Many individual investors don't know what a target date fund (TDF) is. Among those who do, most probably believe - with the conventional wisdom - that a TDF is simply a "one-stop" investment vehicle that automates asset allocation and "de-risks" over time. Put all your retirement savings into one instrument, then "set it and forget."
This view is not altogether wrong, but can be both misleading and insufficient.
Let's step back and ask some basic questions. Why do people invest for retirement? What outcome are they trying to achieve and why?
In the simplest terms, the purpose of retirement investing is to accumulate wealth in order to spend it in the future when we're no longer working and our paychecks stop coming. Breaking the process down in more detail:
- During our earning years, we deliberately choose not to spend our entire income but to save some of it-to defer the satisfaction or enjoyment of spending that saved money;
- The saved money is then invested, with the aim to exceed inflation and earn a return that will increase the buying power of that money at and through retirement;
- The saved money and its accumulated returns are then spent (along with the proceeds, if any, from private or public pensions such as Social Security) in retirement, optimally at a rate that seeks to ensure that we never run out of money and can maintain our desired standard of living.
The common thread running through these three points is spending. During our earning years, we try to consume less than we earn so that we may consume later in life, when we're no longer earning. The goal is to enable relatively consistent spending over a lifetime. In the below figure, the yellow line represents such spending. The blue-striped region above the yellow line (savings and investments) must fund the green region (retirement spending).
Current savings funding future consumption
Once one understands that the goal of retirement investing is to seek relatively consistent lifetime spending, we believe the way to design target date funds becomes clearer.
What's the objective?
We've provided our belief upfront: the proper goal of retirement investing is to enable relatively consistent lifetime spending. But what about other possible objectives? Most professionals in the financial services industry see retirement investing as seeking one of three, as summarized in the table below:
|Wealth Maximization||Can maximize value of assets, leading to potentially greater total wealth at retirement||Typically higher risk and greater volatility; possibility of significant losses and insufficient wealth to maintain spending habits in retirement|
|Capital Preservation||Prioritizes low risk and a more certain outcome; less risk of significant losses||Requires very high savings rate to meet retirement income goal; increases risk of running out of money in retirement|
|Income Generation||Annuities seek to provide secure retirement income for life||Investor must surrender capital; income provided can be less than expected returns from an invested portfolio with same value as annuity purchase cost|
Let's examine these options in more detail:
- Wealth Maximization seeks to maximize the value of assets at retirement. By this standard, the bigger your pot of money on the day you retire, the better you've done. Maximization is generally achieved through higher equity exposure throughout the lifecycle and typically results in higher equity allocations at retirement.
- Capital Preservation aims to avoid losses and preserve more modest gains while forgoing potentially higher, but riskier, returns. The purpose is typically to prioritize certainty-a lower but potentially more certain rate of return. This objective typically results in a transition to fixed income investments earlier than a wealth-maximization focus. By retirement, investors pursuing this objective tend to end up with a lower-than-average allocation to equities.
- Income Generation utilizes some type of annuity product-a variable annuity wrapper, embedded deferred annuity, or annuity beta exposure-to generate a fixed monthly income in retirement. Certainty is also the core priority of this objective.
Each of these goals seems to make intuitive sense. Wealth maximization sounds obvious - we'd all rather have more than less, and the larger our pot of money is at retirement, the more we can do with it. So, too, with capital preservation: who wants to see their nest egg shrink? Similarly, some secure income as a hedge against market volatility is important.
Yet each also carries serious shortcomings. Wealth maximization, for instance, focuses on the accumulation phase - the years during which we are working, saving and investing - often without any clear plan for the decades actually spent in retirement. An investor following this strategy must accept high risk and volatility, and thus great variability in the possible outcomes. That is, the investor might end up with a very large portfolio. But if retirement age arrives during a serious market downturn like the one experienced in 2008-9, that portfolio might be significantly smaller than planned, forcing the investor either to work longer or accept dramatically reduced spending during retirement.
A retiree who prioritizes leaving wealth to heirs may prefer the goal of capital preservation. Yet this strategy, too, is not without costs. Choosing very conservative investments can help reduce and mitigate market risk, but only by increasing longevity risk (the risk of running out of money too soon). The "safer" the investments, typically the lower the returns-and hence the greater the danger that a nest egg won't last long enough. Also, choosing very conservative investments greatly increases the savings rate required to fund retirement income, thus reducing the amount available to spend during the working years.
The main drawback (at least as perceived by most investors) of an income generation strategy is that purchasing an annuity entails handing over all or most of an investor's capital - something very few in the U.S. are willing to do.
