Versus Relative Risk: A Comparison of 2 Retirement Strategies MARCH 2014 CONTRIBUTOR Peter Tsui Director, Index Research & Design peter.tsui@spdji.com Target date funds have grown significantly over the past decade. In fact, assets attached to all U.S. target date indices exceeded USD 500 billion in the first quarter of 2013. 1 The underlying premise of target date strategy is a varying derisking glide path, shifting from a high equity risk level to a low equity risk level over time. This generally has an intuitive appeal, as people may be concerned that their portfolios would not recover if the market were to experience a significant drop shortly before their retirement. However, by the same token, they may worry that they could miss out on positive markets by being too conservative. In this study, we seek to determine how target date strategy performs when compared with a suite of relative risk strategies. Which of the Strategies Would Perform Best in Different Markets? Using historical data from 1983 to 2013, we conducted 12 case simulations, labeled A through L. In each case, five relative risk strategies and one target date strategy were modeled over a 20-year period. We created six hypothetical portfolios for each participant in each case, and personified the portfolios associated with the strategies by inventing names for hypothetical participants (Alice through Larry). The Demographic Profile The 12 hypothetical cohorts have birth years ranging from 1938 to 1949. We postulate that each of the cohorts begin saving for their retirements at age 45. As such, Alice and her generation (all born in 1938) would start their savings regimen at the beginning of January 1983. The appropriate underlying target date strategy would be the one with target date maturity in 2005, as this is designed for participants anticipating retirement between 2001 and 2005. RESEARCH 1 See https://corporate.morningstar.com/us/documents/researchpapers/2013targetdate.pdf.
Exhibit 1: The 12 Cohorts Case Name Year of Birth Age Started Saving Saving Since Underlying TD Strategy A Alice 1938 45 1983 2005 B Brian 1939 45 1984 2005 C Craig 1940 45 1985 2005 D David 1941 45 1986 2005 E Edward 1942 45 1987 2010 F Francine 1943 45 1988 2010 G George 1944 45 1989 2010 H Hank 1945 45 1990 2010 I Irene 1946 45 1991 2010 J Justin 1947 45 1992 2015 K Kathy 1948 45 1993 2015 L Larry 1949 45 1994 2015 The five relative risk strategies are labeled RR100, RR80, RR60, RR40 and RR20, where the numerical values indicate the level of equity risk for the relative risk portfolios. For the target date strategies, we assigned the participants the appropriate target date indices in accordance with the year of their retirement. Hypothetical participants Alice, Brian, Craig and David were assigned the Dow Jones 2005 index. Edward, Francine, George, Hank and Irene were assigned the Dow Jones 2010 index. Justin, Kathy and Larry were assigned the Dow Jones 2015 index. Each participant s portfolio is constructed as follows. At the beginning of the 20-year period, beginning at the age of 45, the participant would start to contribute USD 1,000 to an investment account on a monthly basis, at the beginning of each month, for 20 years (or 240 months). At the end of the 20-year period, the total contributions would be USD 240,000, and the ending values would be determined based on the monthly returns of each of the 240 months. For example, our first participant, Alice, would begin putting in the USD 1,000 at the end of December 1982. Her final contribution would be at the end of November 2002. As seen in Exhibit 2, her portfolio would have grown to USD 705,291 if she had invested with the Dow Jones 2005 index, or