Three Tips for Evaluating Target Date Solutions By: T. Rowe Price

Plan sponsors increasingly recognize the critical role that the qualified default investment alternative (QDIA) plays in helping many of their participants seek successful retirement outcomes. As a result, more sponsors are playing closer attention to the evaluation and selection of target date solutions—by far the most commonly used QDIA in defined contribution (DC) plans.This paper offers three key tips designed to help plan sponsors on their journey of evaluating target date solutions, with an emphasis on identifying solutions that are fit for purpose—i.e., those that are most suitable for their plan’s specific objectives and preferences.

We think it can be a valuable exercise for plan sponsors to take a step back and carefully evaluate the target date solutions in their plans to ensure they still are aligned with the plan’s objectives, the investment committee’s beliefs and preferences, the characteristics of the participant population, and the needs of the covered workforce.As a solutions provider, T. Rowe Price begins every client engagement by asking about plan objectives, with an emphasis on understanding what the sponsor is seeking to achieve with their QDIA.While we understand there is no one“right” answer to this question, there area few baseline facts that we believe are important to review, as they underscore the deepening challenge of helping participants reach their retirement goals: 

  • The U.S. has a savings shortfall. A savings rate equal to 15% of salary is widely considered the minimum necessary to build an adequate retirement nest egg. However,T. Rowe Price’s record keeping data suggest that employee deferrals and employer contributions combined are falling well short of this mark, except in the age 60 to 65 cohort (Figure 1).
  • People are living longer in retirement. Although the COVID-19 pandemic temporarily reversed the longer‑term trend, life expectancy for older Americans has been rising steadily for decades. A growing number can expect to live well into their 90s (Figure 2).
  • Spending needs in retirement can be uncertain. Figure 3 shows that about three‑quarters of retirees have faced one or more spending shocks—such as unexpected health care costs or uninsured property losses—in retirement.

These facts emphasize the importance of making plan decisions that solve for the financial challenges future retirees will face as well as a growing need for sponsors to consider how their benefit structures fit into their overall workforce management policies.

We believe that our ongoing client engagements have enabled us to identify potential opportunities to have a positive impact on the target date evaluation process. We focus here on three specific tips to help sponsors consider critical inputs that are fundamental to selecting a solution fit for purpose but that are easy to overlook or may not be well understood.

We think these insights could prove helpful for plan sponsors reevaluating their existing QDIA offering, for sponsors seeking to add a target date strategy to their existing lineup, or for those who simply recognize that their plan and their workforce needs both have evolved in ways that require a deeper examination of their plan structure.

Tip #1 Use Key Inputs to Inform Glide Path Selection

In our view, there are two important sets of inputs that should inform the overall target date glide path selection process:

  • Plan objectives: A critical first step is to identify priorities—the specific goals the plan sponsor is solving for.
  • Plan characteristics: Plan characteristics—such as salary levels, deferral rates, and employer contributions—offer a baseline for evaluating the current retirement preparedness of plan participants.

Plan Objectives

Despite the importance of starting with an analysis of plan objectives, we often see this step skipped for a straight‑line focus on the decision whether to employ active or passive building blocks for the management of target date portfolios.We believe this represents a missed opportunity that can lead to subpar decisions. Or as our head of target date strategies, Wyatt Lee, says, “It’s hard to know where you’re going if you don’t know your destination.”

We believe one of the key target date trade-offs that sponsors need to consider is whether their primary focus is on helping participants achieve their long‑term retirement income goals, or on seeking to minimize balance variability at any one point in time—such as at retirement or during short‑term episodes of market volatility.

In other words, what is the most important retirement outcome sponsors want participants to be able to achieve?Is the sponsor primarily concerned about seeking to limit the risk that participants might suffer unexpected losses near retirement? Or are they more concerned about participants being able to support their long‑term retirement income needs?

Most sponsors are likely to place high importance on both objectives. However, from an investment perspective the two goals are somewhat at odds—a target date glide path that seeks the portfolio growth needed to help fund adequate retirement income may increase the risk of short‑term balance variability, while a glide path that seeks to reduce balance variability could lead to slower growth and less income in retirement.

This inherent trade‑off is central to the target date evaluation process, in our view. A higher focus on maximizing spending power ultimately will suggest a more growth‑oriented glide path (i.e.,one with a higher equity allocation).

Alternatively, a relative focus on managing variability around retirement and/or over short time horizons will tend to suggest a less growth‑oriented glide path (i.e., lower equity).We encourage our clients to aim for balancing the two objectives relative to the plan objectives in order to assess trade‑offs and choose an appropriate glide path.

Looking Beyond Market Risk

The word “risk” historically has been anchored to market risk, either absolute volatility (standard deviation) or deviation relative to a benchmark (tracking error).But we fundamentally believe this is an oversimplification—one that could leaveDC plans exposed to other risks that can materially impact retirement outcomes.

