Reflecting Demographics in the Risk Level of Target Date Funds
Target date funds (TDFs) have been a big hit among both participants and sponsors of defined contribution plans. From 2008 to 2017, the percentage of participants using TDFs when offered grew from 37% to 77%, and as of 2017, 54% of contributions went to TDFs. But given the variety of off-the-shelf and customized TDF solutions on the market, how should plan sponsors evaluate the risk level of a TDF?
In 2013, the Department of Labor advised plan sponsors to establish processes for comparing, selecting and reviewing TDFs, emphasizing the importance of considering population characteristics. Aon believes some of the most relevant factors include the availability of a defined benefit plan (DB), the population’s longevity profile and retirement age, and human capital risk.
Defined Benefit Plan Availability
For participants, DB plans are like a low-risk asset: They produce a steady stream of income for life. If two participants are the same age and have equal DC account balances and asset allocations in the DC plan, but one also has a pension, then that participant is invested more conservatively overall. Furthermore, pension benefits can significantly extend the life of a retiree’s DC account balance by providing a floor of retirement income, thereby preserving the DC asset base. This implies a greater capacity to take risks in the DC plan to balance out the low-risk nature of the DB plan.
The impact can be estimated by simply observing the DB plan’s status. About 57% of Fortune 500 companies still offer a pension benefit, but the benefits of many of those pension plans are frozen. A population with an active or recently closed DB plan likely has higher-than-average levels of pension benefits and could therefore take a higher-than-average level of risk in the DC plan. Conversely, populations without a DB plan merit a lower-than-average risk level in the TDF glide path.
The impact on the shape of the glide path can be determined more precisely by looking at the size of DB benefits by age cohort. For example, if longer-service employees have grandfathered pension benefits while newer employees only participate in the savings plan, then the appropriate glide path might be more aggressive than average at older ages and more conservative than average at younger ages, leading to a flatter glide path.
Retirement Age and Longevity Profile
Investors with a longer horizon can typically afford more risk. For workers at the end of their careers, the investment horizon is the expected retired lifetime. Healthier populations with longer life expectancies have longer horizons, and thus should take more risk. Other longevity-related characteristics include gender and job type. Assessing population mortality is common for DB actuarial valuations, and it can also be used to inform the risk level of a DC TDF glide path.
Retirement age is another key factor in assessing horizon. A 62-year-old retiree can afford more risk than a 65-year-old retiree because of the longer horizon. The typical retirement age for a population can influence the appropriate level of risk for the TDF.
Human Capital Risk
Workers can be thought of as having two different kinds of capital during their career:
- Financial capital—accumulated assets
- Human capital—potential future earnings that can be converted to financial capital over time
Human capital is often thought of as being “bond”-like, generating a relatively steady stream of income. Younger workers have more of their capital as human capital (bond-like), while older workers have more financial capital (a mixture of stocks and bonds). This is one of the key principles behind TDF glide paths— younger workers with more human capital can afford more risk in their investments than older workers can.
However, some job types make human capital more stable and bond-like, while others are more risky. For example, workers in areas susceptible to layoffs and performance-based compensation may have more equity-like human capital exposures. Workers with higher levels of earnings predictability, such as those in government, have lower human capital risk—which is more bond-like. Consequently, workers in industries with lower human capital risk might be better off with more risk in the TDF glide path, while workers in less secure industries should take less risk.
Reflecting Demographics in the Glide Path
While it may be new to many DC plan fiduciaries, reflecting population demographics has been standard practice in the DB space for decades, and has been part of the DOL’s guidance for DC plans since 2013. Plan sponsors can start by making some high level observations of their plan demographics; for example, the population has a DB plan, typically retires at age 62, and has higher-than-average job security. A more precise evaluation—which is not necessarily costly or difficult—can be done with more data, such as account balances and pension benefits by cohort. This can help assess the fit of different off-the-shelf TDF products or design a custom TDF glide path.
Whichever approach is taken, Aon can help plan sponsors document their process and repeat it periodically. As assumptions, methods, and the population change over time, so too can the TDF glide path. For example, a population with a frozen pension plan might warrant an aggressive glide path today, but perhaps a more moderate glide path in the future as employees with pension benefits retire. The choice of glide path risk level isn’t permanent—it can and should be reviewed to make sure it continues to fit the population.