Q: How Target Date Funds have evolved and why investors should consider these funds?

A lot of people set to retire are not ready and may not have taken all the necessary steps to plan for retirement. There are three factors that have impacted the evolution of target date funds. First, in the last seven years most corporations have transitioned from defined benefits retirement funds to 401(k) retirement funds where responsibilities for investment strategy and fund selection has shifted to individuals. Second, a number of studies have confirmed that most people do not have the time or the knowledge to make prudent decisions as to their retirement assets or how to manage money. The third point is related to demographics. As we go through the next ten years, we will see a significant portion of baby boomers facing retirement and the need for retirement income will continue to increase since a majority of them are not prepared for retirement and are trying to catch up very quickly. Asset managers created target date funds to respond to these three broad changes in the retirement industry.

Q: What core beliefs guide your target date retirement funds management?

The way we have established our investment philosophy over the last decade is that we believe balancing risks and returns throughout an investor’s entire lifespan could be achieved with the help of asset allocation. Our approach recognizes the different risks inherited in each part of the glide path. The asset allocation process provides an appropriate balance between upside potential and prudent downside protection at every stage in the investment lifecycle. Schwab’s rigorous risk management is what distinguishes our glide path and our approach to target date funds from most of the competition. We don’t just think of risk as volatility, we think of risk in a broader sense. We believe that a strong and rigorous risk management process throughout the glide path is important and necessary to help shareholders be better prepared for retirement. First, our investment philosophy is linked to risk management throughout the process, where risk is defined in a very broad sense of what areas of risk we actually should consider at each point in the glide path. Second, Schwab believes in providing solutions that are cost efficient. This is even more important in retirement assets given its compounding effect over time. And the third piece is the experience of our management team and the implementation of our investment process. We believe that, at the end of the day, the combination of a strong team, with an investment process that is systematic, diversified, transparent and objective will provide investors with consistent and repeatable results. The key is maintaining the integrity of the investment philosophy. Our experienced people, disciplined process and attractive pricing are three key components behind our target date funds.

Q: What is your investment process and how it is different from other target date funds?

Our investment approach is based on research and our implementation includes a combination of proprietary funds and sub-advisors as well as a healthy mix of passive and active management. First of all, Schwab was among the first providers of target date funds that offered open architecture. In this sense, our target date fund series contains a combination of Schwab’s proprietary strategies as well as third party sub-advised funds. Part of Schwab’s investment philosophy includes using proprietary funds in core investment strategies at a compelling value. In cases where we don’t have the capabilities in-house, we adopt an open architecture approach and partner with well-known sub-advisors. The second component of our investment process also includes a complementary mix of passive and active strategies. In other words, we believe in the value of using passive index funds for exposures in asset classes that are more efficient, as well as to lower the overall cost. A passive approach is adopted in asset classes that are more efficient and where we believe that there are fewer opportunities to add value. Similarly, we use active management in asset classes that are more inefficient and provide alpha opportunities. All of these components are blended through our research process. Our glide path is based on very specific research components that are part of our investment philosophy. We always start by thinking of risks. For instance, our research suggests that for people that are far away from retirement the biggest risk is the lack of savings and/or insufficient exposure to the market. So the risk associated with somebody that is just out of college or that is just starting to work on their career, is really more about making sure that they are saving money and they are investing in the market. That is a different type of risk than the people that are in the accumulation phase, which is most likely after the first years in the workforce. For the first five years of people’s careers, usually our philosophy is to try to maximize exposure to the market, as well as to try to emphasize the need for employers to educate their employees about savings. This is the first part of the glide path. The second part of the glide path, the accumulation phase, starts at the end of the first phase and ends ten years before retirement. In this phase, our goal is to maximize risk adjusted returns and hence our focus is to diversify the portfolio to make sure that there is enough exposure to different equity asset classes, international or domestic equities, as well as different types of fixed-income funds. In terms of the participants’ behavior, the biggest concern here is to maintain the results so that participants are still invested. Our biggest challenge that we have seen over time is that people without a good experience at the beginning of the year basically stop investing. This has been one of the main reasons why people don’t save enough for retirement. The next phase starts ten years before retirement, from ages 55 to 65. In that period, our objective is protecting capital. At this stage of the glide path, it is not about appreciating assets but more about preventing the potential of loss of capital because, at the end of this process, individuals have already gone through the process of accumulation. They have been exposed to the market, so the main concern associated with these pre-retirement arrangements is to make sure that they don’t exceed their risk tolerance. So the glide path becomes more conservative at this point; our glide path emphasizes higher use of index funds and more fixed-income rather than equities to ensure that we minimize the effect of a single catastrophic event that could potentially damage their capital. As we approach the target date, which is 65 for us, and then through the process of retirement after 65, the risk is generation of income that beats inflation. Thus, at this particular point along the glide path after the age of 65, we pay special attention to changes in interest rates, exposure to long duration assets in terms of the fixed-income portfolio and the potential inflation risks that may arise. At a high level, drawdowns, interest rates, duration and inflation are the biggest risks that will affect income in retirement. In summary and at a very high level, we break down the different parts of the glide path by type of risk that is inherited in the lifespan of the investor of our funds and, as I said, our goal is to help investors achieve their objectives.