The reality is that risk comes in many forms, and the relative importance placed on these risks can vary across investment audiences.

Our studies of plan sponsor and consultant attitudes have shown that longevity risk—defined as the risk of participants outliving their resources—is a leading concern for both groups. In our recent surveys, 64% of plan sponsors and 80% of consultants ranked longevity risk as either their first or second highest concern.1

Prioritizing longevity risk should not suggest that other risks don’t matter.Rather, we believe that sponsors who understand the full range of risks that should be considered and the relevant trade-offs between them will be in abetter position to apply a more informed approach to target date evaluation.

Plan Characteristics

Key plan characteristics also should play a vital role in informing the target date evaluation process. These characteristics influence cash flows both into and out of the plan and help determine how well positioned participants are to achieve their retirement goals. They also directly impact the glide path design that is most compatible with the plan’s objectives:

  • Salaries: Other things being equal, higher pay levels may result in a higher equity glide path. Generally, those with higher salaries will have a higher income replacement rate to target and, thus, may need more portfolio growth.
  • Participant deferrals: Relatively lower employee deferral rates also may result in higher equity glide paths due to the need for growth to help offset lower savings.
  • Employer contributions: Larger employer contributions may result in a lower equity glide path as the higher level of savings from employers may offset the need for growth.

Tips #2 Think Beyond the Averages

Designing a glide path to serve an entire plan population is inherently challenging, because it’s a solution for all when the participant population is likely to be heterogeneous—characteristics such as earnings, savings behavior, and behavioral preferences can, and typically do, vary. The goal, then, is to select a glide path that is robust enough to accommodate those differences.

Many target date providers respond to this challenge by designing solutions that use the characteristics of a hypothetical average participant as key design inputs. These averages are assumed to represent the center of the plan population—and, thus, provide the most appropriate representation for participants as a whole.

The drawback of this approach is that it assumes there is an actual “average” person, which is far from ideal for participants who are not well represented by the hypothetical averages, particularly those who are more financially vulnerable.

Rather than constructing glide paths for a mythical “average” participant, we believe it is more effective to use statistical distributions of key characteristics across the assumed plan population— representing the full curve of those values, not just a single point. Figure 4 offers a visual representation of this concept.

T. Rowe Price’s asset allocation research team used scenario analysis to compare the two approaches. Based on the assumed characteristics of a hypothetical plan population, they generated two different glide paths—one using simple averages as inputs and the other incorporating the statistical distributions of those values across the hypothetical population.

As can be seen in Figure 5, the most striking difference was that the glide path based on simple averages featured a lower equity allocation. This was because a glide path optimization exercise reflecting average values may not account for individuals on the lower or higher ends of the earnings and/or savings spectrums. But these are the participants who are more likely to be vulnerable in terms of income replacement and, thus, most in need of the long‑term growth potential that a higher equity glide path can provide.

Indeed, when our research team looked at hypothetical outcomes in our scenario tests, they found that the distributions‑based glide path significantly outperformed in terms of both asset accumulation at retirement and consumption replacement during retirement. In fact, in 76% of the 10,000scenarios we tested, portfolio values at retirement were higher for the distributions‑based glide path compared with the averages‑based one.

The point here is not to make the case oneway or another for a higher or lower equity glide path. But we do believe that using inputs that represent the full characteristics of a plan population results in a more realistic analysis and is more likely to reflect the needs of participants who might otherwise be underserved.

Tips #3 Align Implementation to PlanGoals and Beliefs

Earlier we mentioned that we often see clients begin their target date selection process by weighing the relative merits of active versus passive implementation.We hope our first two tips made the case for taking a step back and first considering the key inputs—and how those inputs are represented in a glide path design. However, it also is true that the decision to use either active or passive building blocks can materially impact retirement outcomes.

But, before addressing this topic, it’s worth a reminder that, in reality, there is no such thing as a purely “passive” target date solution. The decisions applied across the board in target date designs—such as the shape of the glide path and the level of diversification within the asset mix—are active decisions.

Accordingly, our third tip focuses on the building blocks used for the underlying investment strategies within the target date portfolio and the corresponding trade-offs involved in active versus passive decisions.

In our experience, it is common for the active versus passive investment discussions to focus narrowly on cost. A target date solution implemented entirely with passive vehicles should be cheaper than an active or blend strategy, reflecting the lower management costs of simply seeking to track the performance of a market benchmark. But we believe the evaluation needs to go deeper and examine the potential trade‑offs involved in active versus passive decisions. More specifically, we believe the emphasis should be on the value‑for‑cost equation and how it fits with the sponsor’s objectives for a target date solution.

One driver of a narrow focus on cost has been an assumption that the EmployeeRetirement Income Act of 1974 (ERISA)somehow requires plan sponsors to prioritize the use of passive investments and to seek the lowest‑cost providers. In fact, ERISA dictates nothing of the sort.It describes a need for plan sponsors to seek costs that are “reasonable.”2

Figure 6 summarizes some of the potential benefits of both active (left)and passive (right) strategies. Whether sponsors choose a purely active or purely passive approach, or a combination of both (often referred to as a blend strategy), we believe it is imperative that sponsors carefully consider their own beliefs and objectives relative to these techniques.

