Retirement Insights

Retirement Plan Risk: What to Watch Out For

Retirement Plan Risk: What to Watch Out For

May You Live in Interesting Times

First Eagle views the permanent impairment of capital—that is, the potential for investment losses that are never fully recovered—as the most serious risk retirement investors face.

ERISA appears to share this sentiment to some degree. The Pension Protection Act of 2006 amended ERISA to allow plan fiduciaries safe harbor to direct participant assets to a qualified default investment alternative (QDIA)—including target date funds, lifestyle funds, managed accounts and balanced funds—in the absence of participant elections. There’s much good to be said about the convenience of these packaged-allocation products, especially for the cohort of disengaged plan participants whose contributions and matching funds may otherwise be moldering in cash. Given changing market dynamics over time, however, these vehicles can be a blunt solution to a more nuanced problem, relying on yesterday’s performance to mitigate tomorrow’s risk.

Providing plan participants with investment options focused on retirement outcomes requires not only close consideration of the long-term historical performance of portfolios—and their underlying components, in the case of packaged-allocation strategies—across different invest­ment regimes, but also sensitivity to changes in market risk, return and correlation characteristics. We believe retirement savers may benefit from differentiated investment portfolios that seek attractive long-term results in all market conditions—i.e., high upside capture and low downside capture potential—through benchmark-agnostic exposure to the global opportunity set.

Key Takeaways

  • Key-Takeaway

    The risk-return dynamics of markets since the global financial crisis suggests that the assumptions upon which target-date portfolios are managed may have shifted over time.

  • Key-Takeaway

    Domestic equities appear fully valued by any number of absolute and relative measures after the massive post-global financial crisis rally.

  • Key-Takeaway

    Longer duration and a slim yield cushion suggest an unfavorably asymmetric risk-return profile for core bond investments going forward, potentially undermining their defensive characteristics.

  • Key-Takeaway

    We believe retirement savers need to consider all-weather portfolios—whether individually through plan lineups 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.

Changing Dynamics, Static Approaches

Though not the only vehicle to achieve QDIA status with the 2006 passage of the PPA, target-date funds have been the primary beneficiary of the rule. It’s estimated that 40 million Americans have some portion of their retirement assets in these vehicles, to the tune of more than $1.7 trillion.1 The Investment Company Institute estimates that 27% of 401k plan assets were held in target-date funds as of end-2018; this figure is much higher on a participant basis, however, as 59% of plan participants held shares in a target-date fund, which are more popular among younger cohorts of the workforce with fewer accumulated retirement assets.(Of course, the rapid growth of packaged-allocation products like target-date funds in no way discounts the importance of effective plan design; with about 68% of 401k assets allocated to core investment menu options including equity and bond funds, stable value funds and company stock, plan design is perhaps the single largest opportunity for plan sponsors and advisors to influence the trajectory of participant retirement savings.)

The defining element of a target-date fund is its glidepath, or the changes to asset allocation that occur over time. Though the particulars of glidepath design vary among managers, target-date funds tend to follow the same basic template. With retirement several decades away and asset accumulation a priority, funds maintain a heavy allocation to equities—domestic equities, in particular; as the retirement date nears and asset preservation and income generation grow in importance, funds shift to a more conservative stance marked by a bias toward high-quality fixed income portfolios

Recent dynamics in the capital markets suggest that these traditional approaches to managing risk in target date funds may not be as effective as they had been historically, however, which in our view highlights the need for an asset mix whose risk and return characteristics may help plan participants through the retirement journey’s rough patches.

Traditional Risk Mitigation Methods May Be Tested

Market performance in reaction to the onset of Covid-19 served as a stark reminder of the need for retirement plan sponsors to understand the risk inherent in their investment product lineups. While sharp selloffs often are viewed through the prism of sequencing risk—e.g., the drawdown’s impact on the recent retiree, who suddenly finds her nest egg trimmed by 20% and has little opportu­nity to recover the difference—market shocks are an obstacle retirement savers of all ages must overcome to reach their goals. Not only do mathematics become a headwind following a large loss, behavioral finance tells us that volatile periods increase the likelihood that participants will act in opposition to their long-term needs. Packaged-allocation products like target-date funds should be among the first under the microscope given their popularity—particularly among retirement savers less likely to be actively engaged with their portfolios.

Take, for instance, target date funds’ large exposure to US equity markets, which appear fully valued by any number of absolute and relative measures after delivering a total return in excess of 700% since their post-global financial crisis bottom. For example, as of September 30, 2021, the S&P 500 Index’s price-to-book ratio was nearly 2.5 standard deviations above its 10-year average value, while the MSCI World Index’s was less than one standard deviation from average.4 And as shown in Exhibit X, the relative valuations between the two indexes on an enterprise value to EBIT ratio stood near an all-time high, suggesting more attractively priced investment opportunities may be available in overseas equity markets.

  of October 7, 2021.

