Helping DC plan participants keep their balance

Over time, a well-crafted asset allocation plan may only be as good as the portfolio rebalancing mechanism behind it. Director of Defined Contribution Strategies Jed Petty and Multi-Asset Strategist Cara Lafond look at several options to help DC plan participants put a disciplined rebalancing policy in place.

Views expressed are those of each author and are subject to change. Forward-looking statements and opinions should not be considered as guarantees or predictions of future events. Other teams may hold different views and make different investment decisions. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional or institutional investors only.

For most defined contribution (DC) plan participants, strategic asset allocation is a cornerstone of a successful, long-term retirement strategy. But over time, a well-crafted asset allocation plan may only be as good as the portfolio rebalancing policy behind it.

Consider the experience of seasoned investors who weathered the tech stock debacle at the turn of the century, followed by 9/11, the global financial crisis, and the COVID-19 pandemic. Without a rebalancing policy at work, market shocks like these can quickly cause portfolio allocations to drift far from their intended target ranges. Outsized market rallies can have the same unwanted effect.

Importantly, systematic rebalancing can help keep portfolio allocations on track in the face of the market’s inevitable ups and downs. As long-term investors, DC plan participants in particular should ensure they have a mechanism in place to rebalance periodically and in a disciplined fashion.

Three rebalancing strategies1

Participants can often “set it and forget it” to remove their emotions from the process. For example, target-date funds (TDFs) have built-in portfolio rebalancing, but these vehicles aren’t for everyone. Plan recordkeepers may also offer automatic rebalancing services, but on a time schedule that participants might find too frequent (or infrequent).

Tip for plan sponsors with TDFs

As part of their normal due diligence, we suggest that plan sponsors examine and evaluate the TDF’s rebalancing policy. First and foremost: Is it the best approach for plan participants?

For greater flexibility and customization, some participants may choose to devise and actively manage the rebalancing process themselves. While doing so risks bringing the participant’s emotions into the equation, the right approach can help minimize that human factor. Here are three “do-it-yourself” rebalancing strategies that we have examined:

  1. Calendar-based rebalancing resets allocations to the strategic targets on a fixed schedule, regardless of interim market movements. The investor determines the frequency of rebalancing (e.g., monthly, quarterly, annually). The main advantages of this approach are ease of implementation and risk control. However, the systematic nature of calendar-based rebalancing ignores the size of the deviation from the target allocation and may trade more frequently (with potentially greater transaction costs) than other strategies evaluated.
  2. Symmetric-range rebalancing establishes equal boundaries on each side of the strategic asset allocation target. For example, we used a 5% rebalancing range on a hypothetical 60% stock/40% bond portfolio — if the equity allocation rises above 65% or falls below 55%, the portfolio is rebalanced to the 60%/40% mix. This may provide a reasonable balance between risk control and cost minimization. Wider ranges require larger relative market moves to trigger rebalancing and may result in significantly fewer transactions than calendar-based methods.
  3. Asymmetric-range rebalancing allows the equity allocation to drift higher on the upside than on the downside. For example, in our analysis, we allow stocks to drift up by 7% but down by only 3% before rebalancing is triggered. This method may be intuitively appealing given that bull markets are typically longer in duration than bear markets. However, asymmetric approaches may struggle during prolonged or severe drawdowns. Like symmetric-range rebalancing, the asymmetric variety may result in fewer transactions (and, therefore, lower costs) than calendar-based methods.

How the strategies stacked up

Figure 1 shows the hypothetical results of the three rebalancing strategies, as well as “drifting” (i.e., not rebalancing at all), for the full time period in our analysis. We would highlight the following observations, which also held when we looked at discrete decades and rolling five-year periods:

  • Rebalancing improved risk-adjusted returns compared with drifting. There was no significant difference in risk-adjusted returns across the various rebalancing strategies.
  • Annual rebalancing had a slight edge in terms of the maximum drawdown as a result of fortuitous timing during the global financial crisis. Annual rebalancing allowed for the lowest equity allocation amid the late-2008 sell-off. The strategy then caught the market’s upturn by rebalancing at year-end.
  • While drifting outperformed the rebalancing strategies from an annualized return perspective, it came with significant deviations from target portfolio allocations and, thus, greater volatility and drawdowns. Investors without a rebalancing policy should consider their ability to ride out such volatility without succumbing to an “ad-hoc” decision to reduce risk at the worst possible time.

FIGURE 1

Long-term back-tested performance comparison

Based on these results, we believe plan participants with broadly diversified stock and bond portfolios (and reasonable expectations regarding return/volatility patterns) should consider symmetric- or asymmetric-range rebalancing.

Bottom-line takeaways

  • As a general rule, we would advise plan participants against drifting due to the inherent — and often considerable —– risks involved.
  • In contrast to drifting, all of the systematic rebalancing strategies we examined displayed a propensity to reduce uncompensated portfolio volatility.
  • The right rebalancing policy for each investor is not “one-size-fits-all” and is likely to vary by risk tolerance, along with sensitivity to transaction costs and complexity.
  • The rebalancing strategies that have proven most effective historically tend to be highly disciplined about buying low/selling high and maintaining an appropriate risk profile.
  • Using a symmetric- or asymmetric-range strategy applied over a given calendar period may best capture the desired balance between transaction costs, complexity, and policy discipline.

1Our research assumed a 60% equity/40% fixed income target asset allocation. As the evaluation of rebalancing strategies requires dealing with the time-period dependency of the results, we performed our analysis on a hypothetical portfolio over the entire 1960 – 2019 period, encompassing multiple market environments, as well as rolling periods and discrete decades. We examined risk-adjusted returns across all periods given that symmetric and asymmetric strategies tend to hold more equity exposure on average.

This commentary is provided for informational purposes only and should not be viewed as a current or past recommendation and is not intended to constitute investment advice or an offer to sell or the solicitation of an offer to purchase shares or other securities. Wellington assumes no duty to update any information in this material in the event that such information changes.

Please see the important disclosure page  for more information.

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