Target-Date Risk Management: Balancing Bulls and Bears

By Radu Gabudean, Ph.D. - August 3, 2017

Economies cycle. Policies shift. Markets ebb and flow. Can target-date portfolio glide path construction approaches be more responsive to market conditions?

We believe target-date portfolios should increase the likelihood of retirement success for the broadest number of participants. They should seek to achieve that objective by balancing the multiple risks that retirement investors face over time by constantly, systematically evaluating the asset allocation, underlying asset classes and manager selection. In addition, we believe portfolios should evolve to incorporate a dynamic approach that recognizes and responds to the changing market environment.

Before...

A well-defined, long-term strategic glide path in target-date portfolios considered market assumptions of risk and return. The glide path had to be robust enough to account for a broad range of withdrawal assumptions, providing enough equity exposure to limit the risk of investors outliving their funds in retirement—also known as longevity risk. The slope of the glide path and equity allocations around retirement also needed to limit market risks and any sudden, extreme changes in market prices (tail risks) for individuals near retirement, when their account balances are typically highest.

…and After

Building on that initial glide path approach, we now believe a combination of age and environment factors should determine portfolio allocation—not simply age. This helps evaluate different effects of market events on investors at various stages of retirement readiness—or the lifecycle of their portfolio. This also allows portfolio construction to treat the entire glide path as one pool of wealth moving through time, rather than as a disparate set of portfolios. In doing so, the response to the environment is differentiated by a participant's age and other sensitivities to lifecycle investing risk over time.

How Lifecycle Risks Change with the Market Environment

The balance of risks in lifecycle investing is a function of an investor's age and the market environment (that is, how attractive stocks versus bonds are given current conditions). For each market environment, we believe the glide path should better balance inherent lifecycle risks.

Longevity Risk

Risk of running out of money in retirement

Market Risk

Range in outcomes caused by changes in the level of market prices

Inflation and Interest Rate Risk

Range in outcomes due to rising inflation and/or interest rates

Sequence-of-Returns Risk

Range in outcomes caused by the sequence, rather than the level, of market returns

Tail Risk

Range in outcomes caused by sudden, extreme changes in market prices

Abandonment Risk

Range of outcomes caused by poor timing of exit from an investment strategy

Source: American Century Investments.

Longevity risk is paramount. But it must be balanced against other risks, such as market and tail event risks, which can have negative effects on account balances. Abandonment risk is also important to consider, since it accounts for times when participants make poorly timed sell decisions, or abandon a savings and investment plan altogether.

These risks are influenced, and some even defined, by changing market conditions over time. So taking this dynamic environment into account should help improve the balance among these various risks.

Radu Gabudean, Ph.D.
Radu Gabudean, Ph.D.
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      A target date is the approximate year when investors plan to retire or start withdrawing their money. The principal value of the investment is not guaranteed at any time, including at the target date.

      Each target-date portfolio seeks the highest total return according to a preset asset mix. Over time, the asset mix and weightings are adjusted to be more conservative. In general, as the target year approaches, the portfolio's allocation becomes more conservative by decreasing the allocation to stocks and increasing the allocation to bonds and money market instruments.

      The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.

      Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.

      Diversification does not assure a profit nor does it protect against loss of principal.

      Generally, as interest rates rise, bond prices fall. The opposite is true when interest rates decline.