coupled with a more personalized portfolio justify the cost of these fees. In other words, are retirement savers getting sufficient upside capture with enough diversification and downside mitigation after deducting the cost of the managed account?

Perhaps less clear is that—unlike a target-date suite—a managed account’s investment options are mainly limited to the choices that plan offers all participants. Plan sponsors can give participants a leg up by providing a more thoughtful investment menu that incorporates complementary styles, philosophies, and goals. In our view, retirement savers need access to all-weather portfolios—whether through plan investment menus or as part of a target-date suite—that offer the potential for reduced short-term volatility and limited downside capture, which in turn would likely encourage adherence to long-term plans and promote the steady compounding of assets in real terms over time. One possible way to do this could be to include exposure to active, benchmark agnostic portfolios whose idiosyncrasies offer investors a differentiated investment experience over time relative to indexes blind to fundamental considerations.

A Smarter, More Holistic Approach

With risk ever-present and unpredictable, we believe a more thoughtful menu of retirement plan investment choices begins with the inclusion of all-weather strategies that provide a track record of performance in different investment regimes. Such a product, in our view, can be appropriate for investors at all stages of the retirement journey, from those just starting out to those looking to protect their wealth as they near retirement. In addition, these options can be used to make the managed account option more attractive and effective.

While we’re continually reminded that past performance is not an indicator of future results, mapping multicycle historical performance patterns against prevailing market conditions—outperformance in down markets, for example, or higher risk-adjusted returns over full cycles—may help plan sponsors assemble a lineup of investment strategies with complementary styles, philosophies, and goals. In our view, such an approach likely would better align manager evaluation criteria with participant time horizons, temper participant impulses to overreact to short-term anomalies and help improve plan sponsors’ prudent fiduciary processes.

 

1Source: U.S. Department of Labor “Target Date Retirement Funds- Tips for ERISA Plan Fiduciaries”; as of February 2013.

2Source: EBRI/ICI Participant-Directed Retirement Plan Data Collection Project; data as of December 31, 2018.

3Source: Morningstar 2022 Target Date Strategy Landscape; data as of December 31, 2021.

4Source: Mercer Target Date Fund Survey; data as of December 31, 2021.

5Source: ICI Research Perspective “Trends in the Expenses and Fees of Funds, 2020”; data as of March 31, 2021

6Source: Morningstar 2022 Target Date Strategy Landscape; data as of December 31, 2021.

7Source: FactSet, Bloomberg; data as of October 7, 2021.

8Source: FactSet; data as of March 31, 2022.

9Source: FactSet; data as of March 31, 2022.

This material is for informational purposes only and is not to be construed as specific tax, legal, or investment advice. You are strongly encouraged to consult with your independent financial professional, lawyer, accountant or other advisors as to investment, legal, tax and related matters.

The opinions expressed are not necessarily those of the firm. These materials are provided for informational purpose only. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. Any statistic contained herein have been obtained from sources believed to be reliable, but the accuracy of this information cannot be guaranteed. The views expressed herein may change at any time subsequent to the date of issue hereof. The information provided is not to be construed as a recommendation or an offer to buy or sell or the solicitation of an offer to buy or sell any fund or security..

Risk Disclosures

All investments involve the risk of loss of principal.

Past performance is no guarantee of future results.

There are risks associated with investing in securities of foreign countries, such as erratic market conditions, economic and political instability and fluctuations in currency exchange rates.

A target-date fund is a fund offered by an investment company that seeks to grow assets over a specified period of time for a targeted goal.

A collective investment fund (CIF), also known as a collective investment trust (CIT), is a group of pooled accounts held by a bank or trust company.

Beta is a measure of the fund's volatility (risk) relative to the overall market. The higher the fund's Beta, the more the fund price is expected to change in response to a given change in the value of the market.

Standard deviation is a statistical measure of the distance a quantity is likely to be from its average value.It is applied to the annual rate of return to measure volatility.

Duration is a measure of the sensitivity of the price of a bond or other debt instrument to a change in interest rates.

Diversification does not guarantee investment returns and does not eliminate the risk of loss.

Upside capture is the ratio of a fund's overall return to global equity market returns evaluated over periods when equities have risen.

Downside capture is the ratio of a fund's overall return to global equity market returns evaluated over periods when equities have fallen.

Indexes are unmanaged and one cannot invest directly in an index.

Standard & Poor's 500 Index is a widely recognized unmanaged index including a representative sample of 500 leading companies in leading sectors of the U.S. economy and is not available for purchase. Although the Standard & Poor's 500 Index focuses on the large-cap segment of the market, with approximately 80% coverage of U.S. equities, it is also considered a proxy for the total market.

MSCI World Index is a widely followed, unmanaged group of stocks from 23 developed markets and is not available for purchase. The index provides total returns in U.S. dollars with net dividends reinvested.

Bloomberg Barclays US Aggregate Bond Index is a broad-based benchmark that measures the investment grade U.S. dollar-denominated, fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM passthroughs), ABS, and CMBS.

Bloomberg Barclays Global Aggregate Index is a flagship measure of global investment grade debt from 24 local currency markets. This multi-currency benchmark includes treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging markets issuers. There are four regional aggregate benchmarks that largely comprise the Global Aggregate Index: the US Aggregate, the Pan-European Aggregate, the Asian-Pacific Aggregate, and the Canadian Aggregate Indices. The Global Aggregate Index also includes Eurodollar, Euro-Yen, and 144A Index-eligible securities, and debt from five local currency markets not tracked by the regional aggregate benchmarks.

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First Eagle Investments is the brand name for First Eagle Investment Management, LLC and its subsidiary investment advisers.

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