Target funds weather market storms

by | Sep 7, 2023 | Take 5 Articles

The market correction in 2022 was a painful reminder that downturns can be both sudden and deep. However, historically, market sell-offs have been followed by rebounds of similar—if not greater—magnitude, and markets can often rally even as uncertainty continues.

An analysis of bear markets over the past 60 years shows that all but three downturns recovered within two years; in fact, we would need to go back to 1973 to identify a bear market that took longer than five years to recover. This highlights that patience and perspective are often rewarded in investing.

Even so, behavioural influences are strong during market downturns. Negative investor sentiment and news flow, coupled with short-term losses, often cause plan members to want to cut market risk exposure, and members may reactively want to pause contributions to retirement savings plans under the belief that it will avoid losses.

However, pausing contributions during a downturn doesn’t necessarily avoid losses. In fact, continued contributions may help add growth over the long term, as demonstrated by an analysis of two scenarios over a 63-year period. In scenario one, a plan member consistently contributed $50 a month. In scenario two, a plan member stopped contributions in a market downturn and resumed when markets entered recovery, at which time a lump sum is added to make up for missed contributions. The plan member in scenario one experienced almost 10 percent more in total returns.

Impact of target-date funds

Target-date funds, chosen and managed based on a plan member’s retirement date, are becoming best practice in the industry. Market downturns can have a varying effect on target-date portfolios depending on where a member is in their glide path.

A market downturn that begins while a member is on the cusp of, or already in, retirement is naturally a greater concern and risk to retirement wealth. Preretirement members already in the derisking phase of a glide path face a similar challenge. Target-date portfolios can help manage these risks through the design of the glide path:

  • A “through” glide path gradually adjusts the asset allocation over time, with a focus on capital preservation and income generation in retirement
  • A “to” glide path reaches a specific allocation at the target date and maintains that allocation through retirement.

The benefits of a through retirement approach are threefold. First, it typically de-risks at a slower pace leading up to retirement, and, although this may sound counterintuitive, can potentially weather downturns better than glide paths that follow a to retirement approach that de-risks at a faster pace. Secondly, a through glide path has higher allocations to growth assets versus a to glide path, specifically for the 25 years prior to retirement. This coincides with the period in which account balances and income tend to be at their peak, allowing for potentially higher accumulation within a portfolio.

Finally, a through glide path has higher allocations to growth assets in early retirement versus a to glide path. This is acceptable risk as it will help support lower shortfall risk, especially as members face longer withdrawal horizons due to longevity. It also takes into account that markets have historically rebounded quicker than expected, reminding us that patience is often rewarded in investments.

In contrast, a to retirement glide path reaches its lowest allocation to growth assets at retirement and will maintain that allocation throughout retirement. This type of target-date fund will typically derisk at a faster pace, selling growth assets quicker. In a falling market, this crystallizes losses at a quicker pace, potentially resulting in lower ending balances immediately prior to retirement.

According to data from Statistics Canada, there’s been a notable shift in retirement patterns among Canadians, with an increasing number of individuals choosing to work longer. As well, the average life expectancy at age 65 has increased from 18 years in 2000 to 20 years in 2020, meaning that people are living longer. This highlights the importance of long-term planning when managing retirement savings.

Market downturns are stressful periods, but they shouldn’t derail members’ retirement savings plans. A member’s choice of glide path can have a meaningful impact on investment outcomes. Target-date funds that derisk later in the glide path, typical of through glide paths, maintain higher exposures to growth assets, often generating higher income for longer. Target-date funds that derisk quickly, typical of to glide paths, run the risk of crystallizing higher losses if derisking occurs during an equity bear market.

This article is brought to you by Manulife, a Platinum Preferred Solutions Provider for members of Benefits Alliance. It is excerpted from “Weathering market volatility with target-date funds,” a white paper published by Manulife in August 2023. The complete white paper is available through your benefits advisor.