Target date funds

How the target date fund can help maximize
plan design

Jul 7, 2017
By BlackRock

Plan sponsors have two powerful tools that could help nudge participants toward improved retirements: plan design and target date funds. However, these tools are frequently considered separately. 

Plan design is used to encourage a specific savings rate, often without analysis of the final balance these rates may generate or its adequacy as a source of retirement income. Meanwhile, the target date fund is selected based on a comparison of performance, fees and risk.

Fully understanding the target date fund’s design, however, may help plan sponsors optimize the accumulation potential embedded in the target date fund’s design. This can inform plan design choices, leading to potentially more effective deferral rates and, critically, a better understanding of the risk/reward tradeoffs between market risks on the one hand and increased savings on the other.

Depending on the fund, target date funds may incorporate inputs that reflect real world spending and income data, as well as tools to anticipate spending behaviors over a participant's entire working career. Plan sponsors can use this insight to help increase market exposure when savings rates and balances are likely to be low, and encourage increased saving as balances grow, earnings increase and risk aversion becomes a greater factor.  

Understanding participant evolution 

Let’s consider a typical participant at two stages of her career and the tradeoff between savings and investment risk:

Participant at age 25

With only a couple years on the job, her savings balance is small and, given the realities of starting salaries and the financial pressure of student loans and other expenses, maximizing her deferral rate may not be a realistic option. That leaves maximizing growth potential on the table as an option.  

A young participant may be uncertain in the face of market volatility, leading some plan sponsors to consider a lower equity exposure to try to compensate for that uncertainty. We believe, however, that growth assets should be maximized when participants have time on their side and a lifetime of future earnings ahead of them. What’s more, based on our analysis, reducing equity exposure from 99% to 90% may not, over the course of a forty year career, be significant enough to justify the potential of increased return. (Based on our analysis,1 the difference in annualized risk is estimated as 14.08% against 12.81% for the reduced equity portfolio.)

Armed with this understanding, a plan sponsor may decide that maximizing risk exposure early can help set a foundation for future savings – and ultimately retirement spending.

Participant at age 45

At this point in her career, our participant has begun to build a significant balance – and as a result, her aversion to market losses and volatility has likely increased. Ideally, two behavioral considerations may be reflected in the glidepath. First, the glidepath should begin to de-risk, leaving equity exposure high but layering in fixed income securities and, possibly, real assets or inflation protection, to soften the edge of volatility. (De-risking for most glidepaths will begin to accelerate 10 to 15 years before retirement.)  But implicit in the glidepath is the assumption that our participant is now entering her peak earning years. The increased flow into her portfolio if she maximizes her savings may help offset decreased growth potential of her portfolio, helping keep her on track toward her retirement goals.

Knowing when to take risk

In a recent BlackRock survey, 74% of participants agreed that the purpose of retirement savings is to maintain current spending in retirement. 2 In seeking to achieve this goal, when a participant should take risk is as important as the amount of risk they take.

BlackRock can work with plan sponsors using sophisticated Aladdin® risk analytics to help assess current plan design and investment options and recommend adjustments to help improve retirement readiness. We can also help plan sponsors understand and apply our empirically-grounded, deeply-researched target date glidepath to optimize the balance between plan design and investment risk.

Learn more about how we can help you maximize your DC plan.

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