Q: What is your asset allocation process and what role diversification plays?

We go beyond the traditional equities and fixed income allocation. We do have a definition of asset classes that is fairly granular. We break down the equities into a large cap and small cap, international developed and emerging equities, international small cap, and we also have commodities and real estate as part of what we call the risky assets. In terms of fixed income, we have short-term and long-term instruments and access to other diversified international fixed income managers. In our approach to diversification we believe that the more granular the glide path the better, without necessarily having to over-diversify. We have between 8 and 12 sub asset classes in our glide path that ranges from growth, value, core in domestic equities and further into international stocks and emerging markets, international small cap and to real estate. And, in terms of fixed-income, we have U.S. and international fixed income and short-term cash instruments as well.

Q: How and when does your allocation mix change?

At the early part of the glide path, we tend to be on the higher end of the risk allocation, and that includes equities and real estate. Our glide path starts with 95% in risky assets at the beginning of a person’s career. That tends to be slightly higher than the average in the universe, at least for the retail target date funds. The glide path shifts down as we move through the initial phase, accumulation phase and we turn risk averse, or at least take less risk than the peer groups, roughly by the time we reach ten years prior to retirement, which is where we start our pre-retirement phase, and at that particular point we end up with 45% in equity and 55% in fixed-income securities. At the point of retirement, at age 65, we arrive at 40% in equity and 60% in fixed-income. From there we continue to dial down in riskier assets. In general, we tend on average to be more aggressive at the beginning of the glide path and then our glide path becomes more defensive and more conservative towards its end.

Q: How is your glide path unique in the industry?

Technically speaking, our glide path continues through retirement but we don’t concern ourselves with the technical terms just because we’re in the industry. Clearly, if somebody looks at our glide path they will think this is a through retirement glide path. Our philosophy, however, takes matters beyond that. We think of glide path research to be more about how to minimize risk. I’ll give you an example. If you’re sitting at the point of retirement at age 65, 60% fixed income and 40% equity, even though the percentage of equities and fixed income may actually be similar across different products, the underlying components of what you have in that fixed-income allocation could be very different. We believe in reducing the exposure to active managers, reduce interest rate risks and increase the liquidity profile of the fixed income allocation. In general, for us, the biggest difference in our view is that as you reach and go past retirement you continue to manage risk accordingly. At that point what we believe is most critical is that we want to increase exposure to short duration funds; in other words, raise the liquidity, reduce the exposure to interest rates and protect yourself against inflation. Most people that go through retirement may think that just by having more fixed income they are going to be protected. What we have seen with our competitors is that they end up having potential exposure to long-term or higher duration funds, and tend to have more exposure to international fixed income that overexposes them to currencies and other things that may impact the potential performance even after retirement. The key piece of this analysis even within fixed-income, as I say, is to increase the amount of cash and the amount of short duration bond exposure and potentially the protection to inflation by having equities, real estate and commodities in the mix.

Q: How is your research team organized?

At Charles Schwab Investment Management, we manage about $250 billion. In terms of the target date fund series, we have over $10 billion under management between retail and institutional products. We have 11 people on my team that are dedicated to working on the target date fund series. This includes two people working on portfolio management and three people working just on research. As well, there are six people dedicated to sub-advisor oversight and one person, in my case, providing the oversight on the institutional side, bringing the total to 11 people.

