This glide path’s too cold…

This glide path’s too cold

The first blog in this fairy-tale analogy blog series and the asset allocation approach discussed might suggest that as a portfolio manager I should be concerned about the risk of loss to the portfolios. And I am, but not to the point of ignoring other risks. As I structure target date series I seek to mitigate other risks as well. If I avoid equities altogether in a target date series it can produce the opposite problem – not enough growth potential in the portfolio. This contributes to a participant’s shortfall risk as they age along the portfolio’s glide path. While risk of loss (through market movements) has received most of the press following the financial crisis, given the Federal Reserve’s low interest rate policies, shortfall risk deserves attention.

As lead portfolio manager for target date series at The Principal, it’s my job to address shortfall risk as I design a glide path. Similarly, financial professionals are in a great position to educate their clients about the risk of shortfall and to consult if participants of their client may have an asset allocation that is too conservative based upon their risk tolerance and time horizon, leaving participants with a personal glide path that is too cold.

My decision-making strategy when structuring a portfolio’s glide path can be a lesson in how more than one type of risk exists in a portfolio. Participants should consider how shortfall risk may affect their portfolio as well.

Let’s look at the following example to help understand shortfall risk: two participants begin their careers at jobs paying $35,000 per year with salary increases of 3.5% per year over their careers. They each put 6% into their retirement plans. Participant 1 has a balanced approach and assumes the risk of loss to her portfolio which ends up earning on average 7% per year over her career. It is important to note that an average 7% return, due to her assumption of risk of loss, means that the portfolio may be volatile, at times losing value.

At the same time, participant 2 has a much lower tolerance for risk of loss and allocates all of his investment to a stable value option which is less volatile and traditionally assumes less risk of loss. He earns 1.5% on his “traditionally low risk” investment. At the end of their 40-year investing careers, participant 1 has $715,490 in her portfolio or roughly five times her annual ending salary. Participant 2 has $236,900 in his portfolio or roughly twice his annual salary.

Commonalities: Starting salary: $35,000 which increases by 3.5% each year. Each employee saves 7% per year in their employer’s retirement savings plan. Each works 40 years to retirement. In retirement, each draws 4.5% of the savings balance for income.
Participant 1 Participant 2

Differences

earnings

7%

1.5%

Savings balance at retirement

$715,490 $236,900

First retirement year withdrawal (4.5%)

$32,200

$10,660

Social Security/year

$27,700

$27,700

$ to spend in retirement

$59,900

$38,360

 Desired 80% salary replacement in retirement:

$110,000

$110,000

 

Using our example, let’s further say they both want to replace 80% of their annual income in retirement ($110,000). Social Security income should be approximately $27,700, so they each need an additional $82,000 to reach their annual income goal. At a 4.5% annual withdrawal rate, Participant 1 would generate an additional $32,200 of retirement income while participant 2 only generates $10,660. Neither fully hits their mark, but participant 1 has $59,900 to live on versus $38,360 for Participant 2.

Clearly, these participants were a lot alike – they had the same salary, got the same raises, and made the same retirement contributions. But they have drastically different outcomes – and will experience a markedly different retirement because of their decision making. The major difference? Participant 2 was content to eat the porridge that was too cold – he tried to avoid the risk of lost principal which participant 1 assumed, but did so at the expense of shortfall risk. When you throw in the risk of purchasing power (1.5% doesn’t usually keep up with inflation), Participant 2 is left holding a porridge popsicle.

The target date glide paths I design assume a level of market risk through their allocation to equities. In early years, when a participant has opportunity to ride out the market highs and lows, I believe it’s important to assume this risk for the potential of greater earnings, to help overcome shortfall risk. With people living longer and retirement savings needed 20 or more years in retirement, a smaller – but still meaningful – allocation to equities near the target date may be necessary for the same reason.

Don’t miss part 3 of this series: “Is there a “just right”?

