GMO: 'The Road Less Traveled: Minimizing Shortfall and Dynamically Allocating in DC Plans'VW Staff
As Defined Contribution (DC) plans have taken center stage in many retirement systems throughout the world,2 so too have pre-packaged multi-asset solutions. Target Date Funds (TDFs), Life Cycle Funds, Managed Accounts, Advice, Target Risk, Life Style and Diversified Growth Funds all provide some type of “one-stop shopping” for DC investors. In the U.S., TDFs have become the dominant solution, capturing overwhelming amounts of cash flows from plans that adopt them as their “Qualified Default.”3 In an attempt to maximize return relative to risk, these products are typically anchored in Modern Portfolio Theory. At GMO, we believe DC retirement saving is a wealth challenge, not a return challenge. This may seem a subtle difference, but there are significant implications. We believe minimizing the likelihood of falling short of one’s wealth target (expected shortfall) is more relevant to the participant’s actual needs than maximizing return per unit of risk. Minimizing expected shortfall continually creates portfolios that focus on how much wealth is needed and when it is needed, based on the assets invested and time horizon to retirement. We believe this is a better objective for today’s DC plans.
TDFs put participants on a predetermined asset allocation path (a “glide path”), which systematically decreases equity exposure as an investor approaches retirement. While this approach may be more effective than participants building their own portfolios, it relies on the assumption that expected returns are constant, ignoring current market valuations. While glide paths themselves appear smooth, a predetermined asset mix often puts participants on a bumpy road that crosses every peak and valley the capital markets have to offer. At GMO, we believe this makes no sense. As the evolution of retirement plan investment design continues, we suggest a different approach – one that tries to minimize expected shortfall and incorporates asset valuation into the asset allocation process. This approach can be used as part of a process to transform a glide path “line” (or specific allocation policy) into a glide path “channel” (or range of allocations). Doing so can help a participant underweight expensive assets and overweight cheap assets, potentially delivering a smoother ride. Based on simulations and historical returns, our research4 shows that, by adding a valuation-sensitive component, or a “dynamic lever,” to a glide path, the chance of a participant running out of money in retirement through the age of 95 can be dramatically reduced. It is a road less traveled, yet one where more participants are more likely to meet their retirement needs. And, given the central role of TDFs in today’s DC system, it is a crucial consideration to improve the likelihood of retirement success.
GMO: Evolution of U.S. retirement
The U.S. retirement system is in the midst of a major transition from Defined Benefit (DB) to Defined Contribution (DC) programs. This is no secret: cover upon magazine cover and reams of paper have been dedicated to the topic for nearly 30 years. Two “once-in-a-lifetime” events in one decade – the bursting of the “Dot-com” bubble in 1999-2000 and the “Global Financial Crisis” of 2008 – have changed everything. If a DB plan were a car with the plan sponsor as driver, the legislative guard rails along the DB funding road were narrowed considerably in the Pension Protection Act of 2006 and in subsequent actions. The dramatic market events of the prior decade imposed tighter behavioral constraints at the same time. Sponsors accustomed to speeding down a wide open, multi-lane highway have been thrown onto a winding, single-lane country road where twists and turns, dictated by capital market returns, are often blind. Sponsors are now more immediately liable for writing big checks when capital markets don’t deliver for them. The limited ability to smooth out DB plan results has turned the spotlight to DC plans: a defined funding/contribution commitment for sponsors, with less worry about managing long-term problems in the wake of the short-term vagaries of capital markets.
GMO: DC Plan Design Progress – TDFs Becoming the Primary Investment Architecture
Whether or not we like DC plans, they are here to stay. DC has become the workhorse of the U.S. retirement system. With more focus on plan design, they are now more likely to deliver success than in their early days as voluntary, supplemental savings plans. One significant flaw of the DC system before PPA when compared to DB design related to participant behavior. Even if participants did not take action, they succeeded in DB plans because the benefit automatically accrued. However, in DC, where the sponsor matches participant contributions, if participants didn’t act (sign up to save for retirement and make sound investment choices), they didn’t get any benefit. The PPA of 2006 paved the way for Automatic Enrollment and Automatic Escalation. It also mandated that the Department of Labor identify Qualified Default Investment Alternatives (QDIA) for participants that did not provide investment direction.
The identification of a QDIA with safe harbor protections was the bridge that connected participants to the “auto plan” design, allowing it to work. TDFs are the overwhelming choice for QDIA.5 These investments use a glide path asset allocation design to provide high exposure to equities for young workers and to systematically reduce that exposure in favor of fixed income as a participant approaches retirement. In the last decade, TDFs have helped reduce concentrations in any of a number of offerings (e.g., Stable Value, company stock, or U.S. Large Cap Growth mutual funds). TDF dominance in asset flows has naturally standardized portfolio structures in DC, taking most of the driving (asset allocation evolution through time, rebalancing, manager selection) out of the hands of participants.
The TDF trend is powerful. Indeed, if current cash flow activity continues, many plans will see the majority of their plan assets in TDFs within a few years. Some sponsors have accelerated this trend by “re-enrolling” their participant populations (moving all participant assets to a TDF with 90 days’ advance notice). With this concentration in one approach, the TDF structure has become the chassis of the entire DC system. Maximizing the efficacy of this investment structure is imperative because, just as is the case with DB, the majority of a participant’s benefit in retirement is determined by investment returns, not contributions. While TDFs offer certain advantages to plan participants, they come with some inherent flaws.
GMO: Challenges with retirement investment thinking today
Just as is true with DB, the DC challenge (and opportunity!) is the long horizon: DC is a 70-year problem, including 40 years of saving and 30 years of spending. Unfortunately, TDFs today rely primarily on flawed logic that matches neither return history nor future capital market expectations. To gain a sense of why that’s the case we need to mention a four letter word – with apologies in advance – math.
We all know that lower expenses are better than higher expenses for the same service provided and saving more is better than saving less. However, math isn’t always that obvious. For example, two people with the same savings experience (number of years saving, amount saved, and average annual return) can have different results! Sometimes, in fact quite often, the year you are born has a big impact on your chance of retirement savings success. Why? Sequence of return risk.
Sequence of return risk relates to the difference between investing a lump sum and a series of contributions (such as in a DC plan). If you invest one lump sum at the age of 25, the order of returns you receive doesn’t matter. You could have high returns early and low returns close to retirement, or experience exactly the opposite, and it won’t matter.