Publications

- April 1, 2019: Vol. 6, Number 4

Adding alternatives to the retirement mix: The formula for making target-date funds even better

by Angela Antonelli

As employers have moved away from the simplicity and security of defined benefit pension plans, employees have taken on more responsibility for retirement through defined contribution programs, like 401(k) plans. With more workers taking a bigger role in their own financial futures, investment managers have sought to make the complicated decisions about asset allocation and risk management a bit simpler.

Now, many future retirees rely on target-date funds for their own retirement savings plans. No longer do they have to fret about the mix of stocks and bonds. They don’t have to do the research and evaluation needed to regularly rebalance their portfolios. They simply decide how much to contribute alongside their employers, and the experts address all the other decisions.

The core concept of target-date funds is that they start out with a more aggressive investment mix designed to focus on growing value rapidly. As the retirement target date nears, the investment mix becomes progressively more conservative because the time period to correct for poor investment experience or unfavorable market conditions is shorter.

With target-date funds, the investment fund managers must make the difficult choices to accomplish the objective of managing risk appropriately while still achieving attractive investment returns.

Unfortunately, it is not uncommon for fund managers to focus more on risk management than value enrichment — to the disadvantage of participants.

Recent research from the Georgetown University Center for Retirement Initiatives, undertaken in partnership with the global advisory, broking and solutions firm Willis Towers Watson, shows that target-date funds can improve participant outcomes while managing risk better by expanding the use of alternative investment strategies, like private equity, real estate and hedge funds.

The analysis shows that by incorporating more diversifying asset classes, participants in target-date funds could see their annual retirement incomes improve by 11 percent to 17 percent, depending on market conditions. With results like that, you might think that more diversified target-date funds would be the norm. However, a variety of considerations, including liquidity, pricing, benchmarking, fees and governance, historically have held back fund managers and plan sponsors.

The benefits of alternative asset classes don’t end when a worker retires. Our research shows that a well-diversified target-
date fund has a higher probability of maintaining retirement assets after 30 years of retirement spending. That means retirees can enjoy a better quality of life while depending less on government support.

When many more Americans relied primarily on traditional defined benefit pension programs for their post-work years, there was less need to consider the integration of alternative asset classes in defined contribution plans. As more of us take greater responsibility for our own retirement outcomes, the investment industry must be more responsive to the need for these asset classes to be part of defined contribution plans.

Simplified savings and investment programs, like target-date funds, make it easy for workers to contribute without having to actively manage their assets. Investors believe that by outsourcing the investment decision-making, they will get the best returns with the least risk. To accomplish this, however, maximizing that benefit requires better asset-class diversification.

Fund managers already have the tools necessary to introduce these new asset classes to generate better rates of return and lower risk, while policy makers have the opportunity to take steps to make doing so even easier.

In addition to helping more workers access ways to save for retirement, another way to address America’s retirement-savings challenge is by making investing easy and decisions simple, and providing the freedom to employ the same investment techniques already used by defined benefit pensions to generate strong returns.

Well-diversified target-date funds have the potential to check all those boxes and improve retirement outcomes for millions of retirees.

 

Angela Antonelli is a research professor and the executive director of the Georgetown University Center for Retirement Initiatives. This column was excerpted from MarketWatch, where it originally appeared. Read the complete article at: https://on.mktw.net/2IZWUvJ

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