What You Need to Know
- TDFs were created around 60/40 asset-allocation assumptions that have begun to break down.
- TDF holdings and glide paths vary widely, as do the needs of investors in the same age range.
- The whole retirement industry should be part of the solution; advisors can start by accepting that their working clients need better alternatives.
Target date funds, or TDFs, were initially created to work something like time-lapse photography.
Let’s say you want to capture a tree’s growth to maturity. Individual snapshots are automatically taken at set intervals over a long period of time. You forget about it until things come to full fruition, then lo and behold, you can play back the series of shots in rapid succession to see a sapling grow into an oak, as if 30 years were 30 seconds.
Similarly, TDFs come with a promise to grow an investor’s assets over time by updating “snapshots” of stock-to-bond asset allocations without the investor having to do anything. As the investor grows older, TDFs automatically rebalance away from risky equities and towards safer fixed income assets. This culminates at retirement with a portfolio that is balanced to provide retirement income without taking too much risk.
Unfortunately, the realities of today’s market mean that we can no longer take for granted the oak’s undisturbed path to maturity. The “one and done” concept of TDFs, the premise that a fund would keep growing as an investor moves toward retirement, passively continuing to contribute, is a threatened species. Let’s take a closer look.
Why Are TDFs at Risk?
TDFs surged under the Pension Protection Act of 2006, which paved the way for them to act as qualified default investment options in retirement plans. TDFs offered convenience as well: They came in chassis separated by five-year increments, allowing investors to pick a target retirement date, select that corresponding TDF, and forget it.
But at that time, the industry was still operating under old stock-to-bond asset allocation assumptions that were starting to break down as yields on fixed income assets continued a decades long decline. Add to that, less than two years later came the financial crisis and housing catastrophe. This led to the federal government pulling many levers in both fiscal and monetary policy, with quantitative easing as the end game. The result of that period has been historically low interest rates. What this means, simply put, is that the sapling is going to need a lot more active help to grow into that oak.
Where fixed income investments — usually bonds — had traditionally been the defensive element in a portfolio, those low interest rates now place them in the category of high-risk investments — in some ways riskier than equities. Bonds are now yielding near zero percent — and there’s a salient argument to be made that, factoring in inflation, the net real yield on some of today’s more popular fixed income proxies is actually negative. This has resulted in a much different glidepath than those the industry presented to Congress when it lobbied for the opportunity to sell qualified default fund solutions.
This places a burden on American workers, who were once able to put their money in safe assets and worry very little about the drawdown of their value, while at the same time still enjoying some appreciable benefit in the form of real return, and in some instances real income that could be earmarked for retirement.
The fallout from the current state of interest rates and looming inflation is such that the same comfort level in long-term, fixed income type investing has ceased to exist. And—bad news—we’re not forecasting that it will return to any sense of historical normal in our working lifetime.
But there may be some new ways of thinking about the problem.
Not All TDFs Are Created Equal
The classic investment portfolio construction is a 60/40 stock-to-bond asset allocation, serving as the main proxy for a moderate investor halfway through their investment journey. This model serves as the foundation for everything having to do with glide paths as they apply to target date funds.