Beyond valuations, these dynamics also have culminated in extremely top-heavy US indexes—and by extension a similar top-heaviness in the investment vehicles benchmarked to them, particularly the low-cost passive strategies that comprise a growing share of 401(k) plan account balances and target date fund allocations. Though intended to provide diversified exposure to the US equity market, index funds—in which nearly 36% of 401(k) assets are invested per a recent study5—carry both significant single-stock and sector risk as a result of these changes to the index’s composition. For example, information technology represents 28% of the S&P 500 Index, a percentage that doesn’t include companies like Amazon, Facebook and Google that are bucketed in other Global Industry Classification Standard (GICS) sectors but have tech embedded deep within their DNA. Were those three included, that number jumps to 38%6

 

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 Barclays 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. Longer duration and a slim yield cushion suggest an unfavorably asymmetric risk-return profile for core bond investments going forward, potentially undermining their defensive characteristics. Such outsized interest rate risk is particularly discomfiting at a time when frothy inflation numbers have ratcheted up pressure on the Federal Reserve’s accommodative monetary policies. With the index’s current yield-to-maturity of 1.56% and effective duration of 6.6 years, a mere 0.25% increase in interest rates would result in a price decline that more than offsets a year’s worth of coupon payments. A 1% rate increase would drag down the price of the index by nearly 7% and result in a total return close to -5.2

 

All-Weather Solutions for a Changing Climate

 

The average American spends upwards of 40 years saving for his or her retirement and 25 years drawing on those savings in retirement, a period that may span several different economic cycles.

In our view, retirement savers may need to access to all-weather portfolios—whether individually through plan lineups 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. We think one way to do this is to consider exposure to active, benchmark agnostic portfolios whose idiosyncrasies offer investors a differentiated investment experience over time relative to indexes blind to fundamental considerations.

 

  1. 1. Source: The Wall Street Journal; as of September 3, 2021.

    2. Source: Investment Company Institute, ICI Research Perspective, September 2021.

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

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

    5. Source: BrightScope and Investment Company Institute,

    “The BrightScope/ICI Defined Contribution Plan Profile: A Close Look at 401(k) Plans, 2017” (August 2020). The BrightScope Defined Contribution Plan Database contains detailed information from audited Form 5500 reports for more than 55,000 large private-sector 401(k) plans (i.e., plans with between four and 100 investment options and typically with 100 participants or more). 6 Source: FactSet, as of September 30, 2021. 7 FactSet and First Eagle Investment calculations, as of September 30, 2021 8 Forbes, Young Americans Are Saving for Retirement Sooner (August 2021)

    The opinions expressed are not necessarily those of the firm and are subject to change based on market and other conditions. These materials are provided for informational purposes only. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. Any statistics 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, hold or sell any security. The information in this piece is not intended to provide and should not be relied on for accounting, legal, and tax advice.

    Indexes are unmanaged and do not incur management fees or other operating expenses. One cannot invest directly in an index.

    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. These risks may be more pronounced with respect to investments in emerging markets.

    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. 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. The 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. The MSCI EAFE Index is an unmanaged total return index, reported in U.S. dollars, based on share prices and reinvested net dividends of companies from 21 countries and is not available for purchase. Diversification does not guarantee investment returns and does not eliminate the risk of loss. The Bloomberg Barclays U.S. Aggregate Bond Index is an unmanaged 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 and is not available for purchase Barclays US Credit Index measures the performance of investment grade corporate debt and agency bonds that are dollar denominated and have a remaining maturity of greater than one year. Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. Duration measures a bond’s sensitivity to interest rates, by indicating the approximate percentage of change in a bond or bond fund’s price given a 1% change in interest rates. Target-date funds contain varying amounts of stocks and bonds. Over time, the value of these investments will fluctuate and can decrease in value, causing your investment in the target-date fund to lose value as well. All investments involve the risk of loss of principal. Past Performance is no guarantee of future results. First Eagle Investment Management is the brand name for First Eagle Investment Management, LLC and its subsidiary investment advisers. FEF Distributors, LLC (“FEFD”) distributes First Eagle products; it does not provide services to investors. As such, when FEFD presents a strategy or product to an investor, FEFD and its representatives do not determine whether the investment is in the best interests of, or is suitable for, the investor. Investors should exercise their own judgment and/or consult with a financial professional prior to investing in any First Eagle strategy or product.