Ben Bernanke vs Target Date Funds

(September 3, 2013) — Picture the scene: It’s 9 a.m. on June 19 and you’ve clocked in for your last ever day in the office after a 45-year long career. You’re set to retire to a small house in the country, and your grandchildren have already planned their first visit.

Happy days. Then, the chairman of the Federal Reserve, Ben Bernanke, stands up and gives the tiniest hint that he might, at some point soon, give the nod to start unwinding the quantitative easing program that has been keeping markets afloat for the past four years.

In a flash, bond markets go into meltdown. Traders on Wall Street, in London, in Frankfurt—and some even still awake in Hong Kong—begin to sell off their fixed income holdings at an alarming rate. US 10-year Treasury yields rise to levels not seen in years and general panic ensues. The Barclays Capital Aggregate Index plummets—it seems no one wants to buy bonds (and, to date, they still don’t).

So why does this matter to you? Because your pension is invested in a target date fund (TDF), which automatically moves into bonds as you approach retirement age to avoid unwanted volatility in the portfolio.

And it looks like fund managers might have forgotten that bond markets can be volatile too—or did they?

After several years of being accused of creating overly simplistic models that relied on the idea that all defined contribution (DC) members had the same retirement plans and markets ran on a pre-defined schedule, it seems that asset managers have picked up the target-date fund baton and run with it.

Instead of offering plain vanilla “glide path” options, many have done major surgery on their fund choices, and, while still not perfect, these new options claim to offer some kind of downside protection when spikes—such as the Bernanke QE incident—occur.

“We employ an active management process in managing the overall asset allocation of our target-date funds, and the same applies to our portfolio managers,” says Anne Lester, global head of product and business management for JP Morgan Asset Management Solutions, global multi-asset group.

“We have the ability to underweight rate-sensitive asset classes, as well as overweight assets such as floating rate bank loans, extended credit, and equities that may do well in an economic recovery.”

Around 52% of the company’s 2015 portfolio is given over to bonds, but this contains a mix of five types of securities that behave differently under a range of market conditions. But did it work in June? “Our active management process contributed positively to the funds’ performance over the past quarter,” says Lester. “Our underweight in core fixed income, our moderate overweight in high yield, and shorter duration positions were the major positive contributors.”

Not everyone has taken the same path. T. Rowe Price’s target-date funds have a lower-than-average allocation to bonds in order to lessen their exposure to rising interest rates.

“Despite the long-term benefits of bonds, we recognize the potential negative impact of an increase in interest rates on bond returns during certain short-term market environments,” a note from the company says. “However, T. Rowe Price remains confident in the strategy of its TDFs products, as well as all broadly diversified asset allocation portfolios.

That’s because we believe the impact of a rise in interest rates can be modestly offset, albeit not eliminated, through various investment designs and decisions within our target date products.”

Others have made progress too. The Wells Fargo Advantage Dow Jones Target Date Funds employ a risk-based optimization process that looks at the relationship between its global equity, global long fixed income, and cash portfolios on a monthly basis, says Jim Lauder, a portfolio manager at the company.

“Our strategic allocations for each month are intended to be the optimal mix of those asset classes targeting a pre-defined level of risk relative to the equity portfolio.

If the optimizer picks up on increased volatility in long fixed income, it will view long fixed income as a less effective tool in mitigating equity risk. The optimizer will typically turn to increased cash, thereby shortening the duration of the overall fixed-income holdings and lowering overall interest rate risk.”

Sounds like the scenario in June—but did it work? “Yes. Our most conservative fund increased its cash allocation from 5% to 11% between May 1, 2013, and July 1, 2013, recognizing the increased risk of the long fixed-income holdings and seeking a more efficient diversifier of equity risk given this increased volatility.”

Alliance Bernstein says its TDFs are created with a view to providing income well into the investor’s retirement, rather than focusing on beating a specific market, index, or cash.

“This means,” says David Hutchins, head of pension strategies at the firm, “[that] we can use diversification and dynamic risk management effectively to manage risks.”

Hutchins says its approach recognizes and adapts to investors’ changing needs on a daily basis—which is very handy when Ben Bernanke is about to take the stage.

“All our funds would have either protected or grown the expected retirement outcome for members over this period; this compares to nearly all the standard market approaches that would have seen reductions over the same period,” says Hutchins.

But how many of these “standard market approaches” are left—and how would a corporation putting together a package for its work force tell the difference?

Nigel Aston, head of UK defined contribution at State Street Global Advisors, thinks better-adapted funds are on the rise and is heartened by recent activity in the sector. “It’s really encouraging to see the increased diligence and imagination with which the asset management and consulting communities are addressing the thorny issue of the so-called ‘glide path,’” he says. “Whether this is achieved through life-styling or through TDF, it is essential that we start to be more thoughtful about this critical phase and attempt to stitch the saving element of DC to the payout phase efficiently and with the minimum member risk—for it’s certainly the case that, like any other asset classes, bonds can go down as well as up.”

It is worth noting that, for those quick off the mark—and aiCIO includes providers in this group—annuities, which are also linked to the performance of bond markets, would have sunk in price, meaning members would not necessarily have lost out too badly. Finding a DC member who is happy with a reduced pot might be a challenge, however, whatever the outcome.

“Our goal is to minimize financial shortfall for a majority of plan participants, measured by the purchasing power of their balances to annuitize pre-retirement income,” says Lester at JP Morgan.

“Therefore, we do not try to maximize the return for each individual participant; instead, we focus on maximizing the number of individuals who will meet a minimum level of income replacement, measured by annuity purchasing power. In addition, the other key component of our approach is to minimize the amount by which a participant falls short of this goal of minimum income replacement.”

This last point is the key message for companies that provide DC plans to their employees.

“We believe strongly that fiduciaries should be very conservative with how much downside risk they are willing to expose a near-retiree to,” says Lauder of Wells Fargo.

“I would hate for ‘working longer’ to ever be the best choice for a participant with unfortunate retirement timing.”

Ben Bernanke—the man whose words can shake markets and TDFs alike, and who is set to end his stint at the

Federal Reserve in early 2014—would likely agree.

Contact the writers of this story:

Elizabeth Pfeuti and Charlie Thomas

epfeuti@assetinternational.com and cthomas@assetinternational.com

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