Alliance Provides Blueprint for Target-Date Funds
October 31, 2005
Adequate equity exposure, proper diversification, active management and targeted communications to encourage steady investments over a long time horizon are some of the key ingredients for a successful target-date retirement fund, according to a recent report by the global investment research division of AllianceBernstein of New York.
"Significant equity exposure through early retirement is essential to a successful retirement strategy," the report points out.
Alliance found that most existing target-date retirement funds are too conservative and not adequately diversified. Alliance recommends equity allocations as high as 95% for younger participants and 60% at retirement.
Over the past few years, there has been a shift in retirement savings responsibility, according to the report. The financial security of many Americans has been displaced due to the fact that responsibility and risk has shifted to individuals from their employers. The fact is, Americans are not saving an adequate amount for retirement, and even those who are making an effort to prepare for retirement make bad investment decisions.
Today, most individuals are covered by defined-contribution plans, and the rates of both participation and contributions remain low. On average, only 75% of employees who are eligible for retirement plans participate. Saving levels are also insufficient, as average 401(k) balances are about $70,000.
On the brighter side, sponsors of defined-contribution plans have been doing more for their employees' retirement savings. The amount of defined-contribution plans with written investment-policy statements on how to increase contribution rates has risen from 67% in 2003, to 75% in 2004.
However, poor investment decisions are very common among participants. In a survey conducted by Alliance, 62% of employees surveyed admitted that they are "unprepared" or "reluctant" to manage their investments themselves.
This said, Alliance believes that target-date retirement funds are a "step in the right direction." They are simple for investors because investment professionals handle everything, and even a savvy investor can benefit from professional investment advice.
"To generate sufficient growth and protect participants against both sharp market drops and the mordant effects of inflation on retirement spending power, target-date retirement funds must be well-designed investment portfolios," according to the report.
A fully diversified target-date retirement fund should be equally weighted between U.S. large-cap, small- and mid-cap and non-U.S. equities, and all three categories should be equally allocated to growth and value. Effective equity exposure, as defined by Alliance, "is the engine for growth." Although U.S. small- to mid-cap returns have been volatile lately, exposure to them can smooth returns over short periods of time and help investors feel more secure by giving them exposure to a segment that is in favor at the moment.
Further, extending the international equities world to include emerging markets, such as China, can bring about attractive returns, diversification benefits and incremental returns through active management.
Exposure to bonds is also necessary during the saving years because they provide a welcome buffer "by acting as a stabilizer that mutes the market risk from equities," the report said. "That is, they provide portfolio stability needed to reduce the chances that a short-term loss might reduce savings to an unacceptable degree, possibly causing the investor to make a bad, emotion-driven investment decision."
And in the late saving years and in retirement, inflation-protected securities should be combined with regular bonds to hedge against inflation.
REITs are attractive at all levels, and should get a considerable allocation in all of the life stages. High-yield bonds, on the other hand, should be held from mid-life through early retirement because they are not appropriate for portfolios looking for the highest returns or the most stability.
Naturally, the situation of young savers is different from that of other plan participants. Young savers face the savings shortfall risk, which is the risk of not making adequate contributions and of making investments that are too conservative. This could severely hurt savings accumulation. "Young savers should seize the opportunity to seek high returns afforded to them by their long investment horizons and by the ability to replace lost capital through future labor income," the report said.
As for midlife savers, as retirement nears, their ability to make up for lost investment capital with future contributions disappears. Due to this, these savers cannot afford to take risks in their investments and must be increasingly wary of market drops.
With retirees, asset allocation should look for a level of capital security, and at the same time must produce enough investment returns in order to offset inflation and withdrawals. Hence, market risk is the most dominant risk factor for them.
The report states that returns can be enhanced through active management and constant asset reallocation. "There is no such thing as a passively managed target-date retirement fund," the report said. "To construct effective portfolios for plan participants, it is critical to identify the role that each asset class can play throughout a participant's life, both on its own and in conjunction with other asset classes, and to apply well-considered and sensible time-tested investment strategies to ensure that the components are assembled together appropriately."
Skilled management could help generate an additional percentage point of an annualized return, which could add $220,000 to a participant's final savings and possibly fund more than 10 extra years of retirement spending, Alliance said.
"Identifying skilled managers is difficult and time consuming. However, plan sponsors should rightfully ask whether it is worth the effort," according to the report. "We emphatically believe it is, given the enormous impact the incremental positive return afforded by active management can have on plan participant savings."
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