Market downturns can help target-date investors grow their retirement savings

In times of extreme volatility, it can be tempting to consider cutting your losses and heading for the exits until market swings subside. But for most investors—particularly long-term investors saving for retirement—we believe a market downturn should be viewed as an opportunity rather than a catastrophe.  

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Remaining invested can enable investors to enjoy the inevitable market upswing without having to worry about timing. Just as important, 401(k) investors who maintain their regular contributions can buy stocks at lower prices, which we believe can put them on a stronger footing in saving for retirement.

Target-date fund glide paths harness these principles by design, using those regular contributions to pursue a meaningful allocation to equities for the majority of a participant’s working life, eventually tapering off to balance risk/return potential as retirement approaches. We believe this approach makes them an ideal investment option for participants saving for retirement. 

Surviving a crisis: lessons from history

In times of severe market volatility, it can seem as though the world is collapsing around us. It’s important to remember, however, that market drawdowns are a natural and fairly common market occurrence and can be a good thing for long-term investors making systematic contributions. History has shown us that a sharp market sell-off has typically been followed by a rebound of a similar—if not greater—magnitude that unfolds over the following years, and the volatility of investment returns typically normalizes over time. In our view, the bear market that typically follows a recession can therefore be viewed as an opportunity for long-term investors, as shares suddenly become available at  reduced prices.

Furthermore, the majority of bear markets correct themselves reasonably quickly when viewed through the eyes of a long-term investor (particularly when you compare the length of a typical bear market to the length of a typical bull market). If we look at the bear markets that have occurred over the last 50 years or so, we can see that all but two recovered within two years, while the longest recovery took just over five years.

As long as participants continue contributing to their 401(k)s prior to retirement, their cash contributions has the potential to go further in the market, thereby enhancing their overall savings. 

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The impact of drawdowns at different stages of the glide path

While drawdowns can be seen as beneficial for the majority of target-date fund investors, their impact can differ depending on what stage of the glide path investors finds themselves.

For investors still in the accumulation stage and some years away from retirement, drawdowns tend to result in a better overall outcome. In fact, the deeper and longer the drawdown, the better off they’re likely to be in retirement, assuming the market eventually bounces back to pre-drawdown levels (and as illustrated earlier, bear markets have rarely lasted for more than a few years). Provided the glide path maintains a reasonable equity balance and equity exposure isn’t significantly reduced during that period, investors should ultimately benefit.

For those in the de-risking phase of the glide path, the outcome is likely to be similar. This may sound surprising, but the fact is, even if the market falls while the glide path is reducing its equity allocation, that reduction doesn’t occur fast enough to make a significant impact. It’s worth noting that during some of the biggest drawdowns that markets have experienced, when equity returns were significantly down relative to fixed income, it’s been necessary to add to equity allocations in order to keep the target-date portfolio balanced and in line with the declining glide path. 

Managing drawdowns near retirement

A market downturn that occurs while a participant is on the cusp of or already in retirement is naturally a bigger concern. With contributions no longer being made to the plan and a shorter investment horizon in which to make up returns, a drawdown at the end of the glide path is a significant risk to retirement wealth. This can be compounded by the psychological impact of a drawdown so close to retirement.

Fear can drive an investor to sell out of the market at the worst possible time, thereby locking in losses. Target-date funds can help manage these risks through the design of the glide path, which transitions to a more conservative equity allocation before and during retirement. This is where we believe a through retirement approach, which remains invested beyond the anticipated retirement date, can offer meaningful benefits. 

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Creating greater potential for growth

Although glide paths can vary from one provider to the next, most begin to rapidly de-risk when participants are in their late 30s or early 40s, rebalancing the portfolio by reducing equity exposure in favor of bonds. The rationale sounds reasonable: A steady move away from growth assets could, in theory, help shield the portfolio from sudden market turbulence as retirement inches closer.

We believe de-risking so quickly from such an early age is both unnecessarily conservative and potentially detrimental to participants’ ability to achieve their retirement goals. At age 40, the average target-date fund participant will have another 25 working years in which to make contributions. Furthermore, as our demographic data shows, most participants will have been contributing to their fund for just 15 years by the time they reach 40—at a time when their salaries are at their lowest; conversely, the years between 40 and 65 are generally when an employee’s earning power is at its peak.¹

We think the benefits of seeking greater growth potential, particularly in the preretirement phase of a glide path are clear, regardless of market conditions. To begin reducing equity exposure just as participants are in the best position to make larger contributions to their retirement fund is, in our view, a missed opportunity.

Embracing volatility: taking the long-term view

When markets are volatile, it’s all too easy to panic and head for the exits, but as the old saying goes: It’s time in the market, not timing the market, that matters. We believe long-term investors should embrace volatility and see it as an opportunity rather than a catastrophe. We’ve seen that the majority of previous bear markets corrected themselves within two years, so current or future downturns may not be of consequence to long-term investors.  

Furthermore, investors who maintain regular contributions to their pension plan can reap the benefits of lower market values, with stocks suddenly available at significantly reduced prices. When we combine the opportunities presented by market downturns with the longer investment horizon of a through retirement glide path and spending habits of retirees, we believe that the majority of target-date retirement plan investors have little to fear from market corrections.

 

1. Based on average participant behavior, Manulife Investment Management, as of May 31, 2020.

This article was extracted from a John Hancock Investment Management white paper: Embracing drawdowns in target date funds. To download the paper in full, click here.