There are two significant trends in DC investing: the use of traditional glidepath strategies (reducing equity as an investor ages) and the use of mostly cap-weighted passive money management. Both of these movements are challenged in a recent article in The Journal of Retirement.
“We believe that the heuristic of buying stocks when young and bonds when mature — a rule of thumb by which many billions are invested — is flawed, and that the typical glidepath implementation fails to solve the basic problems facing most investors,” note authors Robert D. Arnott, Katrina F. Sherrerd and Lillian Wu. To prove their point, they compared three different long-term accumulation scenarios:
• a typical 80/20 wind-down from equities to bonds;
• a continually rebalanced 50/50 mix of equity and bonds; and
• a 20/80 wind-up to equity.
The study used 141 years of stock and bond market returns from 1871 to 2011, which created “101 different investment experiences.” The big surprise is that of the three different strategies the typical 80/20 glidepath strategy generated the least amount of assets at retirement. The authors conclude that the “markets don’t care about our glidepath (or lack thereof); we’re as likely to have our best stock market returns late in our career as early.”
Of course, given that account balances are smaller in the early working years and larger nearing retirement, this result should not come as a big surprise. That said, however, depending on how the market behaves during the last 20 years of accumulation, an individual investor laden with equities could indeed have his or her ending balance greatly diminished, which is one reason why the authors do not suggest a 20/80 glidepath.
Arnott, Sherrerd and Wu present what they deem to be an optimal strategy: maintaining a 50/50 mix that is rebalanced annually. Additionally, they begin shifting bond duration 20 years before retirement to 10-year bond indexes, smoothly, one year at a time for 10 years; and then, 10 years before retirement, making another 10-year linear transition to T-bills. On the equity side, 20 years before retirement they shift from book-value weighted indexes to low-volatility indexes at the rate of 5% a year. At least on a back-tested basis (1927- 2011), this strategy produces superior investor outcomes when compared with a typical 80/20 wind-down strategy.
The authors make special note of the projected shift to passive vehicles. These investment vehicles are predicted to represent 80% of target date products by 2019 (Bauer et. al.). However, most of these monies are going into price-weighted passive investments. In their 50/50 simulation, Arnott, Sherrerd and Wu utilize book-weighted verses price-weighted indices, again showing superior results. This shift away from “bulk beta” to “smart beta” in an effort to improve returns and reduce equity risk is indeed a rapidly emerging trend.
For years, I have heard many investment advisors make the statement that most investors could be invested in a 60/40 balanced strategy and call it a day. However, few advisors are willing to take such a position publicly, thus appearing to be out of sync with the trends of the day. Evidence such as found in this study is beginning to mount, and one cannot help but wonder if it is not time to question the linear reduction of equity exposure as an investor nears retirement, which has rapidly become the “sacred cow” of target-date investing.
Furthermore, should the de-risking during the last 20 years nearing retirement be about duration matching and reducing equity volatility rather than simply reducing equity exposure while maintaining static bond duration? And finally, with such a huge shift toward passive underway, is the robotic tracking of commercial cap-weighted indices the optimal way to deploy passive management? These are significant questions that plan advisors ought to be asking themselves.
Jerry Bramlett writes about investments for NAPA Net the Magazine. He was the founder/CEO of The 401(k) Company, the CEO of BenefitStreet and founder/CEO of NextStep.
