Behavior-driven glide path design

Transcription

1 June 2018 Behavior-driven glide pah design Posiioning invesors for greaer self-funded reiremen success For insiuional use only

2 Execuive summary The glide pah for Charles Schwab Invesmen Managemen s (CSIM s) arge dae funds draws from a pragmaic behaviorally driven asse allocaion approach based on exensive research and real-world experience working wih reiremen invesors hrough muliple marke cycles. By focusing on how hese individuals end o selec heir asse allocaions and respond o risk, our arge dae funds seek o enhance he invesmen experience of everyday working people across all aspecs of sraegy delivery, from glide pah developmen o porfolio implemenaion. Our goal is o help invesors secure a successful reiremen by supporing lifelong wealh accumulaion wihou unduly placing savings a risk. To achieve his oucome, CSIM s glide pah design is based on a framework ha carefully quanifies he level of risk invesors can olerae and benefi from as hey coninually move closer o and hrough reiremen. We srive o holisically manage he noable, iner-conneced risks ha invesors may encouner across a lifeime of invesing, being mindful of volailiy and downside risk conrols so ha invesors coninue conribuions, even in difficul marke climaes Key akeaways CSIM s glide pah is buil using comprehensive behavioral and quaniaive analysis. The glide pah design evaluaes risks holisically using our proprieary risk proxy mehodology. Diverse inpus and sress ess help our glide pah address behavioral endencies, invesmen risks, and wihdrawal susainabiliy. Our glide pah is coninually evaluaed and sraegically evolves o help invesors achieve reiremen success. For insiuional use only Behavior-driven glide pah design 2

3 Inroducion This paper provides an overview of he research and pragmaic hinking behind CSIM s arge dae funds glide pah and how i is designed o lead o sronger invesor oucomes. Our glide pah design, depiced in Exhibi 1 below, follows a sric invesors-firs philosophy, boh in erms of addressing he greaes hreas o reiremen securiy as well as aligning our asse allocaion sraegy o he evoluion of invesor risks. This draws from exensive muli-asse managemen experience and in-deph knowledge of he behaviors ha drive invesors savings and spending in reiremen. We believe ha a arge dae fund s glide pah should: Seek a balance beween upside poenial and managing risk a every sage in he invesmen lifecycle up o and hrough reiremen Implemen a risk reducion mehodology ha seeks o limi he possibiliy an invesor oulives asses (i.e., longeviy risk) Be delivered hrough a sysemaic, objecive, and ransparen invesmen process A is core, our glide pah developmen is fundamenally abou idenifying he mos efficien allocaion of risk a various life phases based on he level and ype of risk he ypical invesor is capable of aking on in each phase. The mehodical expression of his in a arge dae fund sraegy can help place invesors on a safer reiremen savings pah across a lifeime of invesing. 100% n 95% n 5% n 40% n 60% n 25% n 75% Iniializaion Accumulaion Transiion Reiremen Exhibi 1: Glide pah design CSIM s glide pah srives o deliver successful reiremens wih appropriae risk exposures hroughou invesors lifeimes. % Equiy 80% 60% 40% Equiy Fixed Income and Cash/Cash Equivalens 20% 0% Years before Years afer Targe dae For insiuional use only Behavior-driven glide pah design 3

