We have a key belief about saving for retirement: The potential for additional upside is not worth an outsized risk of devastating downside.
Case in point: The recent Reuters Special Report on the riskiness of Fidelity Investments’ target date series Freedom Funds highlights important issues on the risk faced by participants in target date funds—risks that may become painfully apparent if or when equity markets pause or reverse their nearly decade-long climb.
The challenge with the Fidelity glide path isn’t so much that they are suggesting a bad portfolio—after all, 60/40 is common enough to be the punchline for most any asset allocation joke. But we believe they are recommending a portfolio with a risk/reward tradeoff that is well above the level necessary for the participant profile their glide path is designed for.
Fidelity Investments is a fund company respected by many, including us. And the report provides a good opportunity to consider how to evaluate a target date fund’s glide path. The fact that the Fidelity Investments’ glide path is more aggressive than virtually all peers (Figure 1) isn’t necessarily damning.The fact that it is more risky than it needs to be is of greater concern.
Figure 1: Range of equity allocations1 of top 10 “To” and top 10 “Through” glide paths by AUM (silhouette) with Fidelity Investments glide path2 (solid line) and an Average of Maximum and Minimum industry equity exposures at each age (dashed line)
Evaluating glide paths
We believe a glide path evaluation should be based on the purpose and goals of the target date funds. Typically, these funds work similarly to that workhorse allocation tool, mean-variance, in the sense that investors in target date funds seek to maximize reward while minimizing risk. In particular, glide paths seek sufficient growth to achieve a desired retirement income—that’s the reward. The risk comes in many forms, but for simplicity’s sake, let’s focus on the main two:
Let’s refer to these two risks as long-term risk (the possibility that the strategy may not succeed in its ultimate goal of providing retirement income) and short-term risk (the short-term volatility that may be so unsettling that participants abandon the plan).
Target date glide paths describe a schedule of when to invest aggressively and when to become more conservative in order to maximize retirement income reward, while working to limit long-term and short-term risk. There are different profiles that lead to the same level of retirement income, but some are less risky than others.The question becomes whether a particular glide path is aimed at the appropriate level of retirement income and whether it achieves that level with the least amount of risk.The evidence suggests that the Fidelity glide path is designed for a higher level of retirement income than is needed and consequently takes more of both long-term and short-term risk along the way.
Conveniently for our purposes and certainly to their credit, Fidelity Investments has carefully described the typical participant for whom their solution has been designed.3They seek to replace 50% of pre-retirement salary from the assets within the account of a full-career employee who saves 8% starting at age 25 (including both employee and employer contributions) with the savings rate increasing to 13% by the time of retirement. Combining this pattern with national salary growth patterns and Fidelity Investments’ suggestion that retirees should have accumulated 8x their salary by the age of 67, we can calculate the evolution of the account balance of a typical participant who receives an inflation-adjusted return of 5.4% on stocks and 1.5% inflation-adjusted return on bonds each year.4 Fidelity Investments does not disclose their market return assumptions. We have substituted the Russell Investments 20-year capital market assumptions4 for a diversified mix of growth assets and a diversified mix of capital preservation assets. In order to determine the return of the portfolio in a bad event, we assume standard deviations of 17% and 3.7% and a correlation of 0.3. In fairness, it is difficult to know how these assumptions compare to those used by Fidelity Investments. In order to work with round numbers, let’s assume the participant has a final salary of $100,000.