Risk Management Is Needed For Retirement Portfolios

by: Robert Boslego

Summary

Target date funds did not perform as advertised - SEC.

Glidepath investing is flawed.

Need to mange downside risk.

The growth in the popularity of 401(k) plans requires more Americans to make their own investment decisions for retirement. Accordingly, the questions then become- "Are Americans able to make informed investment decisions--do they have the critical information they need?"

The Pension Protection Act of 2006 was designed to increase saving for retirement by including a powerful default option: automatic enrollment of employees in retirement plans, unless they opt out. Once people are automatically enrolled, a second default option is required: how to invest their money. The Labor Department developed four default options and qualified default investment alternatives were legislated into law in 2007. The most popular qualified default investment alternative (QDIA) became target date funds (TDFs), selected by about 70% of employers.

According to BrightScope, total target date assets were close to $1.1 trillion in February 2015, a 22-percent increase over the prior year's estimate and a 280 percent increase over the five preceding years.

Nearly three years ago, I wrote an article,"Why target date funds fail in the one area they're supposed to succeed-- downside protection." I highlighted how TDFs dated 2010 had suffered significant losses in 2008 and the first quarter of 2009. People about to retire lost around 35% of their retirement account value from late 2007.

I wrote that there is no guarantee that stocks will recover from a major loss within the timeframe the retirement money is needed. An investor may literally die waiting for his or her portfolio to recover.

My article drew a rebuttal from a co-manager of the Wells Fargo Advantage Dow Jones Target Date Funds. He agreed that there is a big disconnect between how much risk financial advisors are willing to expose retirement plan participants to and the amount of risk taken in most target date funds. He wrote that most investors are uncomfortable with even a 10% loss near retirement, but in 2008, most 2010 target date funds lost much more than that.

He went on to say my article "gives the impression that the Securities and Exchange Commission and Department of Labor have negative views of target date funds. As someone who was invited to testify before a joint hearing following the 2008 crash, I can tell you that is not the case."

SEC Commissioner Luis A. Aguilar Speech

About a year ago, Commissioner Aguilar gave a speech, "Advocating for Investors Saving for Retirement." Within his speech, he cited my article several times. He said that TDFs losses during the financial crisis "should have served as a wake-up call that target date funds were not performing as advertised."

He went on to state:

The relentless growth in target date funds is troubling because studies have shown that investors, and industry professionals alike, do not fully appreciate the risks these funds present. For example, in 2012, the Commission sponsored a study to assess investors' understanding of target date funds, which yielded several alarming findings. For example:

Fewer than one-third of respondents were able to identify the correct meaning of the year in the target date fund's name; Only 36% of respondents were aware that target date funds do not provide guaranteed income after retirement; More than half of all respondents failed to realize that target date funds with the same year in their names do not necessarily have the same mix of stocks and bonds at the target date; and The principal reason respondents gave for choosing a target date fund was that "it seems like a safe investment for retirement."

Equally alarming is that in 2010, Pacific Investment Management Company ("PIMCO") conducted a study that found that many professional consultants who help select options for retirement plans underestimate the degree of risk presented by target date funds. Specifically, this study found that two-thirds of these consultants mistakenly assumed that target date funds are more conservatively invested than was, in fact, the case."

"The GlidePath Illusion"

Target date funds are designed to address a variety of risks faced by individuals investing for retirement: investment risk, inflation risk and longevity risk. Balancing these risks involves making trade-offs. Their classic solution is the "glidepath" strategy, transitioning from equity-centric to bond-centric portfolios as a person approaches retirement.

Rob Arnott, CEO of Research Affiliates, concluded that the glidepath approach does not does not meet the objectives of a retirement strategy. And yet "this type of logic permeates our retirement investment solutions industry."

We believe that the heuristic of buying stocks when young, and buying bonds when mature-a rule of thumb on which many billions are invested-is flawed, and that the typical glidepath implementation fails to solve the basic problems facing most investors. Conventional glidepaths have fallen short of contrarian strategies or ordinary balanced strategies since inception. They offer more, not less, uncertainty about the customers' prospective real retirement income. They typically buy a formulaic asset mix, regardless of valuation levels or yields. And yet, they collect steadily accelerating new asset flows, because the target-date story is so compelling!"

Risk management of target date funds

Perhaps the biggest problem with conventional GlidePath investing is that it exposes retirement investors to losses greater than they can live with. Research shows that when losses exceed investors' loss tolerances, they abandon the investment.

Data shows that older investors approaching retirement made more investment "errors" than did younger investors during the financial crisis. Many got out after they had lost a sizable amount of money. Many have stayed out because of those losses and subsequently missed the recovery of the stock market to new highs.

The best investment is one a participant will not abandon in down markets but will also provide opportunities for long-term capital appreciation. I believe that this is best accomplished by focusing on the management of risk.

In The Intelligent Investor, Benjamin Graham states, "the essence of investment management is the management of risks, not the management of returns." At the heart of this approach is loss minimization, deliberately protecting oneself against serious losses. Warren Buffett described this book as "by far the best on investing ever written."

In the strategy discussed in my article (referred to above), I built in risk management features to limit the maximum likely drawdown, which I consider to be the most important risk measure. It measures the maximum difference between the peak in total return and the trough.

Behavioral Finance

In the 1970s, the efficient markets theory reached its peak of acceptance. The idea was that asset prices, such as equities, always incorporate the best information about fundamental values and that price changes are rational due to "new" news.

In the 1980s, researchers, such as future Nobel Laureate Robert J. Shiller, demonstrated that prices changed much more than the fundamentals they are supposed to reflect. He termed this "excess volatility."

In particular, he described one of the oldest theories about financial markets, which he calls price-to-price feedback theory. Essentially, he argues that the emotions of greed and fear drive market prices far too high on the upside and much too low in downturns. This observation fits with Benjamin Graham's prior description: "The day-to-day market isn't a fundamental analyst; it's a barometer of investor sentiment."

If markets move more by sentiment than by the short-term fundamentals, the trading strategy needs to have a way in which to adjust accordingly. I developed and tested hypotheses to try to quantify conditions that might make investors feel greedy and fearful. And it turns out that the size of market gains and losses, combined with the speed, does a pretty good job in determining when to be long, when to be short and when to be out.

My approach, which I call Vertical Risk Management (VRM), is to separate emotions from investment decisions by running an algorithm that provides systematic, quantitative signals. I first developed this particular model about seven years ago and have applied it to different markets, such as equities, crude oil and natural gas.

Wells Fargo Dynamic Target Date Funds

I concluded in my article three years ago that target date funds need better risk management. Although the co-manager of the Wells Fargo target date funds was critical then, Wells Fargo has since changed its tune.

In December 2015 it announced:

Our research revealed a conundrum: A glide path with meaningful equity exposure throughout may help grow long-term wealth, but a more conservative glide path is needed to hedge against short-term market volatility and the potential for large losses near the target retirement date. Our research also suggested that the industry average glide path may not be built to provide consistent participant success based on our three measures. Our conclusion was that to improve participant outcomes, a glide path must maintain meaningful equity exposure throughout the glide path while also taking measures to manage volatility and downside risk, especially in the critical final years leading to the target retirement date."

I think that the retirement industry is finally recognizing the need for better risk management of retirement portfolios. I also think there is room for more risk-managed target date fund providers.

However, I believe that a critical piece of information for investors is demonstrating effectiveness through back-testing (in-sample and out-of-sample) how a strategy would have performed in past financial markets. It is important for investors to see how a strategy would enable them to participate in the upside during normal times, and how it can protect them better than glidepath investing during financial crises.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.