This article was originally published in Project M, an Allianz SE International Pensions publication featuring unique perspectives on investments and retirement.
Saving enough money for retirement is a struggle for employees across the globe. While demographics, cultures and investing behavior can vary widely from one country to the next, we all share a universal goal: to retire with dignity. And that means having sufficient income when we exit the workforce.
However, squirreling away that nut has gotten tougher over the years, particularly in the United States, as most companies have shifted toward a defined contribution model and away from defined benefits. Decisions on whether or not to participate in a retirement plan, how much of your wage to contribute to it and which investments to choose are now being left up to employees. Meanwhile, the US Social Security system is vastly underfunded. Fact is, more people are responsible for their own retirement than ever before – a challenge they may not be readily equipped to manage.
Fortunately, there are investments that can help ease this burden. One of the most important innovations in retirement planning over the last 20 years has been the target-date fund. Target-date funds’ professionally managed, all-in-one structure, instant diversification and regular rebalancing offer investors a simple way to invest for retirement without having to do the heavy lifting. They typically contain a mix of stocks, bonds and money-market instruments within a single investment that’s more aggressive when you’re younger and shifts to a more conservative allocation as you get closer to retirement.
The Glide Path
Target-date funds were designed to take the guesswork out of investing. Instead of scraping together an asset allocation on your own, money managers do the work for you. The only thing retirement savers would have to do is pick a date. For example, if you expect to retire in 2040, then you would select a 2040 target-date fund. Grouping investors by years to retirement, while not customized for the individual, is a powerful way to simplify retirement planning for the masses. Once you know someone’s time horizon, then portfolios can be built to adjust risk levels over time using what’s called a glide path.
Of course, investors should be aware that target-date fund expenses are generally higher than expenses for a fund that invests directly in individual stocks and bonds. As with other investment, diversification doesn’t assure a profit. And the principal value of a target-date fund isn’t guaranteed at any time, including the target date. Also, the target date included in the fund’s name doesn’t necessarily represent the exact year an investor will begin withdrawing assets – it’s intended only as a general guide.
Yet, proof of the funds’ popularity can be seen in how quickly they’ve been adopted. First launched in 1994, US target-date funds have since ballooned to $543 billion in assets (June 2013) and now make up 12% of 401(k) assets, according to Strategic Insight. By 2018, they’re projected to hit $1.1 trillion and 23% of 401(k) assets with the help of their inclusion as a qualified default investment alternative (QDIA) under the US Pension Protection Act.
To vs. Through
But not all target-date funds are the same. In fact, one of their attractive qualities is their uniqueness. So it’s important to know the differences when making comparisons. Some funds manage assets “to” retirement while others manage assets “through” retirement. “To” funds are easier to explain because they manage assets to a specific date, whereas “Through” funds are managed past the retirement date. Through funds can be problematic because the time horizon is unknown – people generally can’t predict when they’ll die. Intuitively, longevity risk – the risk of outliving your income – spans a wider range than investment risk, making it tougher to manage assets through retirement. However, Through funds may deliver higher returns near or at retirement – with more risk – and may be appropriate for investors seeking systematic withdrawals.
Still, Through funds can be confusing because they attempt to meet two different objectives over the investor’s holding period: accumulation and withdrawal. Further, by extending the glide path past retirement, Through funds ignore evidence of actual investor behavior. An estimated 80% of retirement-plan participants withdraw their entire savings within three years of retirement.
Another critical difference between target-date funds is that equity allocations can vary widely among funds pegged to the same retirement date. For example, stock allocations in funds dated 2010 ranged from 20% to 60% at retirement. What that reveals is a stark contrast in risk and return expectations from one target-date fund to another. As we saw in 2008, a fund’s level of equity exposure can dramatically impact returns: investor losses in 2010 target-date funds ranged from 9% to 41% just two years before the expected retirement date. Sequencing risk – the risk of retiring in a down market – is arguably the biggest threat to retirement savers’ portfolios. Employees with access to target-date funds in their 401(k) plans should do their homework to ensure that the stock exposure is commensurate to their own risk tolerance and time horizon.
Another critical difference between target-date funds is that equity allocations can vary widely among funds pegged to the same retirement date. For example, stock allocations in funds dated 2010 ranged from 20% to 60% at retirement. What that reveals is a stark contrast in risk and return expectations from one target-date fund to another. As we saw in 2008, a fund’s level of equity exposure can dramatically impact returns: investor losses in 2010 target-date funds ranged from 9% to 41% just two years before the expected retirement date.
Sequencing risk – the risk of retiring in a down market – is arguably the biggest threat to retirement savers’ portfolios. Employees with access to target-date funds in their 401(k) plans should do their homework to ensure that the stock exposure is commensurate to their own risk tolerance and time horizon.
A Better Measuring Stick
Broad diversification is also a key feature – across asset classes, geographic regions and underlying money managers. We’re living in a global, multi-asset world. Traditional 60/40 stock-bond allocations and home-biased holdings won’t cut it. And target-date funds that stick to a single in-house fund brand don’t tap the best ideas and niche expertise you’d find in a multi-manager approach. That is, no one fund family can do it all.
For their part, target-date fund managers need to work with regulators to come up with standardized risk measures and create greater transparency. One way to achieve those goals is by aligning target-date funds to public benchmarks. A public benchmark serves as a measuring stick that helps employers and employees gauge how funds will behave in different market environments and how much risk they’re taking. As a result, benchmarks can inspire confidence that the risk in the portfolio is what’s needed to achieve their goals.
Plus, tying target-date funds to appropriate public benchmarks lessens the chances of surprises. In times of turmoil, public benchmarks help fiduciaries better manage return expectations. Public benchmarks also help answer the following questions: “Did I get what I paid for?” and “Did the fund do what it was supposed to do?” Without an expectation of how a portfolio should behave – particularly in the face of volatility – investors could be exposed to unnecessary risk.
Still, when it comes to benchmarking, a lot of target-date fund managers don’t measure up. Public benchmarks for target-date funds have been available since 2005, but adoption rates remain extremely low. And the benchmarks that are being used are often not the best fit. Indeed, there are currently nine widely accepted public benchmarks – offered by Dow Jones, Standard & Poor’s and Morningstar – with far-ranging risk characteristics. But fewer than one in four target-date fund families use one as their primary benchmark. And among the target-date funds that use a public benchmark, 30% of them use the S&P 500, which includes only large-cap US stocks – a poor proxy for a well-diversified portfolio.
While not without challenges, target-date funds are a smart, simple way for most people to save for retirement. They’re far better than the alternative: people doing it themselves. That can often lead to performance-chasing and poor outcomes. What’s more, target-date funds can offer a higher level of confidence. Having spent most of their lives working and paying bills, retirees are likely to find comfort in doing what they want to do in retirement – as opposed to what they have to do. And what’s more dignifying than that?