Risk and retirement: Timing is everything
Any Star Wars fan knows the fictional “jump" to hyperspace can be perilous. It’s the moment of truth when Han, Luke and friends will either escape or risk becoming prisoners of the Empire. Navigating this leap requires skill and critical thinking.
When it comes to retirement plans, an equivalent—though real life—leap comes just prior to and just after a worker’s retirement date. Yet the retirement date is often viewed as the culmination of a lifelong dream. So why, if retirement is so close or has just begun, do our risks tend to increase?
It’s during this pre- and in-retirement window that a formidable factor – sequential risk – often comes into play. Sequential risk is another term for the threat of bad returns at a highly critical time. When retirement plan participants are accumulating assets, they will face a critical period just prior to retirement. Their assets have peaked and their ability to save further is limited. Once they have retired, another critical time occurs at the start of retirement. A downturn in investment returns during this period may compromise potential planned withdrawals for many future retirement years. As the hypothetical diagram below shows, sequential risk peaks just before and just after the retirement date.
Target date funds (TDFs) and their glide paths need to account for this harsh reality. During pre-retirement, as sequential risk increases, de-risking is needed to offset that sequential risk. To varying degrees, TDFs provide retirement plan participants with some degree of de-risking in the face of imminent retirement. During the in-retirement years, as sequential risk decreases (since the amount of future withdrawals is decreasing), the portfolio should not continue to de-risk. Yet, as our research shows, most TDFs continue to follow a path of reducing risk well into retirement, as shown by the glide path in the diagram.
In our recent research and testing, my colleague, Kevin Knowles, and I examined the merits of a flat, or “to” retirement, TDF glide path in retirement. We compared this to the more common de-risking, or “through” retirement, glide path. In this research we found that glide paths that mitigated sequential risk (in essence, zigging when sequential risk was zagging) tested better (meaning showing a more steady income for retirees), both forward-looking and historically.
Sequential risk may not be top of mind for plan sponsors choosing a TDF glide path for their participants, but understanding it is essential to an informed selection. By offering TDFs with glide paths that respect the risks of leaping into retirement hyperspace, plan sponsors can help participants engineer a landing smooth enough to satisfy the Han Solos among us.