A new analysis suggests that incorporating a dynamic glidepath aspect to target date fund design could boost outcomes. Or you could just boost deferral rates by 1%.
That report outlines the results of an analysis measuring the incremental impact that various target date and plan design initiatives might have over the typical span of a working career (40 years) from 1975 to 2015. The GMO researchers tested one variable at a time – passive vs. active, glidepath “riskiness,” pre-determined vs. dynamic glidepaths, and deferral rates – and measured the incremental impact over a baseline.
They held some variables constant, the time frame and some demographic and plan assumptions (e.g., salary, salary growth, match formula), but changed other variables, including:
Passive. The baseline had six different asset classes, all managed passively: U.S. large cap, U.S. small cap, international equity, emerging equity, U.S. investment grade bonds, and cash. Each set of returns was represented by the common industry benchmark return with a modest fee deducted. In the experiment phase, the researchers then replaced passive returns with active returns, using various methods of choosing underlying active managers.
The researchers’ conclusion: “[A]ctive management across this time frame, using admittedly simple backward-looking metrics, did not add value.” The take-away: Plan sponsors should not obsess about open-architecture or “best-in-breed” active frameworks. On the other hand, the researchers noted that “there were numerous time periods when active management in small cap, international, and emerging equity added value over the respective passive benchmark,” but that “given the high weights of most glidepaths to U.S. large cap and investment grade bonds, two admittedly ‘efficient’ asset classes, the aggregated active portfolios did not add much value.”
Moderate Glidepath “Risk.” The baseline started with an equity allocation of 90% and then glided down to 50% over the course of the 40 years. In the experiment phase, they replaced the moderate glidepath with a more conservative one and then a more aggressive one.
The researchers’ conclusion: “[T]he Conservative glidepath barely impacted the results. And the same could be said for the Aggressive glidepath.” The take-away: “Plan sponsors should not obsess about the slope of the glidepath.”
Predetermined Glidepath. The researchers began with a baseline of a predetermined glidepath (allocations were determined four decades in advance, with no ability to adapt to new information), but then in the experiment, replaced the predetermined glidepath with one that used a simple valuation metric that allowed the allocation to change dynamically.
The GMO researchers note that virtually all the major glidepath designs in the industry were originally designed as “predetermined,” meaning that while their asset allocations would change through time, they would change in a predetermined manner, regardless of market conditions at any given moment. “This strikes us at GMO as a bit silly,” the researchers said, noting that “destructive asset class ‘bubbles’ have formed through time, and are, we believe, detectable and largely avoidable.”
In their analysis, they concluded that Dynamic glidepaths had meaningful impacts. One that they called “Dynamic Swing” involved taking the original baseline glidepath, but instead of allocating 100% of the capital (employee and employer cash contributions), they allocated only 80%, shifting the remaining 20% to a Dynamic Fund, which was “paired” with the baseline. That produced a $55,000 incremental impact, close to a 9% increase in retirement wealth. The second, that they called Dynamic Core, was a bit more “disruptive” in that it involved hiring an entirely new manager to manage 100% of the assets in a dynamic fashion. The researchers constrained that a bit, such that the valuations-based allocation could have deviated from the original baseline glidepath no more than 0.5 to 1.5 times the original weight. Even then, they note that it added $86,000 to the baseline wealth. Their take-away: Plan sponsors should explore dynamic allocation options because they appear to show promise.
Deferral Rate. The baseline case started with a 6% deferral rate, but they then increased the deferral rate assumption.
The researchers’ conclusion: While admitting the obvious – that increasing deferral rates would boost the outcomes, the researchers said they were interested in how much it might boost them. For this analysis they simply “assumed that the plan sponsor – through cajoling, education efforts, and an assortment of behavioral ‘nudging’ tricks – was able to boost the median deferral rate of the employee base from 6% to 7%. This fairly modest bump provided an 11% increase in retirement wealth, or about $70,000 – an increase that was in line with the increase that the dynamic allocation approach would have delivered. The take-away: Boosting deferral rates showed meaningful improvement, certainly relative to other variables.
The researchers concluded that incorporating a valuation-sensitive dynamic allocation piece into the glidepath, combined with efforts to boost deferral rates, would have delivered meaningful improvements in retirement wealth outcomes, significantly more than activities related to open-architecture (“best-in-breed”), active management, or different risk levels of glidepath design.