4 Process overview The fundamenal goal behind our arge dae fund design is o help invesors maximize asse accumulaion wihou unduly placing savings a risk, in order o secure a safe, susainable income source in reiremen. To build a porfolio ha srives o achieve his oucome, we developed our glide pah uilizing invesmen and behavioral research and our own experience in working wih a wide range of reiremen invesors. This process is highlighed below in Exhibi 2 and discussed in greaer deail in he pages ha follow. Key iniial inpus Firs, we will discuss he key iniial inpus ino our glide pah design, which apply our research abou reiremen savers and long-erm invesmen views. Savings profile/demographic inpus Our process sars wih wha we know abou invesors based on heir real-world behaviors. For example, he daa from numerous reiremen plan paricipans served by Schwab s 401(k) recordkeeping plaform combined wih Bureau of Labor saisics and Employee Benefi Research Insiue daa enable us o beer undersand he saving paerns, behavioral biases, and anicipaed reiremen needs for a wide range of invesors. For base-case modeling scenarios, we have synhesized his informaion o idenify a ypical invesor savings profile, assuming conservaive salary deferrals and employer mach amouns o anicipae realisic accumulaion poenial and wihdrawal needs (see an example of his in Exhibi 3). Exhibi 3: Savings profile Base-case invesor savings profile (nominal) Age range Deferral rae 4% 5% 6% 7% Employer mach 2% 2.5% 3% 3.5% Annual salary increase 4% 4% 3% 2% We derive several core expecaions from our research of his daa. A sample scenario follows: Invesors end o be reasonably consisen savers for 40 years and hen spenders for 20+ years. Deferrals begin a 4% of salary per year for he younges invesors bu seadily increase as salary, enure, and age increase unil a final deferral rae of 7% is reached o conservaively esimae reiremen balances; employer mach Exhibi 2: From research o implemenaion a comprehensive approach o glide pah design 1. Iniial inpus 2. Theoreical glide pah 3. Real-world 4. Final delivery refinemen Invesor characerisics Invesor demographics Invesmen sages Behavioral research Invesmen consideraions Capial marke expecaions Invesmen risks Behavioral risk profiles Toal capial (human+financial) Value-a-risk Risk proxy Quaniaive/ qualiaive adjusmens Glide pah For insiuional use only Behavior-driven glide pah design 4

5 conribuions are considered a componen of invesors reiremen savings, wih base-case assumpion of 50% employee deferral mach. Typical reiremen age is 65, and approximae life expecancy is 85 (20 years pos arge reiremen, which corresponds o he lowes equiy policy weigh in our glide pah). Average invesor salary and deferral projecions help analyze risk/reurn impac across he glide pah, wih sress es scenarios creaed o es losses under difficul marke condiions; however, invesors individual scenarios will vary based on unique circumsances. Invesmen phases Our research has idenified four main invesmen phases: Iniializaion (ages 21-30), Accumulaion (ages 30-55), Transiion (ages 55-65), and Reiremen (age 66+). Each phase presens disinc risks based on changing invesor characerisics, such as age, remaining working years, salary expecaions, savings raes, downside risk olerance, and need for wihdrawals (see Exhibi 4). The poenially derimenal behaviors we end o see in invesor savings paerns in hese segmens will be unsurprising o anyone involved wih reiremen invesing. Many invesors are simply no saving enough, especially in heir younger Iniializaion and prime Accumulaion years. Behavioral research also shows ha invesors may chase reurns, buying and selling a precisely he wrong ime. This can be paricularly evidenced in reacion o seep marke declines, given ha pain of loss has consisenly been shown o be much greaer han he happiness derived from an equal level of gain. While glide pah design alone canno conrol invesor usage, i can help suppor posiive behaviors. For example, higher allocaions o risk asses early in he glide pah may help compensae for savings deficis by maximizing he poenial of long-erm gains and invesmen compounding. However, he larger akeaway, in our view, is he imporance of volailiy conrols and reducing he risk of ousized losses in order o keep savers invesed and avoid fear-based selling. This becomes increasingly crucial as he glide pah progresses and he ime o recover from loss becomes shorer. For a real-world example, consider he Transiion sage invesors enering he 2008 financial crisis wih equiy-heavy porfolios who may have had o delay reiring o help recover invesmen losses before saring o make wihdrawals or worse who sold in reacion o noable losses and were never able o recoup heir original balances due o missing he subsequen marke rebound. Our glide pah seeks o reduce hese ill-imed dramaic losses by properly allocaing risks wih he remaining ime horizons of our invesors. Exhibi 4: Invesmen phases Invesors' primary life sages and key consideraions hroughou he invesmen horizon. Iniializaion Accumulaion Transiion Reiremen Age range Characerisics Many working years ahead Low salary Deferrals sar a approximaely age 25 Highes human capial Lowes financial capial Increasing salary Prime earning years High human capial Increasing financial capial Preparing for reiremen Rapidly falling human capial Peak financial capial No addiional income Wihdrawals begin Major Risks Low deferral rae Too lile marke exposure No accumulaing enough wealh Disruped savings sraegy Large marke losses Loss of purchasing power Depleing asses For illusraive purposes only. For insiuional use only Behavior-driven glide pah design 5

