In our October 2017 newsletter, the featured article addressed Target-Date Funds (TDFs), covering background information, how they work and their benefits. While TDFs have experienced explosive growth and offer clear benefits, do they offer participants the best chance of a stable, predictable income stream in retirement?

The main issue centers on what the appropriate goal of participants should be. This seems like a “no-brainer,” but is it? For many, the obvious answer is for the participant to accumulate a big “pot of money” to last them through retirement. This is the way defined contribution (DC) participants are encouraged to save and invest, and how they have historically measured progress toward their goal. However, in a Harvard Business Review article (July-August 2014 edition), Robert C. Merton argues that this approach is wrong and that the focus should be on the income stream required to sustain a standard of living in retirement, not the value of the accumulated retirement investments themselves.

If one invests with the goal of achieving a large account balance with an acceptable level of volatility, shouldn’t that also provide an appropriate, predictable income stream? Unfortunately, this is not necessarily the case. The types of assets and the allocation utilized to achieve the “stable” account balance leave an investor exposed to the risks associated with being able to achieve clarity and certainty around a desired income stream.

The question then becomes, are typical TDF portfolios designed to help participants just grow a “big pot of money” or can they actually help investors gain clarity around how much income they can spend in retirement? It turns out that typical TDF portfolios don’t succeed in achieving the retirement goal of a predicable income stream, but why?

The typical TDF consists of an allocation to growth assets (equities) and risk management assets (fixed income). Equities are typically seen as “risky” because they are highly volatile, whereas fixed income is “less risky” because it provides the ballast to temper the volatility of the portfolio. If the goal is to maximize the account balance, this is a perfectly valid way to manage the portfolio. However, the goal of typical retirement plan participants is to achieve a relatively predictable income stream to sustain them throughout retirement.

So, what’s missing? The answer relates to three main risks that impact the conversion of the typical TDF portfolio to a stream of income in retirement – market, interest rate and inflation risk. Perhaps surprisingly to some, the typical TDF is subject to a considerable amount of market risk at the target date. For example, the Fidelity and T. Rowe Price 2020 TDFs both have approximately a 60% equity allocation at the target date and Vanguard’s 2020 TDF has a 56% equity allocation. Any large equity market decline, especially near the target date, would have a big impact on the income stream that these TDFs could provide. Interest rates also impact the amount of income a participant can get from his or her account. Most TDFs allocate towards fixed income to dampen account volatility, which means investing in shorter term fixed income. However, if the goal is to provide a stream of income in retirement, then this approach introduces significant uncertainty. Finally, inflation will eat away at the purchasing power of a participant’s account unless the portfolio is managed to mitigate this risk.

How should a retirement portfolio be managed if focusing on minimizing account balance volatility does not meet the participant’s objective? Dimensional Fund Advisors (DFA) has addressed this question with a relatively new kind of TDF offering that they refer to as Target-Date Income Funds (TDiFs). These funds utilize an income-focused strategy to reduce the amount of income stream uncertainty. The objective of these TDiFs is to provide a way for plan participants to invest with the goal of achieving a predictable future income stream. Like other TDFs, the DFA TDiFs start out with a large allocation to equities and a small allocation to fixed income. About 20 years before the target date, the TDiFs begin adding US Treasury Inflation-Protected securities (TIPS) as the allocation to equities declines. At the target retirement date, the allocation is 25% in a globally diversified equity portfolio and 75% in a duration matched TIPS portfolio. This equity landing point is held constant for the first ten years of retirement upon which time the equity allocation begins to be gradually reduced to a final 20%, 20 years after retirement. To manage income uncertainty, the TIPS portfolio evolves throughout the entire life of the portfolio; no two funds are ever the same.

Here’s how these new funds manage the risks to a retirement income stream:

  • Market Risk: Its relatively low allocation to a globally diversified basket of equities (25%) at the target date, combined with a unique asymmetrical rebalancing schema between asset classes, mitigates any impact on the income stream from equity market declines, while still providing the opportunity for some growth if equity markets are strong.

  • Interest Rate Risk: DFA mitigates this risk by structuring the TIPS portfolio to match the duration of the required income stream. (The assumed life of the income stream is 25 years). This is a proven technique used by defined benefit (DB) plans to meet their expected payouts to pensioners, often referred to as “liability-driven investing” (LDI). While changes in interest rates will still impact the market value of the TIPS portfolio, this strategy reduces the uncertainty of the future income stream.

  • Inflation Risk: The 75% allocation to TIPS mitigates the impact of inflation on the income stream because the principal of the TIPS is adjusted for increases in the consumer price index. The remaining 25% allocation to global equities also helps grow the portfolio throughout retirement and defend against inflation.

  • In summary, the typical TDF is designed to facilitate the growth and accumulation of retirement assets, but this is just one half of the retirement equation. The other half is the ability to translate the “pot of money” into a stable stream of income in retirement. However, as described herein, the income stream achievable from a portfolio managed in the typical TDF fashion is highly volatile. This makes it difficult for someone to plan his or her retirement and meet their required cash flow goals in retirement. By utilizing an income-focused fund that purposefully manages the risks associated with both the “accumulation” (growth) and “decumulation” (spend down/income) aspects of the retirement equation, such as the DFA TDiFs, participants can have a much higher level of clarity and certainty as to the retirement income stream they can expect. Reduced uncertainty creates a platform for more informed decisions on saving rates and expense budgeting in retirement, and ultimately leads to better retirement outcomes.

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