The Bottom Line

At T. Rowe Price, we think of retirement planning as the long game. Accordingly, the goal of our work is designed to help plan sponsors and financial professionals make sound long‑term decisions that are in the best interests of their plans and their participants.In keeping with this philosophy, we offer the following action items for plan sponsors to consider:

  1. First think about your objectives, then consider the characteristics of the plan population. Finally, consider how the combination of these inputs collectively can inform the selection of a glide path fit for purpose.
  2. Think about the distributions of key characteristics across your plan’s population, rather than relying on simple averages.
  3. Be mindful of the trade-offs when evaluating active versus passive implementation approaches.

Additional Disclosure

Monte Carlo simulations model future uncertainty. In contrast to tools generating average outcomes, Monte Carlo analyses produce outcome ranges based on probability—thus, incorporating future uncertainty.

Material Assumptions include:

  • Underlying economic and behavioral inputs, including savings rates and cash flows, are generated from a structural model built up from factors relating to both financial markets and the broad economy as well as data calibrated based on T. Rowe Price’s record-keeping platform’s participant population.
  • The mortality weighting is sourced from the Society of Actuaries. Retirement age is assumed to be 65 years old.

Material Limitations include:

  • The analysis relies on assumptions, combined with a return model that generates a wide range of possible return scenarios from these assumptions. Despite our best efforts, there is no certainty that the assumptions and the model will accurately predict asset class return ranges going forward. As a consequence, the results of the analysis should be viewed as approximations, and users should allow a margin for error and not place too much reliance on the apparent precision of the results.

Users should also keep in mind that seemingly small changes in input parameters, including the initial values for the underlying factors, may have a significant impact on results, and this (as well as mere passage of time) may lead to considerable variation in results for repeat users.

  • Extreme market movements may occur more often than in the model.
  • Market crises can cause asset classes to perform similarly, lowering the accuracy of our projected return assumptions, and diminishing the benefits of diversification (that is, of using many different asset classes) in ways not captured by the analysis. As a result, returns actually experienced by the investor may be more volatile than projected in our analysis.
  • Asset class dynamics, including but not limited to risk, return, and the duration of “bull” and “bear” markets, can differ from those in the modeled scenarios.
  • Fees and transaction costs are not taken into account.
  • The analysis does not use all asset classes. Other asset classes may be similar or superior to those used.
  • The analysis models asset classes, not investment products. As a result, the actual experience of an investor in a given investment product may differ from the range of projections generated by the simulation, even if the broad asset allocation of the investment product is similar to the one being modeled. Possible reasons for divergence include, but are not limited to, active management by the manager of the investment product. Active management for any particular investment product—the selection of a portfolio of individual securities that differs from the broad asset classes modeled in this analysis—can lead to the investment product having higher or lower returns than the range of projections in this analysis.

Modeling Assumptions:

  • The primary asset classes used for this analysis are stocks and bonds. An effectively diversified portfolio theoretically involves all investable asset classes, including stocks, bonds, real estate, foreign investments, commodities, precious metals, currencies, and others. Since it is unlikely that investors will own all of these assets, we selected the ones we believed to be the most appropriate for long‑term investors.
  • The analysis includes 10,000 scenarios. Withdrawals are made annually at the beginning of each year.
  • The results are not predictions, but they should be viewed as reasonable estimates.

IMPORTANT: The projections or other information generated by T. Rowe Price regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. The simulations are based on assumptions. There can be no assurance that the projected or simulated results will be achieved or sustained. The charts present only a range of possible outcomes. Actual results will vary with each use and over time, and such results may be better or worse than the simulated scenarios. Clients should be aware that the potential for loss (or gain) may be greater than demonstrated in the simulations.

(1) Sponsor attitudes based on a T. Rowe Price survey of 451 corporate, nonprofit, and government plan sponsors conducted in November and December of2019. Full details are available in: Kim DeDominic is and Lorie Latham, Evolution with Purpose: An Informed, Research-Based Approach to Better RetirementOutcomes, T. Rowe Price Retirement Insights, January 2021. Consultant attitudes based on a T. Rowe Price survey of 20 large U.S. defined contribution consulting firms conducted in early 2020. Data reported in T. Rowe Price’s 2020 DCConsultant Study, November 12, 2020.

(2) For more on this topic, please see: Alison V. Douglass, The Misperception of Fiduciary Risk and Active Management in DC Plans: A Legal Perspective, Goodwin LLP,March 17, 2017. The contents of the paper, which was sponsored by T. Rowe Price, are for informational purposes only and not for the purpose of providing legal advice. The analysis and conclusions are solely those of the author.

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