Q: Please tell us more about your retail and institutional target date series?

We offer three types of target date fund series. Our institutional series holds the bulk of our assets. We have roughly $8 billion in the institutional target date fund series. Those are one hundred percent open architecture and through institutional mandates. The retail target date funds have $2 billion in assets and we manage 50% in-house through proprietary Schwab funds with the remaining managed by third-party or sub-advised relationships. We currently don’t use Exchange Traded Funds in our target date funds at all. They all go through either collective trust funds in the case of the institutional side or mutual funds in the case of our sub-advised or third party products.

Q: What metrics drive your research process?

As a part of our research process we have few inputs that go into the analysis and creation of our glide path. Every single firm has their capital market expectations and as such, we review them and discuss risks and returns for each one of the asset classes. In addition, Schwab includes investor behavior as one key component to our glide path. As I said before, one of the issues associated with investing for retirement is making sure that people stay invested. We have seen through our research process that we can provide more help to participants if we can relate to them in a way that is prudent, but at the same time evaluates their reaction and their sensitivity to changes in market volatility. Just to give you an example, after 2008 most people that were far from retirement recovered their risk appetite a few years after the market bottomed out. In other words, despite the fact that there was financial turmoil in 2008, their risk behavior normalized just a few years after the event. However, for people that were closer to retirement, particularly people that were 55 and older in 2008, they still have yet to recover their risk behavior run up in the equity market since then. That tells us clearly that investor behavior is not the same, regardless of where you are along the glide path so pay particular attention to those changes. Before 2008 I would say that there was less differentiation in terms of investor behavior – most people were behaving similarly, but market events affect people differently and our objective is to create solutions that encourage investors to stay invested in funds for their age. The other piece that’s important for us in our processes through retirement is managing longevity risk. That is, our glide path solutions aim to minimize the probability that people will run out of money before age 85 under generic assumptions. In summary, our research process incorporates a blend of capital market expectations and investor behavior with the ultimate objective being to manage longevity risk.

Q: How do you analyze glide path and when do you make changes in your glide path direction and break points?

Our philosophy is based on research; hence we perform numerous simulations, stress tests and sensitivity analyses. We are always looking for opportunities to enhance our investment approach. For me however, the best way to evaluate the results of our approach is to look at our historical track record. Over the last ten years, the market has gone through significant changes and we have maintained the same underlying philosophy, the same process, and have evolved our glide path to become more diversified and sophisticated. We have a ten-year track record in institutional funds and we have a five-year track record in our retail funds with top quartile performance. This is the best confirmation that our philosophy and approach are robust and consistent. We strongly believe in the evolution of investment process through the dynamics of the market. For example, last year we looked at what may happen knowing that interest rates will eventually go up in the next few years and how that will impact our fixed-income portfolios. So we did a great deal of stress testing, as well as back testing to consider what is going to happen to that part of the portfolio for the different parts of the glide path. As a result we reduced the amount of exposure to the long end of the curve and increased the liquidity profile of the portfolio in the part of the glide path that is close to retirement and/or in retirement. That’s the kind of analysis that we do in our research process to try to anticipate potential changes into the market going forward. Similarly, we evaluated how to minimize the effect of inflation. There is no real hedge for inflation that you can utilize to have zero risk to inflation. Our approach utilizes equities, commodities and global real estate exposure as ways to reduce inflation risk. In addition, we evaluate inflation risks relative to downside protection at the end of our glide path. So our glide path solution balances interest rates, inflation and volatility in an optimal way following our research process.

Q: In general what are your views on risk and how you manage it?

Our glide path is focused on rigorous risk management foundations. We create a solution that directly incorporates the evolution of human capital to financial capital through the lifespan of an investor. Therefore, the focus on risk will start at the beginning of the glide path to ensure there is enough exposure to the market to complement their savings rate. In the middle of the glide path, the goal is to minimize volatility while increasing accumulation or growth. In the pre-retirement component we are looking to reduce downside risks, making sure that we protect capital prior to retirement and in the post-retirement phase, we focus on managing inflation risk and interest rate risk while maximizing income. In thinking about Schwab, we look at risk holistically. The risk is not the same for everybody in the glide path; the risk is different depending on where you are in the glide path and, for us, embracing a rigorous risk management process is the best way to provide consistent solutions to our clients.