Fund Companies Scale Back Risk in Target Date Funds

Target date providers have adopted risk management 2.0 as they follow the lessons learned from the losses they incurred in 2008.


It looks like the ride has gotten less bumpy for many target-date funds aimed at people near retirement, according to a Morningstar report published in September. To get there, it has taken a bit of risk management tinkering at fund providers.

Performance for 2010 and 2015 funds likely will be less volatile overall for the third quarter and the year than in the wake of fall 2008, says Josh Charlson, Morningstar senior fund analyst. Much of the improvement stems from lowering glide paths’ equity exposure for short-dated funds, he adds. Also, some funds had generated losses as much from fixed income as from stocks, and have shifted into less-risky fixed-income holdings.

Some target date providers are now using more direct risk-management strategies, Charlson says. As examples, he points to the PIMCO RealRetirement series’ emphasis on long-term real returns and use of a tail-risk hedging strategy, the Invesco Balanced-Risk Retirement Funds’ utilization of a risk-parity approach, and the AllianceBernstein Retirement Strategies series’ addition of a “volatility-management sleeve” to its glide path.

The challenge now is to pull off that risk-control focus without sacrificing too much of investors’ long-range retirement income outlook. “There is definitely a risk of the pendulum swinging too far in the other direction,” Charlson says of being overly conservative. “A number of providers, as they have lowered the stock allocation relatively close to retirement, have raised it a bit in longer-dated funds. That is a way of bar-belling the approach.”

Three target date providers opened up their tool boxes to explain how they are trying to achieve a risk-control balance.

AllianceBernstein implemented the volatility-management sleeve in 2010. The firm uses quantitative models to signal an in-house team when market conditions warrant them, considering short-term shifts in asset classes like an equity reduction. “The other solution is to say, ‘I am going to load up on bonds as part of my strategic asset allocation.’ But that can be devastating to a portfolio in the long term,” says Thomas Fontaine, global head of AllianceBernstein’s defined contribution business.

While the new risk-control tool does not alter the long-term strategic allocation, it can affect up to 20 percent of the short-term allocation for near-retirees. “That is 20 percent to a component where the neutral position is 100 percent global equity. But within that strategy, we can change the mix from 100 percent global equity to 100 percent Treasuries,” Fontaine says. “Right now, it is basically all bonds.”

“Through the first three weeks of September, it reduced the losses by about 2 percent for the month and the quarter, relative to our normal strategic asset allocation,” Fontaine says. “If and when markets recover, we will give back a little of that extra return if we remain underweight in equities relative to our strategic weight. We are going to tend to lose less when the market goes down, and we will gain less when the market recovers. Over the full cycle, the returns should be about the same, but with less volatility.”

Meanwhile, Schwab is among the providers bar-belling the equity exposure. Its 2009 glide path shift increased equity exposure for younger investors, and decreased it for those nearing retirement. The 2040 fund went to 91 percent stocks and the 2030 fund to 82 percent, a Morningstar report on its fund series says.

“People close to retirement do not have the ability to recover from big losses. They need to make sure they can maintain the level of income that they have accumulated,” says Omar Aguilar, senior vice president and chief investment officer of equities and multi-asset strategies at Charles Schwab Investment Management. The equity holding drops to 40 percent by the 2010 fund, he says. “On the flip side, for people who are young, they need to follow a disciplined investment process so they accumulate as much wealth as they can,” he adds.

Schwab has been satisfied with the impact those changes have had on the funds’ results in the past few months, Aguilar says. The near-dated funds have been less volatile and the further-dated funds have been somewhat more volatile, but the idea is that younger investors have plenty of time to stick with it and earn good long-term returns.

BlackRock’s LifePath Portfolios have had the same glide path since 2003, with a strategic focus on consistency of drawdown in retirement. The goal is for retired investors to have accumulated enough to withdraw 4 percent of their balance annually and have sufficient retirement income.

When managing market risk for the target date funds, rather than only trying to maximize income replacement, “it comes back to delivering a consistent and reasonable range of outcomes that will provide for reasonable drawdowns in retirement,” says Chip Castille, head of BlackRock’s U.S. and Canada defined contribution business. “We are forecasting market risks, and we decide, if we want a 4 percent drawdown for 30 years, in real returns, what the glide path needs to be.” Results for the past couple of months have been within BlackRock’s expectations, he says, without discussing specifics.

Asked about some of the relatively new risk-control approaches that Morningstar cites, Castille considers it part of the evolution of the target date space. Some providers came in later to the field, he says, and prior to fall 2008 tried to differentiate themselves with very aggressive equity landing points. “And then they realized that approach led to some surprises,” he says.