6 Capial marke expecaions Anoher key inpu o modeling a successful glide pah sraegy is a robus se of long-erm capial marke expecaions. In order o undersand he possible marke scenarios ha invesors may experience as hey save for and spend in reiremen, Charles Schwab Invesmen Managemen develops long-erm reurn, volailiy, and correlaion expecaions for each asse class. Our process uilizes boh qualiaive and quaniaive research leveraging inernal and exernal insighs o creae hese expecaions for a long-erm horizon of a leas 10-years. We formally review our capial marke expecaions on an annual basis o ensure ha our expecaions remain responsive o evolving marke condiions. As our reurn and volailiy expecaions change over ime, we regularly rees our glide pah and underlying asse allocaion o ensure our srucure suppors long-erm accumulaion and wihdrawal needs. Developing he risk proxy he heoreical glide pah To help beer undersand he role of risk in glide pah design, our research applies hese key iniial inpus o develop a measure for invesor risk olerance. We call his proprieary meric he risk proxy. We use he risk proxy o firmly base our glide pah consrucion on a realisic foundaion of appropriae invesmen risk levels a differen ages and invesmen phases, drawing from a deailed analysis of projeced capial accumulaions, required reiremen funding levels and a pruden undersanding around how invesors are likely o experience and reac o marke volailiy. Quanifying risk in glide pah design: Financial and human capial The premise behind he risk proxy is sraighforward. The value an invesor places a risk a any poin in he glide pah draws from wo ypes of capial. Financial capial measures he presen value of exising accrued savings balances. Human capial measures he presen value of fuure income and, by exension, fuure conribuions. A is mos basic level, he risk proxy implies ha younger invesors beginning heir careers ypically have limied savings, which ranslaes ino low financial capial. This suggess ha he real dollar impac from marke volailiy is insignifican relaive o fuure savings and liabiliy concerns. As such, low financial capial indicaes a higher risk olerance, all hings being equal. Conversely, when invesors are young, human capial is significan, given expecaions for a large number of working years ahead, years ha can help offse marke volailiy and ime o earn and increase income and conribuions. When human capial is high, i is furher indicaive of a higher risk olerance, all else being equal. As invesors age, hey generally have greaer financial capial, placing a progressively higher accoun value a risk as hey accumulae more. In addiion, heir human capial fades over ime, bu remains imporan as invesor conribuions grow. Toal capial combines financial capial and human capial o represen he oal value a ypical invesor is placing a risk a various invesmen sages (see Exhibi 5). Exhibi 5: Measuring value a risk Evaluaing invesors sources of wealh, and recognizing heir value a risk hroughou he glide pah. Value of invesor capial Iniializaion Accumulaion Transiion Reiremen Years before Years afer Targe dae Human capial + Presen value of fuure income Financial capial Accumulaed wealh = Toal capial For illusraive purposes only. For insiuional use only Behavior-driven glide pah design 6

7 Once oal capial is defined, we use i o quanify invesors risk olerance as a proxy for marke risk ha is appropriae a various invesmen sages. We projec he annual wihdrawal invesors can ake in reiremen under various scenarios o adequaely mee heir funding needs. In his sep, as an added layer of cauion, we do no assume Social Securiy or oher pos-reiremen income sources. Thus, a simplified version of he risk proxy is represened by he equaion below: Human capial + Presen value of wihdrawals Toal capial + Presen value of wihdrawals Noe, however, ha he proprieary risk proxy meric is a funcion of many more variables. 1 The resuling raio calculaes a value beween 0% and 100% wih a higher value equaing o a higher assumed poenial marke risk olerance, and vice versa. We hen apply his o every age, offering a numerical expression of invesor risk olerance across he glide pah, covering an overall ime horizon of a leas 40 years of saving and 20 years of pos-reiremen wihdrawals (see Exhibi 6 below). Translaing he risk proxy ino acual equiy exposure As explained, he risk proxy offers general guidance on deermining a pruden glide pah slope he change in equiy exposure over ime. However, he risk proxy calculaion is no inended o be used in isolaion. Any single meric, our risk proxy included, canno enirely reflec all risks ha mus be accouned for in glide pah design. Thus, relying on a purely quaniaive analysis does no compleely explain he risk aversion and oher emoional and cogniive biases of invesors. Accordingly, we make furher adjusmens o accoun for behavioral biases, ensure diversificaion, reduce overall volailiy and proec agains dramaic downside risk. Specifically, our design akes ino accoun poenial invesor behavior and reacions o marke volailiy. For example, he design assumes ha invesors may be more prone o sell afer pronounced marke correcions. As a resul, he glide pah inends o reduce maximum poenial drawdown and limi he risk of invesors selling a inappropriae imes, increasing he probabiliy of savers remaining invesed and coninuing o conribue o help achieve susainable wihdrawal raes in reiremen. 100% 80% Iniializaion Accumulaion Transiion Reiremen Exhibi 6: Glide pah equiy allocaion Our model glide pah assumpions closely mach many employee populaions. 60% 40% 20% CSIM's Glide pah equiy exposure Risk proxy 0% Years before Targe dae Years afer For insiuional use only Behavior-driven glide pah design 7