Focus on spending
Spending is financed either by current income (whether from a paycheck or a pension) or accumulated savings. The dilemma for investors - for everyone who earns a paycheck - is to weigh the relative importance of spending today versus spending in retirement, which requires saving today. Increasing current spending reduces future spending and vice-versa.
In fact, an individual's spending over the lifecycle is entirely determined by the present discounted value of lifetime income, with financial assets providing a means of transferring spending from one point in the lifecycle to another. What most people want for their retirement is the ability to maintain a relatively consistent pattern of spending after their paychecks stop coming.
In terms of the investment objectives discussed above, this focus on spending may be seen as a combination, and tempering, of all three such objectives. The goal is not to maximize wealth but to generate enough wealth to help enable relatively consistent spending, while seeking to take the minimum amount of risk necessary to achieve that goal. Similarly, capital is not preserved for its own sake nor is certainty prioritized as the objective.
A spending focus rather seeks enough certainty to help enable stable spending through a retirement lasting decades, while avoiding the stringent conservatism that requires very high savings rates. Finally, the goal is to produce income - as with an annuity strategy - but without the necessity of surrendering capital. This preserves flexibility for the future - for instance, the ability to enjoy relatively consistent spending and leave wealth to heirs.
TDF theory: The two forms of individual wealth
Spending is enabled by wealth. And, for individuals, there are two principal forms of wealth: human capital and financial capital, or earning potential and savings potential.
Human capital is the value of all of the labor income we've yet to earn over the course of a working life. Financial capital is wealth accumulated through saving and investing. As we work and earn wages, human capital is transformed into financial capital. As an asset, human capital operates much like a long-dated bond. Like a bond, it pays a (more or less) steady amount in salaries or wages (the equivalent of a bond's coupon) at set intervals over time. Also like a bond, human capital has an overall value: the present value of those future wages. When we begin our working lives, all our earnings are in the future and we've not yet accumulated any savings (financial capital).
Hence all our wealth is held in the form of human capital. As we convert human capital into earned income through working, we spend some on goods and services, and save and invest the rest, i.e., convert it into financial capital. As our working life progresses and this process continues, we convert more and more of our human capital into income, so our human capital shrinks, while our financial capital rises as a portion of our overall wealth-and hopefully in real terms as well, as our investments earn returns in the markets.
Consider two hypothetical investors. Jane is 25, recently graduated from professional school and has been working less than a year. She hasn't yet saved much but she has a 40-year career ahead of her. I.e., she possesses a great deal of human capital but, at this point in her life, not much financial capital. Joe, on the other hand, is 55. He intends to retire at 65. Having saved and invested consistently over the course of his career, he has a sizeable portfolio in his retirement accounts, but only 10 more years in which to earn and save. Thus Joe, unlike Jane, has a good deal of financial capital but much less remaining human capital.
Since the investment characteristics of human capital are bond-like, it makes sense to diversify one's human capital exposure with equities. Thus, when younger - when human capital makes up the bulk of our wealth - we should invest primarily in equities for diversification. Younger investors, with very long investment horizons, can often better assume the risk associated with equities and seek to capture their higher expected returns.
As we move through the lifecycle and convert human capital into financial capital, our bond-like human capital shrinks relative to our financial capital, and we begin to shift the latter from equities to fixed income-again, to diversify. In the below figure, see a depiction of this human-financial capital interaction.
Transforming human capital to financial capital
The conventional understanding of TDFs, as noted, is that they are mechanisms for dialing down risk with age - a relatively simple matter in the final analysis. But in fact, "age" in this sense is just a proxy for the more complex - and more fundamental - relationship between human and financial capital. Managing this relationship - more specifically, managing the ongoing conversion of human into financial capital - is what a TDF should be designed to do.
The TDF model
How to put this theory into practice? We believe there are four fundamental steps to a TDF design process that connects the final product to individual income and how such income changes over a lifetime, and thus to human capital.
- First is to use real-world data to construct detailed income profiles of actual and potential plan participants;
- Second is to take that data and determine optimal spending rates for those participants;
- From these two calculations are derived necessary savings levels;
- The final step is to determine the asset allocation in the portfolio-broadly diversified among global asset classes and becoming more conservative over time.
Let's go through these steps in more detail.
Income profiles are essentially large-scale proxies for granular data about participants' income over their working lives. An individual working directly with a financial advisor can expect to receive a detailed investment plan that looks carefully at actual, individualized income data. This is clearly impossible for large, heterogeneous populations such as the hundreds or thousands of investors in any given company's defined contribution plan.
