As risk becomes more relevant to fund members as they enter retirement, new approaches to investment are being assessed. Broadly speaking, they fall into one of three categories: • Administration strategies • Derivative strategies • Insurance/outsourcing Administration strategies Administration strategies rely on dynamically altering the underlying investment mix to achieve a smoother return or risk-management outcome. Three approaches that appear to be growing in popularity are targetdate funds, target-volatility funds, and continuous portfolio protection insurance (CPPI). Target-date funds: This strategy rebalances investors’ assets between different mixes of conservative and growth assets based on an age-based “glide path,” traditionally focused on the investor’s planned retirement age. The principle behind target-date funds (also known as life-cycle funds, targetmaturity funds, and age-based retirement funds) is that investors need to adopt more conservative investment styles as they approach retirement. Target-date funds, however, have become the subject of much criticism.
Debate has centred on the grounds that there is no “one-formula-fits-all” solution to the needs of investors with widely varying needs, lifestyles, and levels of risk tolerance. Also, absent risk-management techniques and market volatility can defeat even the most carefully planned glide path. Target-volatility funds: Like target-date funds, target-volatility or controlled-risk funds attempt to manage investor risk through rebalancing, but instead of focusing on an investor’s age, the rebalancing is based on market volatility. The funds are designed to increase allocations to conservative assets in times of high volatility, and growth assets in times of low volatility. Target-volatility funds are relatively new entrants into the market, and time will tell how well they perform. Continuous portfolio protection insurance: CPPI has been around for some time in various forms.
In general, CPPI rebalances investors’ assets between bonds and growth assets based on an algorithm designed to replicate an option. The goal is to preserve capital, and CPPI may be combined with options provided by an investment bank to offer a guaranteed solution. CPPI, however, has suffered because of negative publicity focusing on investors getting locked into cash who were unable to participate when markets rebounded. The next generation of CPPI is on the way, but given the level of administrative complexity involved, it remains to be seen whether this technique will be popular. Derivative strategies Derivative strategies rely on the use of assets that directly facilitate risk management. Institutions have used derivatives to hedge risk for hundreds of years. Derivative strategies can work by creating exposure and by managing risk. Creating exposure: Some strategies utilise derivatives to provide market exposure while combining them with conservative assets to provide security—for example, a bond combined with a call option.