 

About Target Date investment options:

Target date portfolios are managed toward a particular target date, or the approximate date the investor is expected to start withdrawing money from the portfolio. As each target date portfolio approaches its target date, the investment mix becomes more conservative by increasing exposure to generally more conservative investments and reducing exposure to typically more aggressive investments. Neither the principal nor the underlying assets of target date portfolios are guaranteed at any time, including the target date. Investment risk remains at all times. Neither asset allocation nor diversification can assure a profit or protect against a loss in down markets. Be sure to see the relevant prospectus or offering document for full discussion of a target date investment option including determination of when the portfolio achieves its most conservative allocation.

Additional Important Information

Investors should carefully consider a mutual fund’s investment objectives, risks, charges and expenses prior to investing. A prospectus, or summary prospectus if available, containing this and other information can be obtained by contacting a financial professional, visiting principal.com, or calling 800-547-7754. Read the prospectus carefully before investing.

Before directing retirement funds to a separate account, investors should carefully consider the investment objectives, risks, charges and expenses of the separate account as well as their individual risk tolerance, time horizon and goals. For additional information contact us at 800-547-7754 or by visiting principal.com.

Delaware Charter Guarantee & Trust Company, conducting business as Principal TrustSM Company (“Principal Trust”), a member of the Principal Financial Group®, maintains various Collective Investment Funds, as trustee, under certain plan and declaration of trust documents, which may be amended from time to time (“Trusts”). Principal Trust has discretion over the investment of the Collective Investment Funds which may only consist of assets of qualified plans. . Principal Management Corporation (“PMC”), an affiliate of Principal Trust, provides nondiscretionary advisory services to Principal Trust with respect to the Collective Investment Funds. The Collective Investment Funds are not guaranteed by Principal Trust, PMC, any of their affiliates, the FDIC or any other governmental agency.  Participation in Collective Investment Funds offered by Principal Trust is governed by the terms of the applicable Trust and a Participation Agreement. Visit principal.com to obtain a copy of the relevant Collective Investment Fund Summary document for addition important information.

Investment options are subject to investment risk. Shares or unit values will fluctuate and investments, when redeemed, may be worth more or less than their original cost.

Asset allocation does not guarantee a profit or protect against a loss. Equity investment options involve greater risk, including heightened volatility, than fixed-income investment options. Fixed-income investment options are subject to interest rate risk, and their value will decline as interest rates rise. International and global investment options are subject to additional risk due to fluctuating exchange rates, foreign accounting and financial policies, and other economic and political environments. These risks are magnified in emerging markets. Investing in real estate, small-cap, international and high-yield investment options involves additional risks.

There is no guarantee that a target date investment will provide adequate income at or through retirement.

Insurance products and plan administrative services are provided by Principal Life Insurance Company. Principal Funds, Inc. is distributed by Principal Funds Distributor, Inc. Securities are offered through Princor Financial Services Corporation, 800-547-7754, Member SIPC and/or independent broker/dealers. Securities sold by a Princor Registered Representative are offered through Princor®. Principal Funds Distributor, Princor and Principal Life are members of the Principal Financial Group®, Des Moines, IA 50392. Investment options may not be available in all states or U.S. commonwealths. Separate Accounts are available through a group annuity contract with Principal Life Insurance Company. See the group annuity contract for the full name of the Separate Account. Principal Life Insurance Company reserves the right to defer payments or transfers from Principal Life Separate Accounts as permitted by the group annuity contracts providing access to the Separate Accounts or as required by applicable law. Such deferment will be based on factors that may include situations such as: unstable or disorderly financial markets; investment conditions which do not allow for orderly investment transactions; or investment, liquidity and other risks inherent in real estate (such as those associated with general and local economic conditions). If you elect to allocate funds to a Separate Account, you may not be able to immediately withdraw them.

May lose value. Not a deposit. No bank or credit union guarantee. Not insured by any Federal government agency.

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