One way to estimate the lifetime income of a fund's target population is to compile extensive data on the age that income begins and at what level, how fast and how high income rises, when it begins to decline and by how much, and the risks arising from income fluctuation, for instance owing to periods of unemployment. In other words, the goal is to form a lifetime estimate of how much financial capital a person in a given population could accumulate through the conversion of human capital via labor.
The data could have a variety of sources, from information provided by clients to publicly available sources such as censuses, surveys and academic studies. But all of it is based on what people in a given market - and even in some cases at a given company - actually earn. In other words, this data is not hypothetical but directly relevant to the local market for which the fund would be designed. The idea is to capture, as much as possible, individual outcomes by examining as broad and as representative a sample as possible.
Income profiles then enable the calculation of optimal spending rates over the participants' lifetimes. The math is complex but the concept is simple. Remember that the main goal of a TDF is to help enable relatively consistent lifetime spending. This is possible only when we defer spending some of our accumulated financial capital until after the point at which all our human capital has been converted.
If we spend too much as we work, we won't be left with enough financial capital to generate our desired annual income in retirement. Spending too little means to forego the core purpose of all our hard work. Optimal spending is the "Goldilocks" level at which we maximize the enjoyment of our labor income both as we work and after we are done working.
Optimal spending levels help determine necessary savings levels. Investors typically prefer to save the least amount possible consistent with the ability to consume in retirement. Our calculations are designed to determine that level. Put simply, optimal spending rates determine necessary savings levels.
The final step is asset allocation - building the actual portfolio and glidepath - which is determined in part by all of the above factors. The goal - again - is for investors, at retirement, to have enough financial capital to help enable a relatively consistent pattern of spending over the rest of their lives. Based on the income profiles already calculated, it's possible to further calculate how much accumulated capital will be necessary to generate the income stream that participants need. What investment returns, over how long a period, will be required to accumulate that capital?
To make those calculations, it's necessary to begin with a set of capital market assumptions (CMAs) to forecast possible outcomes - and potential volatility - of various asset classes. CMAs might have two fundamental sources. The first would be proprietary forecasts (typically 10 years) of the expected returns on broad, representative portfolios of local equities and local bonds. The intent would be for these to serve as "anchor points" later in the analysis.
Second, for other asset classes-such as real estate, commodities, and international equities - a TDF designer could construct a reference portfolio by examining their allocations in the relevant market. This reference portfolio is an important benchmark of local investor practices and expectations. In creating the reference portfolio, the key is to look at two factors: what asset classes are represented and what are the percentages of each in the overall portfolios?
This can be determined by examining actual portfolios invested in the actual, relevant market to get a clear picture of how sophisticated investors in that particular market, seeking to solve a similar problem, are investing the money they manage. The aim should be to tailor or localize in-house analysis with local expertise.
Knowing the assets and allocations that are most relevant to a given market, it is then possible to construct a glidepath whose objective is to meet the TDF's endpoint goal - the amount of wealth accumulated at retirement - with the minimum possible level of risk and volatility. This is an important point. Recall the investment objectives described above. The goal of a good TDF should not be wealth maximization. It should rather be to help enable, once investors reach retirement, spending that is relatively consistent with their standard of living during their working lives.
Well designed TDFs can help solve the investment challenge
Target date funds have done an effective job (at least in the U.S., where their market penetration is highest) of transitioning many individuals to lower risk portfolios as they age and delivering better risk-adjusted performance for members during the accumulation phase. However, while the accumulation phase may have been improved through the use of these automatic and/or diversified vehicles, most funds still don't adequately address investors' most urgent concern: will I have enough to maintain my standard of living after I retire?
Furthermore, there are few investment products that can help manage an investor's path toward an explicit lifetime income benefit. Annuities have been offered in some plans, but remain unpopular and so utilization (within plans and in the broader market) is very low. Other guaranteed income products are often complex, expensive, and inflexible. Adoption of these has also been relatively low (again, both within plans and in the broader market) and probably will remain so for the foreseeable future, given the historically low popularity of annuities.
Target date funds can be good option for most investors - but only if done right. When comparing target date fund options, it's important to keep in mind that while they may appear to be similar in offering automatic dynamic asset allocation, and in reducing risk as the investor ages, each has a unique objective and correspondingly unique asset allocation that ultimately can provide very different experiences. Only once the objective is understood is it possible to choose a target date fund whose objective is consistent with the experience the plan seeks to deliver to the member.
This post originally appeared on the BlackRock Blog.