Target-Date Funds: Why Higher Equity Allocations Work
August 20, 2013
by Joe Tomlinson
Following the 2008 financial crisis, target-date funds (TDFs) were criticized for exposing investors nearing retirement to excessive equity allocations. Were those criticisms justified? How well do TDFs stack up against the venerable strategy of matching one’s bond allocation to one’s age? My research has yielded surprising answers to those questions and to the proper role of single-premium immediate annuities (SPIAs) alongside TDFs.
TDFs are grabbing a bigger share of retirement savings portfolios and getting more attention from advisors. As clients approach retirement, they will need advice about what to do after retiring – whether to stay with the same TDFs or change strategies. Part of the evaluation will involve examining stock allocations and post-retirement glide paths. Advisors may also recommend investments to supplement TDFs such as annuities. I'll use an example to show how allocations and glide paths can affect retirement outcomes, and I’ll show how outcomes can be improved by adding SPIAs to the investment mix.
TDFs have become hugely popular since being named a qualified default investment alternative for 401(k) plans under the Pension Protection Act of 2006. Savings in these funds topped $500 billion in 2013's first quarter, and the rapid growth continues.
But since the stock market losses of 2008, the growth has been accompanied by controversy. For TDFs with a target maturity date of 2010 (two years from retirement as of 2008), losses ranged from 3.5% to 41.3% in 2008, according to Ibbotson®. This was devastating for many workers preparing for retirement.
Congress and Government Accountability Office launched investigations. Everyone involved began to learn about stock-allocation glide paths and the difference between "to" funds (which gradually reduce stock allocations up to a target retirement date) and "through" funds (which continue to reduce stocks over the full course of retirement). It became apparent that, even within the "to" and "through" categories, various TDFs were using widely different stock allocations.
This commotion awakened clients and advisors to the importance of allocation strategies and glide paths. These fund characteristics are critical as clients approach retirement.