- Careful menu design can help retirement plan participants make better investment decisions.
- Investors nearing retirement are among the most vulnerable to downward market volatility because they have less runway available to make up any losses.
- “Defensive equities” may offer older employees a better balance of risk and return than simply lowering equity allocations.
As the market neared its ninth consecutive year of bullish growth in early 2018, volatility made a return to the market — and again, dramatically, in the fourth quarter. Its return sent retirement plan participants back to their 401(k) statements as many confronted sudden declines in their plan balances.
Despite the widespread understanding that retirement plans are long-term investments, it’s hard to remain unfazed by volatility when nest eggs are on the line.
Here are three specific ways volatility can impact retirement plan participants:
1. Even retirement plan investors make bad decisions.
Common-sense investment advice rightly emphasizes long-term investing and diversification strategies. But the typical investor rarely replicates the kind of growth represented by the indexes, as studies by the financial research firm Dalbar have repeatedly shown.
In a comparison with S&P 500 historical returns over 20 years, Dalbar found the average equity investor’s returns lagged by nearly 2% over the same period. Put another way, on a hypothetical initial investment of $100,000 in 1997, the average investor would have seen $120,000 less gain than the S&P 500 by 2017.
The reason for such a disparity may come down to a number of factors, including fees and the underlying risk of selected investments. But one of the biggest drivers of suboptimal investment returns is investor behavior, which can be driven by emotional reactions to the market.
And yes, this affects retirement plan investors, who may be just as susceptible to knee-jerk trading as shorter term investors. According to an analysis by the benefits administration firm Alight Solutions, the volatile fourth quarter of 2018 saw extended above-normal trading activity among 401(k) investors, “mostly concentrated around days when the stock market lost ground.”
Emotional decisions in response to market fluctuations can derail retirement planning — especially if the participant hasn’t contributed enough.
Simplifying menu choices is one way retirement plan sponsors who want to limit risk exposure can help. In a 2000 study that looked at nearly 800,000 participants in 401(k) plans, researchers found that too much choice often leads people to make poor decisions — even ones that go against their best interests. The study’s authors wrote that people are “burdened by the responsibility of distinguishing good from bad decisions.” As a result, they found that more options can lead to dissatisfaction with the choices.
The upshot is that limiting retirement plan menu options to a few carefully designed and easy-to-understand choices – perhaps organized around life stages, years to retirement or other investment objectives — may help guide investors to better behavior overall.
2. The older the investor, the greater the impact.
Managing volatility often comes down to recovery time. Those investors nearing retirement are among the most vulnerable to downward market volatility because they have less runway available to make up any losses.
According to Goldman Sachs data, the S&P 500 requires an average of 22 months to recover after a bear market bottoms out. But actual time-to-recovery could be much longer if the investor had greater exposure to losses in their portfolios than the S&P 500. And the closer that investor is to retirement, the greater the impact on their future income.
Any market decline requires a proportionally larger gain to break even. So, a 20% loss requires a 25% gain to recover, while a portfolio that loses half its value needs to fully double in value to recover all losses.
Understanding this short-term volatility risk is critical, especially where retiree nest eggs are at stake.
Here’s a silver lining to ponder: Even if volatility erodes a portion of retirement savings, it may matter less to retiree’s standard of living than they might expect. A 2017 Capital Group survey found that while pre-retirees anticipate spending about 20% of their retirement savings a year, actual and semi-retirees polled had only spent 3%-4% a year.
3. Equities can help mitigate risk, too.
So, how can older workers and retirees balance the growth potential they need to last them throughout retirement while protecting against volatility?
One potentially overlooked approach is investing in lower volatility equities, as recent research by Capital Group’s Sunder Ramkumar has highlighted. Ramkumar’s analysis of more than 50 years of market data found that higher allocations of “defensive equities” — broadly characterized by lower volatility, dividend payouts and consistent results even in periods of market stress — can reduce risk and improve overall portfolio results.
“Higher allocations to these defensive equities can provide an investment option preferable to simply having a lower overall equity allocation,” Ramkumar says. “An investor can reduce downside risk by lowering the allocation to equities, but the upside capture declines more substantially, and the expected return is substantially lower.”
In this way, defensive, dividend-oriented equity allocations can help mitigate downside risk for older workers who are more susceptible to short-term volatility as well as reduce long-term appreciation risks for younger workers.
“We find this strategy better addresses changing risks for participants as they age in comparison to simply holding the same equity index … throughout the retirement life cycle,” Ramkumar says.
Finding the right balance of risk and return
Volatility can cause anxiety that leads to poor investment decision-making and interfere with retirement outcomes — but it doesn’t have to.
There are several strategies plan sponsors can employ to help guide participants to better decision-making — and meet their own fiduciary duties. These include simplifying menus, adding retirement income options and looking at the mix of equity and fixed income in target date funds, especially the type of equity employed.
Here are three suggestions for how older workers and retirees can deal with increased volatility:
- Avoid emotion-based, reflexive investment decisions. Staying with a long-term plan is vital with today’s longer and more-active retirements.
- Plan for the extra risk at retirement and beyond by seeking a greater proportion of risk-managed investments, including equities.
- Consider shifting not only the amount of equity allocated over time, but the types of equity — to allow for appreciation while still providing downside protection.
Sunder Ramkumar is senior manager, client analytics at Capital Group. He has 15 years of investment experience, four at Capital. Sunder was previously a managing director and portfolio manager at BlackRock. He holds a master's in management science and engineering from Stanford and a bachelor's in mechanical engineering from Mangalore University. He is also a CFA charterholder.
Returns for average equity investors calculated by DALBAR. DALBAR uses data from the Investment Company Institute (ICI), Standard & Poor’s, Bloomberg Barclays indexes and proprietary sources to compare mutual fund investor returns to an appropriate set of benchmarks. The study utilizes mutual fund sales, redemptions and exchanges each month as the measure of investor behavior. These behaviors reflect the “average investor.” Based on this behavior, the analysis calculates the “average investor return” for various periods. These results are then compared to the returns of respective indexes. Ending values for the indexes and hypothetical equity and fixed-income investor investments are based on average annual total returns.
Standard & Poor’s 500 Composite Index is a market capitalization-weighted index based on the results of approximately 500 widely held common stocks.
Past results and are not predictive of results in future periods. The market indexes are unmanaged and, therefore, have no expenses. Their results include reinvested distributions but do not reflect the effect of sales charges, commissions, account fees, expenses or taxes. Investors cannot invest directly in an index.
Hypothetical results are for illustrative purposes only and in no way represent the actual results of a specific investment.