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Building Better Retirement Funds

Widely held assumptions about how people save for retirement are flawed, a Wall Street money manager told attendees at the SVIA's 2007 Spring Seminar. These false assumptions may be undermining the effectiveness of target-date retirement funds, one of the fastest-growing investment vehicles in 401(k) plans.

Anne Lester, a Managing Director and Senior Portfolio Manager with JPMorgan Asset Management, said that because of asset managers' flawed assumptions, some target-date retirement funds may not provide the secure retirement investors want from them, especially under worst-case market scenarios. Target-date funds are asset-mixed funds that rebalance as the investor ages and approaches retirement. They automatically become more conservative as investors approach retirement.

In calculating how much investors will need in retirement and how their target-date funds should be constructed, Lester said asset managers make several assumptions. They often assume that 401(k) participants will gradually increase their savings deferral rates to 10 percent of salary by age 35, enjoy annual salary increases, not borrow from their accounts prior to retirement, and smoothly withdraw about 4 percent to 5 percent of their assets from their accounts once they do retire.

In fact, Lester said, an analysis of the behavior of the more than 1.3 million participants in a proprietary JPMorgan database shows that they increase their deferral rates slowly, typically not reaching 10 percent of salary until age 55. They get raises only every two to three years, not annually. Twenty percent borrow, on average, 15 percent of their account balance prior to retirement. And the average participant withdraws more than 20 percent of their account balance shortly after retiring rather than parceling it out at a conservative rate of 4 percent to 5 percent annually.

Among other things, Lester said, these misperceptions can lead asset managers to calculate that investors will need higher levels of income in retirement than they actually do need. The result is higher-than-warranted allocations to equities in their target-date retirement funds once they've stopped working. "We think people are making very dangerous assumptions about the length of time people are staying in their plans," Lester said. "We think the actual time horizon is much shorter, which influences how much equity their portfolios should have at the end."

The best way to measure the success of a target-date fund, Lester suggested, is by the degree to which it maximizes the number of investors who hit a targeted, minimum level of income replacement by retirement age. The best way to maximize that number, she suggested, is to build highly diversified funds that include allocations not only to domestic and international stocks and domestic bonds but also to domestic real estate investment trusts, high yield, fixed income securities, emerging-markets debt, and direct real estate investments. She said an efficient frontier analysis of two target-date funds, one invested only in the first group of asset classes and the other in the broader group, showed the more diversified portfolio yielding slightly higher returns with less volatility. In Monte Carlo simulations, she added, the more highly diversified portfolio also yielded higher-than- expected account balances under worst-case market scenarios than did the more concentrated portfolio.

Worrying more about how well a retirement fund will do in a negative environment than a positive one is important, Lester said. The pain of retiring with less money than needed is worse than the pleasure of retiring with more than is needed. "Let's say you have $200,000 extra; that's nice," she said. "But if you have $200,000 less, you're moving out of your home, you're not paying for your medicines. You've seriously hampered your lifestyle."

Broadly diversified target-date funds, she concluded, can play an important role in minimizing the number of retirement plan participants who meet that fate.

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