Session 9 – Winning in the Long Run
Asset allocation strategies for DC plans.
By Thomas Nelson, Senior Quantitative Analyst, Franklin Templeton
Capital markets are generally forward-looking, moving on expectations for the future. Unfortunately, investor opinions are often formed based on hindsight and recent history. This dichotomy was evident in early January, when Franklin Templeton Investments Corp. commissioned Angus Reid to poll more than 1,000 Canadians on their opinions about the markets.
Some of the results were surprising. A solid 87% of Canadians did not participate in the strong market turnaround in 2009. Almost all were unaware that it had occurred, despite extensive media coverage. Even more discouraging, 67% had no plans to make new investments in 2010. Just as investors’ judgments became irrationally optimistic leading up to the market meltdown in 2008, they appear to have become irrationally risk-averse in the post-meltdown period.
Investor inertia and lack of discipline make it imperative for sponsors of DC pension plans to provide prepackaged solutions that minimize decision-making by investors. Long-term solutions should also be straightforward and include automated products to help investors move past their biases. The best of these products typically has three essential features: broad diversification, professional asset allocation and ease of implementation.
Turnkey solutions available for DC pension plans include balanced funds, target risk funds, TDFs and TDFs with a risk overlay. TDFs are known for their dynamic asset allocation mix that adapts as investors age. And TDFs with a risk overlay go one step further by offering diversification while addressing the investment lifecycle and risk profile of the individual.
The backbone of any TDF is the asset allocation glidepath: the portfolio’s strategic asset allocation over time. As investors age, their objectives and constraints evolve. The glidepath represents the most appropriate asset mix across all stages of an investor’s lifecycle.
The choice of glidepath used within target date/risk funds is extremely important because the proper choice of asset mix from initial investment through retirement has a great impact on the value of the portfolio at retirement, as well as the risks taken in order to get there. In order to be consistent with the needs of DC investors, the optimal glidepath should take into account three specific risks:
• interim risk, which measures the extent to which investors are exposed to too much portfolio risk when striving for excess returns;
• retirement income shortfall risk, that the portfolio value at retirement won’t be enough to cover expected annual income needs; and
• longevity risk, that the investor will outlive the value of the portfolio.
When analyzing these potential risks, the optimal glidepath tends to exhibit a parabolic shape whereby equity allocations are higher in earlier years, when investors can tolerate more portfolio volatility and risk, and then shifts at a faster pace toward stable, income-oriented investments when closing in on retirement.
It’s important to understand that not all target date and risk solutions are created equal. In evaluating these programs, look for the presence of a robust, demonstrable glidepath methodology. Ensure that the TDF managers have access to a broad range of investment opportunities, strong fund research and due diligence capabilities. They should also have both strategic and tactical asset allocation expertise, as the flexibility to take advantage of cyclical and tactical opportunities can enhance risk-adjusted returns. BC
Continued on the next page…
Session 10 – CAP Investment Selection and Monitoring
What Forrest Gump can teach us about investing.