8 Considering his holisic approach, we adjus our final equiy marke exposure o be slighly more conservaive han he purely quaniaive risk proxy would sugges, alhough we sill mainain he shape and slope implied by he modeling. Invesmen risks In addiion o behavioral risks and our invesor focused approach, here are a number of specific invesmen risks ha we acknowledge and address hroughou our glide pah, each of which are incorporaed ino he overall design of our arge dae funds (see Exhibis 7 and 8). The naure and magniude of hese invesmen risks inherenly evolve as invesors age, moving coninually closer and evenually pas heir reiremen daes. They can also change across marke and economic cycles. Asse allocaion remains he mos useful way o help miigae hese risks, alhough he inerconneced naure of muli-asse invesing means ha hey canno all be fully eliminaed simulaneously. Indeed, decreasing one risk may acually increase anoher. For example, reducing marke and ail risk early in he glide pah migh increase longeviy risk laer in reiremen. Hence, we believe hese invesmen risks mus be viewed holisically o prudenly balance he ypes of risk ha invesors are vulnerable o a any given life sage. Sub-asse class diversificaion Wih broad equiy/fixed income exposures se, we nex begin o use sub-asse classes o furher diversify each of hese allocaions. Our glide pah invess in a wide specrum of asse classes drawn from long-erm, sraegic allocaion decisions, wih each segmen inended o enhance he risk/ reurn profile hroughou he glide pah. Some of he major characerisics we consider are long-erm risk/reurn expecaions, abiliy o fundamenally esimae long-erm resuls from inclusion, diversificaion benefis, availabiliy of implemenable sraegies, liquidiy, specific marke segmen exposure, cos, downside risk and appropriaeness for each invesmen phase. Sub-asse class weighings are no held consan, as we believe ha risk exposures should change boh a he sock and bond level and wihin hose allocaions as well. Consequenly, boh mixes become more conservaive over ime, inending o beer mach he invesors changing risk olerances and liquidiy needs. For example, overall equiy allocaions may be biased oward U.S. large cap securiies and generally reduce exposures o hisorically more volaile segmens, such as emerging marke, inernaional and small cap equiies, as he glide pah moves oward reiremen. Exhibi 7: Addressing risk How CSIM's glide pah addresses risk hroughou he invesmen horizon. Iniializaion Accumulaion Transiion Reiremen Age range CSIM s Glide pah Maximize equiy exposure o suppor long-erm growh Mainain broad marke exposure o suppor accumulaion Sysemaically reduce marke risk exposure a an increasing rae over ime Accelerae shif o more conservaive asses o proec accumulaed wealh and prepare for reiremen Conservaive marke exposure a reiremen year and beyond Coninue risk reducion for 20 years For insiuional use only Behavior-driven glide pah design 8

