Examining the Glide Path Methodology for Target Maturity Funds

A paper from Ibbotson Associates offers one perspective on why and how the equity/bond glide path of a portfolio should evolve throughout an investor’s lifetime. Ibbotson argues for the creation of asset allocation funds that equate to lifetime financial advice.

“The creation of robust lifetime asset allocation solutions begins with an analysis of the evolving risks investors face throughout their lifetimes,” the Ibbotson paper says. During the accumulation phase, the primary risks are expense risk, savings risk, mortality risk, and market risk, while during the decumulation (or retirement) phase, the primary risks are expense risk, longevity risk, bequest risk, and market risk, the report points out.

Ibbotson argues that a portfolio’s glide path should still create some capital during retirement since an investor’s retirement income liability becomes more relevant as he or she approaches retirement. Retirement expenses form the retiree’s retirement liability and determination of a glide path should apply liability-driven investing to individuals.

“For retirees drawing down their assets to pay for retirement, with every passing year the capacity for a negative investment event decreases while concern regarding the ability to pay for the liability increases,” the report says. This creates the need for large differences in the underlying asset allocations of target-maturity portfolios.

Ibbotson explains that for younger investors, there is relatively high exposure to high expected-return asset classes like non-U.S. equity, emerging markets, and small-cap equities. Younger investors are relatively unconcerned with currency exposure, and human capital provides an ample defense against inflation. As bonds enter the glide path, these initial allocations are fulfilled with long duration nominal bonds.

As investors approach their 50s, allocations to non-U.S. equity, emerging markets, and small-cap equities slowly decline and the increasing allocation to bonds is now implemented with a mixture of long and intermediate bonds. With retirement looming and human capital declining relative to financial capital, a gradual shift from nominal bonds to inflation-linked bonds begins.

As investors move into retirement, the allocation to bonds continues to grow, but Ibbotson says the allocation should still include exposure to equities with a move away from non-U.S. equities.

For an individual investor, his or her overall economic situation is influenced by financial capital (tradable assets) and human capital (non-tradable assets), Ibbotson notes. The report says human capital affects all four of the primary accumulation phase risks that investors face in the following ways:

• Expense Risk - During the accumulation phase, human capital generates current income that hedges current expenses, thus allowing financial capital to grow untouched until retirement. Over time, expenses and salaries increase with inflation.
• Savings Risk - If current expenses require all of the investor's current income, the investor runs a high risk of not saving enough to fund future (retirement) expenses.
• Mortality Risk - Mortality risk is a catastrophic risk to human capital and the current and future income that it is expected to generate.
• Market Risk - For younger investors, human capital is likely their largest single asset.

Human capital includes earnings to be used for pre-retirement expenses, earnings to be directed toward savings (typically to fund post-retirement expenses), and earnings that will lead to deferred labor income in the form of Social Security and defined benefit pensions. It also includes liabilities: the present value of all future pre-retirement expenses, the present value of all future post-retirement expenses, and the present value of assets that will be given away.

Ibbotson says that for most investors human capital is bond-like, and especially for younger investors. Because of this, most younger investors' financial capital should be invested 100% in equities. As investors age and amass financial capital, they no longer need to invest 100% of their financial capital in equities. To optimize an individual's total portfolio, Ibbotson changes the investor's financial capital asset allocation so that the investor's total economic wealth (financial capital plus human capital) matches the stock-bond split of the target market portfolio - 54% bonds, 46% stocks.

Ibbotson warns that everyone's human capital is unique. If an individual has "safe" human capital, his or her financial capital should be invested more aggressively to create a total portfolio that matches the target market portfolio, but if an individual has "risky" human capital, his or her financial capital ought to be invested less aggressively.

The report also advises that two key dimensions that affect an investor's particular glide path are risk preference and risk capacity. "Glide paths should be customized based on these dimensions in order to best meet the evolving risks faced by investors."

This Ibbotson Lifetime Asset Allocation Methodologies primer is organized into three sections:

• Lifetime Financial Advice - introduces the primary risks that investors face during their lifetimes.
• Customized Stock-Bond Glide Paths - explains how the Ibbotson Target Maturity Methodology embraces modern portfolio theory, including an enhanced understanding of human capital's important role in the market portfolio.
• Inside the Glide Path - focuses on Ibbotson's use of liability-driven investing techniques to develop detailed asset allocation guidelines that are optimized for inflation-protected retirement income.

The Ibbotson report is here .