Since 2006, Wespath Benefits and Investments (Wespath) has offered the LifeStage Investment Management (LifeStage) as a convenient solution for participants who do not want to manage their own retirement account balances. Instead of offering target date funds, Wespath offers LifeStage which is a form of a managed account program designed to provide flexibility in developing optimal solutions for allocating participant account balances among several different types of investments. This article will more closely examine the complex challenge for target date funds in effectively managing the allocation to higher risk assets. It will also examine how LifeStage addresses these issues.
Definition of Target Date Fund
The concept of a target date fund is simple and appealing: provide investors with a single investment fund that automatically adjusts the mix of stocks and bonds as investors approach retirement. The “target date” is an individual’s anticipated retirement year and is reflected in the name of the fund. For example, “2050” target date funds are intended for investors retiring approximately 40 years from now. While they share some similarities, LifeStage offers advantages over target date funds.
The Glide Path to Conservative Investing
With target date funds, the asset mix is determined largely by the number of years until the target date. Investors in target date funds with many years before the target date can expect large allocations to stocks as the impact of stock market disruptions should be muted over the ensuing years. Target date funds with fewer years before the target date will have larger allocations to bonds in an effort to protect assets and to avoid the impact of stock market volatility. The process by which the allocations between stocks and bonds adjust to become more conservative through time is called the glide path.
The glide path that target date funds generally employ is primarily based on the opinions that fund managers hold regarding participant behavior at retirement. A February 2011 United States Government Accountability Office report on target date funds found quite different philosophies among fund managers regarding the appropriate allocation between stocks and bonds at the target retirement date. As a result, two different types of target date funds have evolved with different investment objectives. One type of target date fund will manage balances “to” retirement and another type of fund will manage balances “through” retirement.
Behavior Assumptions Affect Asset Mixes
Some target date funds have very small equity allocations at the target retirement date. The managers for these funds assume that participants will likely withdraw their assets at retirement and purchase an annuity (or another investment vehicle). Therefore, fund managers seek to preserve capital and lessen the possibility of severe losses near retirement. The more conservative glide path may sacrifice the possibility of high investment returns, but limits the possibility of severe equity market losses and increases the possibility that participants arrive at retirement with an adequate level of savings. Fund managers who take this approach believe that investors prefer to avoid the “pain” of arriving at retirement with insufficient savings rather than experience the “pleasure” of arriving at retirement with more than is needed. These target date funds seek to manage the fund assets “to” retirement with the belief that the target fund’s job is done at retirement.
Other target date funds have much higher equity allocations at the target retirement date and manage “through” retirement. These fund managers assume that most participants will maintain their investments in the target date funds at retirement. Since these participants will not allocate their capital to a different fund or investment vehicle at retirement, they will need the growth that equities can provide and cannot overly rely on cash and bonds in retirement to yield satisfactory financial results. These funds are designed to serve participants up to and through retirement, and fund managers take the position that the key risk with retirement-based portfolios is that a participant may outlive his or her retirement assets.
Given these differences in assumptions, the equity allocations among “to” and “through” target date funds can be quite different as investors in these funds approach the target retirement date, although equity allocations may be very similar in the period that is decades away from the target retirement date.
Target Dates Affect Equity Allocations
Morningstar, an independent provider of investment research, recently reported that for all “2040” and “2050” target date funds that it tracks (intended for investors aged 20 to 35), the equity allocations are quite similar, averaging roughly 90%. However, for 2010 target date funds, “through” retirement funds average a 50% allocation to stocks while “to” retirement funds average a 29% allocation to stocks.
The average allocations for 2010 target date funds mask a wide distribution of allocations. Despite a 29% average equity allocation for “to” funds, the range of equity allocations is 15% to 40%. Similarly, “through” funds may average a 50% equity allocation, but there is a range from 25% to 67%. Consequently, target date funds with a “to” philosophy can have more exposure to stocks than some target date funds with a “through” philosophy!
The philosophies that determine the glide paths for the “to” and “through” target date funds are subjective and may be based on assumptions that are not rooted in actual investor behavior. For those funds that manage “to” retirement, it is clear that most investors do not actually purchase an annuity at retirement. For those funds that manage “through” retirement, it is assumed that investors will methodically withdraw 4% to 5% of their account balance per year. However, in the 2009 publication Ready! Fire! Aim?, JP Morgan reported that the average participant actually withdrew 20% annually at, or soon after, retirement.
LifeStage’s One Step Approach to Account Management
Rather than offering target date funds, Wespath offers LifeStage, a convenient, one-step approach for managing retirement accounts. LifeStage develops a customized investment mix based on your age and information in your Personal Investment Profile, such as your risk tolerance and whether or not you will qualify to receive Social Security. To attain your target mix, LifeStage allocates your account balances among several of Wespath’s investment funds. More detailed information regarding LifeStage is available.
Throughout your career and retirement, LifeStage continues to work for you. It adjusts your investment mix as you age or when you make changes to your Personal Investment Profile. In addition, LifeStage periodically rebalances your investment portfolio to maintain your target investment mix. These adjustments help maintain an appropriate balance between equity and fixed income investments.
LifeStage Invests ‘To’ and ‘Through’ Retirement
LifeStage administers Ministerial Pension Plan (MPP) balances and non-MPP balances differently. It manages MPP investments “to” retirement, so that more substantial reductions are made to equity investments as retirement approaches. It manages MPP balances in such a way because participants must convert at least 65% of their balance to a monthly benefit payment (annuity) and will often have an immediate need to spend the portion of the MPP balance not-converted to annuity. For non-MPP investments, LifeStage manages accounts “through” retirement, maintaining higher equity positions. LifeStage assumes that participants will rely on their non-MPP account balance(s) as a source of income throughout the remainder of their lives.
How has LifeStage Performed?
* Based upon the historical exposure to stocks and bonds of participants (MPP and non-MPP assets) in each appropriate age group relative to the target date fund, and linking this exposure to the historical returns of Wespath funds, comparable hypothetical performance was generated.
** Actual performance that individual participants achieved may be different from the aggregate performance reported below.
Wespath recently conducted an analysis* to compare the investment performance for participants enrolled in LifeStage to a universe of target date funds.** The comparable universes of target date funds for each time period were provided by Wilshire Compass. The results were quite striking. For 2010 (see Exhibit A), participants enrolled in LifeStage achieved better returns than the average target date fund across various target dates. For the three-year and five-year periods (see Exhibits B and C), LifeStage participants earned returns that were meaningfully better than most comparable target date funds and often performed better than the top 5% of target date funds.
The investment performance is likely attributable to the following features of LifeStage:
- LifeStage asset mixes include stable value investments, whereas target date funds do not.
- LifeStage invests in Wespath-administered funds, which typically have lower expense ratios.
- LifeStage incorporates a more diversified asset mix than many target date funds.
While LifeStage is a viable solution for participants wanting their account balances to be managed, Wespath recommends that all participants secure the advice of a professional, and impartial, financial planner. EY Financial Planning Services is available to most participants in Wespath-administered plans at no cost. EY can be reached Monday through Friday at 1-800-360-2539 between 9:00 a.m. and 8:00 p.m., Eastern time.