to USD 526,410 if she had invested with the RR100 index. The USD 705,291 value at the end of the 20-year period (1983-2002) is equivalent to an internal rate of return (IRR) of 9.43%. For the relative risk indices, we used the Dow Jones Global Relative Risk Indices. For the target date indices, we used the Dow Jones Global Indices. Both of these index series use the same underlying building blocks, thus allowing us to test the difference in impact between varying and non-varying asset allocations. For a detailed presentation of the composition and methodology of the Dow Jones Global Relative Risk Indices and the Dow Jones Global Indices, please refer to the Dow Jones Relative Risk Indices Methodology and the Dow Jones Indices Methodology. 2
Exhibit 2: Simulation Results 20-Year Ending Balance in USD RR100 RR80 RR60 RR40 RR20 Strategy 1983 2002 A Alice 526,410 541,249 547,635 541,922 537,492 705,291 1984 2003 B Brian 679,811 660,760 636,854 599,746 558,070 729,623 1985 2004 C Craig 723,704 688,126 653,889 607,114 551,496 692,163 1986 2005 D David 736,021 685,453 637,957 579,157 523,780 621,098 1987 2006 E Edward 792,103 720,490 653,670 577,584 517,857 640,958 1988 2007 F Francine 785,477 713,633 646,937 571,875 512,057 623,202 1989 2008 G George 422,134 434,370 445,703 446,679 461,609 500,314 1990 2009 H Hank 538,689 525,004 509,268 485,245 477,056 521,603 1991 2010 I Irene 582,494 557,685 531,674 498,227 482,394 521,095 1992 2011 J Justin 500,746 495,236 489,283 473,836 474,365 501,801 1993 2012 K Kathy 531,519 516,416 501,643 477,628 468,614 495,175 1994 2013 L Larry 616,045 572,709 531,190 482,050 446,413 481,817 Maximum 792,103 720,490 653,889 607,114 558,070 729,623 Average 619,596 592,594 565,475 528,422 500,934 586,178 Minimum 422,134 434,370 445,703 446,679 446,413 481,817 Spread 369,968 286,120 208,186 160,436 111,656 247,806 Source: S&P Dow Jones Indices. Monthly returns from Dow Jones Series and Dow Jones Relative Risk Series, 1983-2013. All returns are hypothetical. Charts and graphs are provided for illustrative purposes. Past performance is no guarantee of future results. The pattern embedded in the simulation results can be seen more clearly when the results are normalized. To see the relationship among the five relative risk strategies, we normalize the results using the RR100 ending values as the anchor. Exhibit 3: Normalized 20-Year Ending Balance Results Using the RR100 Strategy as the Anchor RR100 RR80 RR60 RR40 RR20 Strategy 1983 2002 A Alice 1.00 1.03 1.04 1.03 1.02 1.34 1984 2003 B Brian 1.00 0.97 0.94 0.88 0.82 1.07 1985 2004 C Craig 1.00 0.95 0.90 0.84 0.76 0.96 1986 2005 D David 1.00 0.93 0.87 0.79 0.71 0.84 1987 2006 E Edward 1.00 0.91 0.83 0.73 0.65 0.81 1988 2007 F Francine 1.00 0.91 0.82 0.73 0.65 0.79 1989 2008 G George 1.00 1.03 1.06 1.06 1.09 1.19 1990 2009 H Hank 1.00 0.97 0.95 0.90 0.89 0.97 1991 2010 I Irene 1.00 0.96 0.91 0.86 0.83 0.89 1992 2011 J Justin 1.00 0.99 0.98 0.95 0.95 1.00 1993 2012 K Kathy 1.00 0.97 0.94 0.90 0.88 0.93 1994 2013 L Larry 1.00 0.93 0.86 0.78 0.72 0.78 Source: S&P Dow Jones Indices. Monthly returns from Dow Jones Series and Dow Jones Relative Risk Series, 1983-2013. Note: Highlighted areas indicate results above 1.00. All returns are hypothetical. Charts and graphs are provided for illustrative purposes. Past performance is no guarantee of future results. With the exception of cases A and G, the five relative risk strategies exhibited a pattern that is expected; the ending values were higher for higher relative risks. For case G, the poor market in 2008 was a key factor. In Exhibit 3, we also see that the target date strategy outperformed the relative risk strategies in three of the 12 cases, and it was a draw in a fourth case (for Justin). When we switch the normalizing anchor from RR100 to the target date strategy, we see another interesting pattern emerge (see Exhibit 4). 3