9 Exhibi 8 Invesmen risks addressed by CSIM's glide pah Challenges Marke risk Exposure o invesmens wih higher volailiy and risk of large downside marke moves Can include exposures o various counries and currencies Our approach Maximum marke exposure for invesors wih longes ime horizon Less equiy for invesors near and in reiremen. Reduce allocaions o more volaile sub-asse classes and acive sraegies as glide pah progresses Mainain broad diversificaion o a wide range of sub-asse classes Larger inernaional exposure early in glide pah, increased domesic bias near and in reiremen Longeviy risk The risk of invesors ouliving asses Higher level of marke exposure early in glide pah o suppor savings growh Coninue o manage exposures for invesors hroughou heir lifespan Moderae/conservaive equiy allocaions a reiremen and coninue o roll down beyond he reiremen year o mach risk olerance and help offse drawdown needs Mainain equiy exposures well ino reiremen despie a declining risk proxy, o acknowledge changing moraliy raes as invesors age Manage overall volailiy o reduce chance of behavioral reacion o marke downurns Ongoing sress ess for age of zero balance under various wihdrawal scenarios Sequence risk The risk of a arge funds selling volaile asses during a down marke as par of he glide pah rolldown Maximum annual roll down is less han 4% in any year Equiy roll down slope is flaer afer arge dae Volaile asse classes and sub-asse classes are sysemaically reduced each year Cash allocaion provides source of liquidiy, reducing need o immediaely liquidae more volaile asse classes Mainain broad diversificaion hroughou glide pah Porfolio managers use of cash flow during imes of marke sress Inflaion risk The risk of declining purchasing power Mainain allocaions o equiy and oher asses classes ha have sensiiviy o various sources of inflaion hroughou glide pah, including managing exposures beyond he reiremen year Inclusion of sub-asse classes ha may proec agains differen ypes of inflaion (TIPS, REITS, ec.) Inroducion of dedicaed TIPS exposure as he glide pah nears reiremen Tail risk The risk of crisis-level losses Mainain broad diversificaion o a wide range of sub-asse classes Reduce allocaions o more volaile sub-asse classes and acive sraegies as glide pah progresses Mainain a more conservaive allocaion near and a reiremen Ineres rae risk The risk ha fixed income asses migh lose value when ineres raes rise Mainain diversified allocaions hroughou reiremen, balancing fixed income and equiy exposures o miigae any specific asse class risk Increase allocaions o lower duraion asse classes such as shor erm bond and cash as glide pah nears and eners reiremen For insiuional use only Behavior-driven glide pah design 9

10 Poenial oucomes and sress esing across he glide pah We pu our glide pah o he es by esimaing poenial accoun balances, risks, and downside exposure in various phases using differen saving profiles and capial marke expecaions, as noed earlier. This allows us o beer idenify poenial oucomes under various sress es scenarios for invesors over ime. Our expeced risk/reward improves over ime as we ransiion he glide pah oward proecion laer in life, relaive o our earlier focus on wealh accumulaion. Addiionally, noe ha he impac of poenial marke losses is far greaer as invesors near reiremen, furher supporing our focus on downside proecion in laer phases, relaive o he less significan impac of poenial marke loss for a younger invesor. Examples of his oupu are illusraed in Exhibis 9 and 11. In our sress ess, CSIM s glide pah provides increasing proecion as invesors progress o and hroughou heir reiremen years. Addiionally, we esimae our glide pah s abiliy o provide susainable levels of reiremen wihdrawals for invesors. Exhibi 10 illusraes how long he accoun migh be expeced o suppor various annual wihdrawal raes for he ypical invesor s experience. A 5% wihdrawal may provide over 20 years of wihdrawals in reiremen. A higher 6% wihdrawal migh exhaus asses a approximaely 20 years, and a more modes wihdrawal rae of 4% may exend wihdrawals well beyond 30 years. Exhibi 10: Hypoheical wihdrawal scenarios We analyze several differen scenarios, and inend o provide for various invesor wihdrawal needs well ino reiremen. Reiremen asses Targe allocaion 95 40% Equiy Age 65 Final allocaion 25% Equiy Age Years afer Targe dae 6% Wihdrawal Reiremen 5% Wihdrawal 4% Wihdrawal Exhibi 9: Reduced downside risk as invesors age 2 0% Iniializaion Accumulaion Transiion Reiremen -5% Downside risk -10% -15% -20% -25% -30% Age For illusraive purposes only. For insiuional use only Behavior-driven glide pah design 10

