RPA2 Module 7 Flashcards
What are four factors impeding successful individual retirement planning that
lifecycle funds address?
(1) Investors are not inclined to be actively engaged.
(2) Investors are overwhelmed by too many fund choices.
(3) Investors have limited basic investment knowledge.
(4) Investors have limited interest in investment issues.
What are the two basic types of lifecycle funds?
(1) Targeted-maturity funds. These target a specific retirement year and then change their asset allocation from aggressive to conservative as that date approaches. The final allocation is intended to see the investor through retirement.
(2) Static-allocation funds. These funds maintain a defined asset allocation. They are typically offered in sets ranging from aggressive to conservative, with the investor determining which portfolio is appropriate for his or her circumstances at any given time.
Compare the two types of lifecycle funds in terms of (a) risk profile, (b) asset
allocation shifts, (c) allocation monitoring and (d) time horizon.
(a) Under a targeted-maturity fund, it is assumed that investors who share a
retirement date have similar objectives and risk tolerance. Under a staticallocation fund, investors assess their own risk tolerance.
(b) Under a targeted-maturity fund, an advisor automatically changes the asset allocation over time. Under a static-allocation fund, the investor decides when and how to shift to a more conservatively allocated fund as retirement draws nearer.
(c) Under a targeted-maturity fund, all asset allocation changes occur within the fund. Under a static-allocation fund, periodic monitoring by the investor is necessary to determine whether the fund’s asset allocation continues to match the investor’s risk profile through the stages of accumulation, transition and retirement.
(d) Under a targeted-maturity fund, the time horizon is predetermined, based on the fund’s target date. Under a static-allocation fund, investors have flexibility to alter their asset allocations based on their changing time horizon.
When choosing a lifecycle fund provider, what should plan sponsors and investors evaluate?
investment methodology employed in constructing the funds.
Describe the two approaches used in transition from stocks to bonds in a targeted maturity fund.
Under the approach called glide path, incremental changes are prescribed from the start. The asset allocation does not vary; it is known in advance for any point in the transition toward the target date.
Under the approach called tactical, there is systematic market timing to determine when allocation changes will occur. Under this approach, the asset allocation path is not prescribed; it will vary with the manager’s assessment of financial market conditions and the relative valuations for various asset classes.
What is a risk that arises from the very nature of lifecycle funds?
These funds encourage many participants to take a more passive approach in managing their retirement investments.
If a lifecycle investor fails to adjust portfolio allocations to reflect changing time horizons or spending needs at any stage of the retirement planning
process (accumulation, transition or retirement itself), that investor will incur a risk of not being able to meet spending goals during retirement.
The degree of risk will depend on the specific allocation and the desired level of spending. Although the degree of loss in decision making is much less with the static allocation funds, both types of funds require an educational effort on the part of the plan sponsor to ensure that participants understand the inherent risk of lifecycle funds.
What are the reasons for the growth of target-date funds (TDFs)?
One reason for the growth is that TDFs are a means to simplify the retirement
investment decisions of plan participants.
Another reason is the designation by the U.S. Department of Labor of TDFs as one type of qualified default investment alternative (QDIA).
TDFs are the most popular default investment options of plan sponsors that have added or are adding an automatic enrollment feature to their 401(k) plans.
In addition, a number of plan sponsors are actively transferring
participants into TDFs from other funds in their plan.
Summarize how TDFs are designed to simplify retirement plan investing.
TDFs are designed to be easy for a participant to simply pick the funds that most closely correspond to his or her retirement date.
What are key considerations in evaluating and adopting TDFs?
Four key considerations in evaluating and adopting TDFs are:
(1) Asset allocation glide path
(2) Passive or active management
(3) Packaged or customized solution
(4) Impact on participant portfolios.
Describe the variations that exist in the construction of asset allocation glide paths for TDFs.
Variations exist in how quickly risk exposure diminishes as the transition out of equities is implemented, in the stock/bond/cash allocations, in how
the glide path will operate once the target date is reached and in the asset classes being used.
What is the rationale for the human-capital-based argument holding that equity
exposure of TDFs should decline over time?
Based on the premise that, for most people, the value of future earnings and Social Security is an asset with bondlike characteristics, which should be balanced with a significant exposure to stocks. As investors age, the present value of the income they will receive in the future from continuing to work systematically declines, reaching a low level at the point of retirement.
Theoretically, to maintain a balanced exposure to market risk through time, this diminishing asset should be gradually replaced with bonds or other fixed income instruments, which share characteristics similar to human capital.
Also, younger individuals have far more flexibility to alter their future labor supply in response to bad stock market outcomes, and they have greater flexibility to work more or harder in the future if financial outcomes are poor.
As an investor/worker ages, the ability to rely on future work to offset poor outcomes generally declines. This further suggests that as investors approach retirement, they should take on generally lower levels of risk.
What is meant by the notion that stock returns “mean revert”?
The term mean reversion is often used loosely, and its exact meaning in terms of an assertion about the properties of equity returns through time can be unclear.
In general, it is interpreted to mean that if stock returns have been unusually good in the recent past, they are more likely to be poor in the future, while if they are unusually poor in the recent past, they are more likely to be good in the future.
What are the implications of mean reversion for investors?
The existence of mean reversion in long-term equity returns would in part imply that equity risk is generally lower for those with longer investment horizons; hence, equity allocations should be higher for younger investors versus older investors.
Mean reversion would also, however, imply that one could successfully move in and out of mean-reverting assets (selling when reversion suggests future returns will be poor and buying when reversion implies returns will be higher) to improve overall returns.
Investors’ historical lack of success in doing so weakens the case for the
simplest forms of mean reversion in returns.
Stocks, bonds and cash play a major role in determining TDF asset allocation
strategies. List several nontraditional asset classes and their potential advantages and flaws as a means of enhancing asset allocation strategies.
The nontraditional asset classes include:
Real estate investment trusts (REITs)
Commodities,
Private equity
Currency.
Among the alternative investment strategies are long/short and market-neutral approaches. These asset classes and strategies can offer several important potential advantages compared with investing in traditional stocks, bonds and cash, including the following:
(1) potentially higher expected returns
(2) lower expected correlation and volatility vis-à-vis traditional
market forces
(3) the opportunity to benefit from market inefficiencies through skill-based strategies.
However, it is important to note that it may be difficult to assess the degree to which these advantages can be relied upon. A study of actual returns shows that there have been extended periods when the inclusions of these nontraditional asset classes have led to significant underperformance.
Most TDFs are funds of funds, and plan sponsors must decide whether the
underlying funds are to be all active management, all indexed (passive) management or a combination of the two. What are the factors to consider when assessing a passive management strategy?
The ease with which performance results can be communicated to participants
The inherent lower costs of this strategy and the implications for fiduciary oversight.
Index funds provide returns that are close to those of asset-class performance benchmarks. This is an especially important factor since most TDFs are designed based on expected asset-class returns, and index funds can virtually ensure that those asset-class returns are generated for investors.
Index funds also provide return patterns that are potentially easier to explain to the participant population. Of course, it is possible for the active manager to outperform the market, generally leaving little need for explaining.
A big reason for the advantage of index funds is cost. Cost can be a significant determinant of active management’s long-term success relative to an index. The longer the time period—and TDF investing can span up to 40 years—the more important the role of costs.
From a fiduciary perspective, and with a default investment fund in mind, an index approach may have advantages over an active approach. Fiduciaries that venture from the relative safety of indexed funds to actively managed funds assume greater risk of their choices being judged imprudent in the event of poor returns
