Everything Has a Purpose

Smart diversification can deliver successful outcomes for target date fund investors throughout their savings journey, provided the diversification approach addresses the right risks at the right times. 

Here, we describe our perspective on managing the four risks that can have a profound effect on retirement plan returns:

  • Accumulation Risk: Strategies that don’t account for young investors’ unique qualities can result in underperformance over the long term.
  • Inflation Risk: Balancing efficient growth with protection against the erosion of purchasing power is a key concern for mid- to late-career investors.
  • Longevity and Volatility Risks: As investors approach retirement, well-diversified strategies can maximize the value of assets saved and help protect those assets as retirees draw down an income.

Essential Diversification

Diversification is a foundational feature of target retirement strategies — but being essential has made it easy to overlook. Here, we will highlight how a strategy that offers thoughtfully selected asset classes can enable the more precise management of the critical issues savers face, as they face them. When it comes to true strategic diversification, every investment vehicle has a purpose.

Accumulation Risk

Young investors focus on accumulating assets, which often leads them to a stock-heavy asset allocation that increasingly mixes with bond exposure as time goes by. But this simple approach can miss opportunities to capitalize on the qualities that make a young investor unique.

For example, US government bonds provide multiple benefits for plan participants with longer time horizons. Adding a 10% allocation to US government bonds can allow State Street to provide approximately 95% of the expected return of an all-equity portfolio with less than 90% of the risk.1

Figure 1: Long Government Bonds Shine in Down Markets Average quarterly returns during rising, stable and declining equity markets

(Rising: S&P 500 Quarterly Returns >5%, Falling: S&P 500 Quarterly Returns <-5%), (December 1997– December 2020)

Long Government Bonds Shine in Down Markets Average quarterly returns during rising, stable and declining equity markets

On the stock side of the equation, State Street’s broadly diversified approach builds in more exposure to small- and mid-cap stocks for younger investors. Stocks of these companies offer investors greater long-term growth expectations in exchange for higher volatility — a tradeoff that can be more appropriate for investors with long time horizons.

Inflation Risk

After a long period of dormancy, the recent market environment has highlighted the impact that inflation can have on retirement savings. This risk is particularly significant for participant approaching and entering retirement who are focused on protecting purchasing power.

The first step in accounting for inflation risk is to provide a meaningful allocation to inflation-managing asset classes as participants approach retirement. Our approach involves complementing an allocation to TIPS with additional asset classes such as commodities and real estate investment trusts (REITS), which can offer inflation management benefits at different points of the economic cycle along with higher long-term return expectations.

Figure 2: Real Assets Have Outperformed in Periods of Rising Inflation

Real Asset Class Returns from 1973-2021

This approach allows State Street to meaningfully address inflation risk within the context of the other key risks that participants are facing, rather than viewing the problem in isolation.

We expect our more diversified mix of asset classes to improve efficiency over a full market cycle, while providing crucial protection against the erosion of purchasing power. In stable markets where equity returns greatly exceed those of diversifying asset classes, this approach can lead to underperformance compared to those managers who de-emphasize inflationary risks. We believe that tradeoff is worthwhile, given the destructive impact that unexpected inflation can have on investor savings.

Balancing Longevity and Volatility Risks

As participants age, their balances grow, and their time horizons shorten, making volatility risk a more significant concern. The first, most obvious step in addressing this risk is to decrease the allocation to equities. Pursuing stabilization and reducing longevity risks are competing yet critical objectives that diversification can help manage simultaneously.

When it comes to our US equity allocation, we increase the percentage of large cap stocks in our allocation compared to market cap weighting, capitalizing on their lower volatility relative to smaller cap stocks. For bonds, State Street uses six underlying funds to evolve our asset allocation intelligently, adding more diversified fixed income exposure to reduce volatility and protect against the impact of rising interest rates.

While managing volatility is crucially important, today’s retirees also face uncertainty around the length of the retirement period that they need to fund. At State Street, we believe that participants should be able to safely withdraw assets in retirement while limiting the probability of running out of money.

Balancing Longevity and Volatility Risks

Our glidepath seeks to steeply reduce risk as participants approach and enter retirement, reaching its most conservative point at age 70, when research suggests that the majority of participants begin to draw down retirement savings.2

We believe that this approach best balances the needs of pre-retirees and retirees: preserving capital, combating inflation, and achieving enough growth to reduce the probability of outliving one’s assets.

Expertise Where and When it Matters

Not all diversification is equal. Simply expanding investments across countries doesn’t always create the desired portfolio diversification. In an intelligently diversified strategy, every component has a purpose. Diversification is often invisible and unsung until a market turn, at which point it can become the difference between a seamless retirement and one that’s difficult or delayed.

Please contact us for the full report.

More On Defined Contribution