Resist the temptation to increase risk for low savers, as every dollar becomes more important.
The debate about target date funds revolves around the nature of the glide path and how aggressive it should be with respect to the equity allocation near the retirement date.
It's not a black or white question. As with other investments, what's right differs from person to person and depends on a number of factors.
This is especially important for retirement plan advisers and plan sponsors, who are tasked with making an already complicated decision not just on behalf of an individual or family but for a broad array of participants.
Plan participants differ in terms of how much they can expect to receive in Social Security benefit payments; what their expenses will be after they stop working; and how much they have saved on their own, outside their plan.
Some plan sponsors may be tempted to solve a low-savings problem by offering target date funds with more aggressive glide paths. The logic is that for those who have undersaved, each dollar of target date fund saving must be invested more aggressively to provide participants with some hope of not outliving their nest egg.
We would argue the opposite.
If investors have not saved enough for retirement, each dollar of savings becomes that much more valuable and needs to be protected. Plan participants who have undersaved are particularly unable to sustain losses associated with higher equity exposure near retirement, as most of their savings likely is earmarked for basic living expenses, such as housing and health care.
If employees without adequate savings take a significant loss to their nest egg just before retirement, their basic standard of living could be profoundly affected.
Retirement advisers and plan sponsors who argue for aggressive glide paths should consider participants' need to incur risk versus their ability to withstand potential account losses near or in retirement. It is very difficult to make the case that workers with less savings should be investing more aggressively because they need higher returns.
Research shows that the vast majority of participants in defined-contribution plans do not have enough money saved for retirement and cannot absorb major losses near or in retirement without making dramatic changes to their lifestyle.
A February 2014 report from Fidelity Investments showed the average 401(k) balance on its record-keeping platform was $89,300 at the end of 2013. For workers 55 and older, the average account balance was $166,200.
In light of the five-year bull market, it is easy to forget that equity markets do not always go up. Surveys indicate that DC-plan participants have neither the temperament nor resources to absorb significant losses around the time of retirement.
CATASTROPHIC LOSS
Data from Morningstar Inc. indicate that an investor in the average 2010 target date fund had a 34% loss during the 2007-09 financial crisis. The impact on a 62-year-old plan participant who had saved a relatively modest $250,000 before retiring in 2007 would have been a catastrophic loss of $85,000.
Cash flows into shorter-dated target date funds during that period turned negative — a sign that investors were not as risk tolerant as they had thought they were.
For these reasons, we think retirement plans should offer target date funds with a more conservative glide path as the default option.
In addition, in the spirit of one size does not fit all, participants with deeper investment knowledge could choose a more aggressive fund to access the level of risk and opportunity that best suits their situation.
Advisers and plan sponsors should consider two key questions when selecting target date funds for their plans: Should I offer more risk in my default target date option to help participants with inadequate retirement savings? And, in the event of another market meltdown, can my plan's participants withstand the potential losses associated with the higher equity allocations?
Evidence would suggest that the answer to both of those questions is no.
James P. Lauder is chief executive officer of Global Index Advisors Inc., a subadviser to the Wells Fargo Advantage Dow Jones Target Date Funds.
