The majority of workplace retirement money is funneling into target-date funds, but most employers and plan participants don’t truly understand how they work.

Many retirement experts believe target-date funds are the best option for retirees who want to set their money aside and forget about it. They are actively managed and are supposed to de-risk as the account holder gets closer to their target date of retirement.

But, that’s not what is happening with most TDFs, and it all has to do with glide path: the rate at which accounts become less risky.

Most large companies offer TDFs with “through” glide paths, meaning people will hit retirement age still heavily invested in equities, which are more risky. The theory is that most people who make it to retirement will need to make their accumulated wealth last at least 20 years, if not 30, so they will need to continue earning money on those assets.

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The economic downturn in 2008 was a “wakeup call to plan sponsors to understand the glide path of their target-date fund and how much equity participants were being exposed to along the way, particularly near retirement,” said Holly Verdeyen, director, defined contribution, at Russell Investments. “But there are many other assumptions underneath the glide path that the market has not really tried to understand or appreciate. With target-date funds garnering the vast majority of flows coming into plans, it is time for plan sponsors to have a much deeper understanding of the allocations and the assumptions that lead to those allocations.”

Currently, TDFs are judged almost solely on performance.

“Comparing target-date funds to their peers on a pure performance basis, a backwards looking return analysis, is inefficient and there’s other ways. You should take the objectives of the TDF and their methodology into consideration as well,” said Kevin Knowles, product manager, defined contribution, at Russell.

Knowles and Daniel Gardner, defined contribution analyst at Russell, wrote a paper looking back five years to see which glide paths are being used and what that means for plan participants. They found that the majority of TDF providers use a “through” glide path, but they believe a “to” or “flat” glide path is a much better option for most people. That means that the majority of the account’s risk is experienced before the target retirement date and then it flattens out and remains stable through retirement.

The biggest risk to a TDF account is the sequence-of-returns risk, the report said.

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“Sequential risk and asset allocation risk should move in opposite directions,” the report found. “We believe continuing to de-risk in retirement — as most glide paths do — does not make sense. A flat glide path with a more conservative allocation at the target date — perhaps, even a “re-risking” glide path, which starts even more conservatively and becomes more aggressive over time — may help to better reduce sequential risk, relative to a de-risking glide path.”

The defined contribution market doesn’t speak enough about sequential risk, said Verdeyen.

“We do a good job of laying out participant risks but we are missing some. Sequential risk is not publicized enough. It is a pretty simple concept; pretty straightforward for participants to understand. The timing of returns do matter. When participants start drawing down their account it would be nice if they were counting sequential risk as part of the longevity and shortfall risk and market risk,” she said.

Gardner added that, the years closest to the retirement date are the most crucial because if the market drops at that time, it “can completely derail your retirement plans. You don’t want to put all your eggs in that basket. It is important, almost imperative, that you don’t have bad performance around [your target date.]”

He added that “if the markets do well around retirement, great, but if they don’t do well you will find yourself in a hole you can’t get out of.”

De-risking after you’ve had that bad market experience is like locking in the losses, he said.

“Our research has shown that it does, in fact, lock in the losses. Basically, if returns are bad, then you take a more conservative allocation, it is going to be really difficult to get back to where you want to be. You are in a much better position if you play it safe at first.”

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The reason most providers haven’t moved to a “to” glide path from a “through” glide path is because it is hard to change a glide path in a vehicle that has been running for a long period of time, Verdeyen said.

What some providers have done to get around that problem is offer participants both types of target-date funds.

“We think that demonstrates a lack of conviction,” Verdeyen said.

Re-risking after the target date could also pose problems, Knowles said.

“We are not an advocate for increasing growth in assets after retirement. Participants could get spooked and pull their assets, and that is the worst situation of all,” he said.

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