The conventional wisdom — as is evident from the mainstream glide paths imbedded in the most popular target date funds (TDFs) — is that DC investors should be invested in portfolios that decrease investor equity exposure over time.
On the other hand, a smattering of studies over the last few years has shown that participants, on average, would experience better investor outcomes utilizing a glide path that increases equity exposure as investors near retirement. This should not come as a surprise for two simple reasons:
- stocks outperform bonds over most longer time periods; and
- DC investors have larger account balances nearing retirement and, thus, the positive impact of higher stock returns are much greater later in the accumulation cycle.
This logic, however, does not guarantee that all DC investors will benefit from rising equity exposure. It simply means that, on AVERAGE, most investors would have better investment outcomes utilizing this strategy.
The primary challenge of glide paths that increase equity exposure over time is that, depending on the market cycles experienced during the final stage of the accumulation phase, a rising equity glide path could result in many DC investors who are nearing retirement having their portfolios severely depleted due simply to bad timing.
This creates a dilemma for asset allocators when it comes to designing glide paths. They have to choose between what is best on “average” for DC investors or a strategy that is designed to protect near-retirement investors. However, there is a third way — a way that few TDF providers embrace.
Michael Kitces recently posted an article on kitces.com that, though focused on in-retirement investors, sheds a great deal of light on constructing optimal glide paths for the accumulation phase of retirement. Kitces explored (through back testing) the impact of all three strategies: decreasing equity over time, increasing equity over time and a strategy that “adjusts equity exposure dynamically based on market valuation from time to time throughout retirement.”
Based on the outcomes of various simulations, he concludes that:
In fact, as it turns out, market valuation measures like Shiller CAPE can actually be so predictive of the optimal asset allocation glidepath in retirement, that the best approach may not be to implement a rising equity glidepath or a static rebalanced portfolio at all, but instead to adjust equity exposure dynamically based on market valuation from year to year throughout retirement. While such an approach is not necessarily a very effective short-term market timing indicator, the results suggest nonetheless that it can help to minimize risk when necessary, take advantage of favorable market returns when available, and have some of the best of both worlds – albeit with the caveat that markets can still deviate materially in the short run from what valuation alone may imply regarding long-term returns!
As has been demonstrated by Benjamin Graham and David Dodd of Columbia Business School in their 1934 book, Security Analysis, the core factor that should drive security selection is valuation. This strategy — utilized by famous investors such as Seth Klarman, Walter Schloss and, of course, Warren Buffett — forms the basis for value investing. However, adjusting glide paths based on valuations (or value investing) creates a new set of challenges.
Though there is growing belief that “valuation aware” portfolios could be an effective method of dynamically managing TDFs in the accumulation phase, money managers have been slow to adopt this type of strategy. There are several reasons why this may be the case.
It seems the number one challenge of value investing is that “stretched valuations” can stay high for extended periods of time — something that does not pose a significant challenge for the patient individual value investor. However, TDF providers are largely judged based on their short- to mid-term performance relative to other providers as opposed to investor outcomes as far as 35 years out.
It would not be hard for a money manager to justify cutting back on equity exposure based on high valuations — such as when the markets are trading at 25x (Shiller P/E) as they are today. However, given the Fed’s “put” — first called the Greenspan put, then the Bernanke put and now the Yellen put — who knows how long the markets will stay at their current levels or even climb a great deal higher. Low interest rates are viewed as favorable as they relate to economic expansion. They also provide a strong rationale for investing in risky assets.
If a TDF provider does cut back on equity exposure and the equity markets continue to climb, the following year their performance will look worse than those of their competitors. On the other hand, if the equity market slumps, they will look like geniuses. The safest route to being retained as the TDF provider of choice is to not deviate too far from what other TDF providers are doing. If a TDF provider’s performance is above average or average, it is likely to be retained. In short, there is little incentive to outperform over the long term given the risks of being booted from a lineup somewhere along the way.
Conclusion
Plan advisors are, in many ways, in the same boat as TDF providers. If they deviate from the pack, then it is more important that they be right in the short term, since the long-term impact of their recommendations is something by which they are rarely judged. The challenge of embracing “valuation aware” portfolios is that the correlation between current valuations and future returns becomes increasingly correlated over time. Put differently, changes in allocations based on current valuations may not appear to have been a good decision for five or even 10 years out.
Given the fact that both TDF providers and plan advisors take on the additional risk of underperforming their peers in the short term when they invest like a traditional value investor, it may be some time before valuation aware portfolios become a popular means of constructing and dynamically managing portfolios.
Also, considering the risk (on near retirement investors) of flipping the traditional glide path from progressively reducing equity exposure to progressively increasing equity exposure as DC investors near retirement, this later type of glide path is not likely to become popular anytime soon.
When stocks have historically high valuations, perhaps the best course of action is for TDFs to be managed in a way to provide as much downside protection as is reasonable. This can best be accomplished through extensive diversification through the use of alternatives, frequent rebalancing and managing portfolios with a tilt towards value.