Exhibit 4: Normalized 20-Year Ending Balance Results Using the Strategy as the Anchor RR100 RR80 RR60 RR40 RR20 Strategy 1983 2002 A Alice 0.75 0.77 0.78 0.77 0.76 1.00 1984 2003 B Brian 0.93 0.91 0.87 0.82 0.76 1.00 1985 2004 C Craig 1.05 0.99 0.94 0.88 0.80 1.00 1986 2005 D David 1.19 1.10 1.03 0.93 0.84 1.00 1987 2006 E Edward 1.24 1.12 1.02 0.90 0.81 1.00 1988 2007 F Francine 1.26 1.15 1.04 0.92 0.82 1.00 1989 2008 G George 0.84 0.87 0.89 0.89 0.92 1.00 1990 2009 H Hank 1.03 1.01 0.98 0.93 0.91 1.00 1991 2010 I Irene 1.12 1.07 1.02 0.96 0.93 1.00 1992 2011 J Justin 1.00 0.99 0.98 0.94 0.95 1.00 1993 2012 K Kathy 1.07 1.04 1.01 0.96 0.95 1.00 1994 2013 L Larry 1.28 1.19 1.10 1.00 0.93 1.00 Source: S&P Dow Jones Indices. Monthly returns from Dow Jones Series and Dow Jones Relative Risk Series, 1983-2013. Note: Highlighted areas indicate results above 1.00. All returns are hypothetical. Charts and graphs are provided for illustrative purposes. Past performance is no guarantee of future results. The target date strategy portfolios almost always outperformed the RR40 and RR20 portfolios, but they were inferior to RR100 in eight out of 12 cases. Since none of the participants can predict future earnings or performance, they may be satisfied with a target date strategy that performed relatively well, even if it was not optimal. We also calculated the IRRs for these portfolios (see Exhibit 5). Exhibit 5: Annualized IRR RR100 (%) RR80 (%) RR60 (%) RR40 (%) RR20 (%) Strategy (%) 1983 2002 A Alice 7.09 7.31 7.41 7.32 7.26 9.43 1984 2003 B Brian 9.14 8.92 8.62 8.14 7.56 9.69 1985 2004 C Craig 9.63 9.23 8.83 8.24 7.47 9.28 1986 2005 D David 9.76 9.20 8.64 7.86 7.05 8.43 1987 2006 E Edward 10.32 9.59 8.83 7.84 6.95 8.67 1988 2007 F Francine 10.26 9.52 8.75 7.76 6.86 8.45 1989 2008 G George 5.23 5.48 5.70 5.71 5.99 6.67 1990 2009 H Hank 7.28 7.06 6.81 6.41 6.27 7.01 1991 2010 I Irene 7.91 7.56 7.17 6.63 6.36 7.00 1992 2011 J Justin 6.67 6.58 6.48 6.21 6.22 6.69 1993 2012 K Kathy 7.17 6.93 6.69 6.28 6.12 6.58 1994 2013 L Larry 8.36 7.77 7.16 6.36 5.71 6.35 Maximum 10.32 9.59 8.83 8.24 7.56 9.69 Minimum 5.23 5.48 5.70 5.71 5.71 6.35 Spread 5.10 4.12 3.14 2.53 1.86 3.34 Average 8.23 7.93 7.59 7.07 6.65 7.85 Median 8.13 7.67 7.29 6.98 6.61 7.72 Mean Absolute Deviation 1.34 1.14 0.95 0.80 0.54 1.14 Sample Std. Dev. 1.61 1.34 1.10 0.89 0.62 1.25 Source: S&P Dow Jones Indices. Monthly returns from Dow Jones Series and Dow Jones Relative Risk Series, 1983-2013. All returns are hypothetical. Charts and graphs are provided for illustrative purposes. Past performance is no guarantee of future results 4
Exhibit 6 shows the overperformance or underperformance of the relative risk portfolios with respect to their target date strategy counterparts. Exhibit 6: Relative Annualized IRR (Relative Risk-) RR100-TD RR80-TD RR60-TD RR40-TD RR20-TD 1983 2002 A Alice -2.34-2.11-2.02-2.10-2.17 1984 2003 B Brian -0.55-0.78-1.07-1.55-2.13 1985 2004 C Craig 0.35-0.05-0.45-1.04-1.81 1986 2005 D David 1.33 0.78 0.21-0.56-1.38 1987 2006 E Edward 1.65 0.92 0.16-0.83-1.72 1988 2007 F Francine 1.81 1.07 0.30-0.69-1.59 1989 2008 G George -1.44-1.19-0.97-0.95-0.67 1990 2009 H Hank 0.27 0.05-0.20-0.60-0.74 1991 2010 I Irene 0.91 0.55 0.16-0.37-0.64 1992 2011 J Justin -0.02-0.11-0.21-0.48-0.47 1993 2012 K Kathy 0.58 0.35 0.11-0.30-0.46 1994 2013 L Larry 2.01 1.42 0.81 0.00-0.64 Max 2.01 1.42 0.81 0.00-0.46 Min -2.34-2.11-2.02-2.10-2.17 Average 0.38 0.08-0.26-0.79-1.20 Median 0.47 0.20-0.05-0.64-1.06 Source: S&P Dow Jones Indices. Monthly returns from Dow Jones Series and Dow Jones Relative Risk Series, 1983-2013. All returns are hypothetical. Charts and graphs are provided for illustrative purposes. Past performance is no guarantee of future results. Observations First, on average, taking more risk would have paid off in these situations. The RR100 (100% equity risk portfolio) has an average IRR of 8.23% vs. 7.85% for the target date strategy portfolio over the most recent 30 years market conditions. However, results vary on an individual participant basis. For example, in George s cohort, the 20-year IRR for the RR100 was only 5.23% because of the financial meltdown in 2008. Most prospective retirees are afraid of precisely this situation: what if the year before they are about to retire, when their savings would be at their highest, the market turns against them? If George had been following a target date strategy, the IRR would have been 6.67%. This result is still significantly less than the average IRR of 7.85%, but not devastatingly so. Second, even though the target date strategy did not have a fixed equity allocation by design, it came closest to the RR80 strategy in terms of its overall performance over these empirical comparisons. The mean absolute deviation for these strategies is identical at 1.14, and the average returns are 7.93% for the RR80 vs. 7.85% for the target date strategy. However, the target date strategy may seem to be the better choice, as it has a smaller spread between its best and worst returns (3.34% TD vs. 4.12% RR80), smaller sample standard deviations (1.25 TD vs. 1.34 RR80), and a higher minimum historical return (6.35% TD vs. 5.48% RR80). The average difference in the IRRs was 0.08% (see Exhibit 6). Third, over the past 30 years, the bond markets enjoyed a secular boom, as the long-term Treasury rates moved from a high of 15% to a low of 2%. Thus, cohorts whose retirement horizons were in the first decade of the 21 st century (like Alice and Brian) benefited from a healthy return derived from the fixed income component of their portfolios. As a result, Alice and Brian were the only cohorts whose target date strategy portfolios beat the relative risk portfolios in rising markets. The same cannot be said for Larry, as the fixed income portion of his portfolios had a negative return in 2013 and his target date strategy portfolio suffered accordingly, despite a booming stock market. 5
Finally, the specific ending wealth of the 12 cohorts clearly depends on the paths the markets took over their investment periods. Adopting the target date strategy may not deliver the best results most of the time, but it seems to avoid the worst outcomes more reliably. ABOUT S&P DOW JONES INDICES S&P Dow Jones Indices LLC, a part of McGraw Hill Financial, Inc., is the world s largest, global resource for index-based concepts, data and research. Home to iconic financial market indicators, such as the S&P 500 and the Dow Jones Industrial Average TM, S&P Dow Jones Indices LLC has over 115 years of experience constructing innovative and transparent solutions that fulfill the needs of institutional and retail investors. More assets are invested in products based upon our indices than any other provider in the world. With over 830,000 indices covering a wide range of assets classes across the globe, S&P Dow Jones Indices LLC defines the way investors measure and trade the markets. To learn more about our company, please visit www.spdji.com Like What You Read? Sign up to receive complimentary updates on a broad range of index-related topics and events brought to you by S&P Dow Jones Indices. 6
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