11 Exhibi 11: Accouning for he four invesmen phases An example of he invesor experience hroughou CSIM's glide pah Age Average balance wih 5% real annual wihdrawals saring a age 65 Average poenial dollar impac of 10% loss Average expeced reurn Average expeced risk Average expeced Sharpe raio Iniializaion % 16.5% $6,610 ($660) 6.5% 16.3% 0.40 Summary $3,700 ($370) 6.5% 16.4% 0.40 Early savers have minimal impac from marke losses, and our glide pah maximizes growh poenial $22,240 ($2,220) 6.4% 15.8% $47,850 ($4,790) 6.3% 15.3% 0.41 Accumulaion $88,650 ($8,870) 6.0% 14.5% $149,170 ($14,920) 5.7% 13.3% $235,550 ($23,560) 5.4% 12.0% 0.45 Summary $108,690 ($10,870) 6.0% 14.2% 0.42 As savings accumulae, our glide pah balances growh wih reduced volailiy over ime. Transiion $351,650 ($35,160) 4.9% 10.5% $517,020 ($51,700) 4.3% 8.3% 0.52 Summary $441,850 ($44,190) 4.6% 9.3% 0.50 Nearing reiremen, we focus on proecing invesors' nes eggs, as he impac from losses could be significan $575,140 ($57,510) 4.0% 7.0% 0.56 Reiremen $514,440 ($51,440) 3.9% 6.7% $423,690 ($42,370) 3.7% 6.2% $295,960 ($29,600) 3.5% 5.5% 0.64 Summary $452,310 ($45,230) 3.7% 6.3% 0.60 For illusraive purposes only. Our glide pah emphasizes sabiliy over growh, while helping invesors susain a successful reiremen. For insiuional use only Behavior-driven glide pah design 11

12 Conclusion CSIM s glide pah has been buil wih he reiremen needs of real invesors in mind, using a behavioral approach o asse allocaion and a hisory of demonsraed experience hrough muliple marke cycles. In his paper, we have highlighed he exensive research, pracical insighs, and key porfolio inpus ha have gone ino building and monioring our glide pah design, including: A deep undersanding of invesors and heir behavioral biases A pragmaic allocaion sraegy ha seeks o holisically balance a full range of invesmen risks ha migh be experienced across a lifeime of invesing A sraegic framework accouning for invesors changing wealh accumulaion, and projeced savings and risk olerances hroughou heir lifespans A glide pah slope aligned wih invesors broad risk capaciy, uilizing a proprieary measure called he risk proxy Tigh conrols around relaive volailiy and downside exposure o help increase he probabiliy ha savers remain invesed and making conribuions even in periods of marke sress This inense focus on enhancing he reiremen invesmen experience of everyday working people carries hrough o all aspecs of our arge dae fund porfolio managemen, from real-world glide pah developmen o innovaive porfolio consrucion. We believe our emphasis on maximizing reiremen oucome poenial can help posiion a greaer number of invesors o achieve suiable wihdrawal levels ha are susainable across reiremen. Charles Schwab Invesmen Managemen As one of he naion s larges asse managers, our goal is o provide invesors wih a diverse selecion of foundaional producs ha aim o deliver consisen performance a a compeiive cos. 1 The CSIM definiion of a risk proxy is a funcion of many variables, such as human capial, financial capial, wihdrawals, discoun rae, value-a-risk, longeviy, risk aversion, age, expeced reurn, and volailiy. 2 Represens he average annual expeced reurn in negaive wo sandard deviaion even by age range. All chars, ables, and relaed daa were generaed by CSIM. The opinions expressed are no inended o serve as invesmen advice, a recommendaion, offer, or soliciaion o buy or sell any securiies, or recommendaion regarding specific invesmen sraegies. Informaion and daa provided have been obained from sources deemed reliable, bu are no guaraneed. Charles Schwab Invesmen Managemen makes no represenaion abou he accuracy of he informaion conained herein, or is appropriaeness for any given siuaion. Charles Schwab Invesmen Managemen, Inc. (CSIM) is an affiliae of Charles Schwab & Co., Inc. (Schwab) and a subsidiary of The Charles Schwab Corporaion Charles Schwab Invesmen Managemen, Inc. All righs reserved. IAN (0618-8DFD) MKT (06/18) For more insighs, visi us a schwabfunds.com