Investors are often bombarded with information about retirement savings and investments, but the guidance for properly financing retirement spending is less clear. In a way it makes sense. After all, amassing the assets you need to secure your retirement finances is a priority, takes decades, and requires discipline.
Investing for retirement is pretty easy. It is widely agreed that investors should start investing as early as possible, invest as much as possible, and heavily allocate to equities early, before gradually shifting to bonds. Moreover, for most investors, the time they must invest is fairly well defined.
Navigating retirement, on the other hand, is a challenge. First and foremost, there is no way to know how long the money will last. The wisest advice suggests at least 25 years, but it could be 10 or 35 years. You may need to change your spending levels due to inflation, medical costs, or other unknown issues. Finally, the amount of income you receive generally fluctuates with interest rates. And do it all before evaluating how and when to use all possible sources of income, such as social security, pensions, and distributions from various IRA and 401(k) accounts.
Funds intended to help retirees after retirement fall into the Target Date Retirement Morningstar category, but they cannot address all of these issues. However, they strive to help the investor focus on his two key investment agendas. As we will see, there is no broad consensus on how to navigate these related challenges. Frankly, there is more than one correct answer. By understanding the different approaches of the 35 funds in this category, investors can find a strategy that suits their needs and preferences.
As it happens, the capital markets have provided a powerful illustration of these issues over the last few years. Interest rates are generally very low for 10 years, making it difficult to generate income, and both bonds and stocks will plummet in 2022, indicating that these funds risk losing money.
target date retirement strategy
Equity capital growth is an established way for investors to maintain a standard of living without running out of money in retirement. Over the long term, the higher the equity weighting of the retiree portfolio, the more likely it is that growth will help combat inflation and overcome the risk of outlived savings. He has two rather small problems and a big problem. First, stocks don’t tend to generate huge amounts of income through dividends. Therefore, you cannot simply own shares. Second, the stock is highly susceptible to a bad recession (which is why it’s important not to allocate retirement money to his 100% stock).
Traditional bonds, such as cash and high-quality bonds (US Treasuries), essentially reverse the pros and cons of equities. That said, bonds tend to bring in more income than stocks, but generally don’t grow significantly. Correspondingly, high-quality bonds tend to be less at risk of a sharp decline in capital during an economic downturn. Cash invested in very short-term holdings (such as money market funds) is the most stable, provides the lowest income, and can generally accommodate inflation at best. Bonds offer more income at the cost of less stability. Additionally, there are different risks/rewards. That asset class, generally speaking, requires investors to take on additional interest rate risk, credit risk, or both in order to raise their return (income).
With these concepts in mind, we can consider a range of asset allocation approaches in the target date retirement category.
As you can see, asset managers build very different retirement portfolios. A typical target date retirement fund has about 30% of its assets in equities, with a high of about 1.5 times that level at 44% and a low of about 1/3 that level at about 10. % is. Correspondingly, common bonds have a slightly higher weighting of 60%, with a high of 76% for more than three-quarters of bonds and a low of 47% for less than half of bonds. Finally, typical funds in the target date retirement category hold about 7% or 8% cash, while some hold more than 25% cash and have negative cash exposure. There are also couples who are Most of these funds hold very little “other” assets, with one exception.
Across Equities and the Impact of Various Fixed Income Exposures
Equity returns tend to be strong, especially during the strong rallies of 2018-21 and bear markets like 2022, with their weights driving overall returns for mixed-asset portfolios. Retirement funds demonstrate this clearly and why stock weighting is an important consideration for retirees.
Averaged the overall equity weight of each of 31 target-date retirement funds with a 5-year track record and plotted the returns of these funds from the beginning of 2018 through the end of 2021 and the first 8 months of 2022. Did. Then group the categories into four segments according to the five-year average stock weight.
From 2018 to 2021, funds with higher equity weights posted higher total returns on average. A company with a 33% to 43% stake has an average annualized rate of 7.7%. Funds with 30% to 33% equity average 6.5%. The average interest rate for funds with equity between 25% and 30% was 6.3%. 11% to 21% funds average 4.9%. The reverse is also true, and arguably more dramatic. In the first eight months of 2022, these four fund groups fell 13.2%, 12.0%, 10.6% and 9.1% in the same order. Investors with little need or desire to risk their capital are wise to keep retirement equity low. Companies seeking higher overall returns must accept the risk of capital loss.
We reversed the fields to examine how target-dating retirement funds met the challenge of providing income for spending. We looked at overall income levels over the past five years to see how the fund’s bond statistics explain these yields. We divided the target date retirement fund into quartiles using the five-year (2017-21) average income return. We then looked at duration and credit quality from different angles, and found that the proportion of high yield bonds was the most important.
In some fixed income environments, the maturity of a bond and its interest payments are very important. In other words, long-term bonds may offer significantly higher returns than short-term bonds of similar credit quality. In these regimes, income generating portfolios can hold longer bonds to generate more income. However, as noted above, this is not the case these days. In fact, funds with the highest income levels have shorter overall durations than those with lower income levels. (Of course, that could change in the future, as interest rates have risen significantly.)
The most notable difference in target-date retirement fund revenues over the years has been the amount devoted to high-yield bonds on bond sleeves. The quartiles of funds with average yields of 3.4% and 2.7% devoted an average of 16.6% and 15.1% of their bond portfolios to high yield bonds. Quartiles of funds with average yields of 2.4% and 1.9% held only 5.6% and 3.9% of bond sleeves in high yield bonds. Clearly, the gap is large and significant.
Overall risks and rewards of retirement
Now that we’ve explored the basic causes of risk and reward, let’s look at the results. Below we show the 5-year standard deviation and 5-year returns to give an overview of the risk/reward trade-offs in this area. Here are the 31 funds in this category with good history (as of August 31, 2022).
In general, the higher the risk, the higher the return. There are three fairly clear groupings of funds with standard deviations of 4% to 6%, 6% to 8%, and over 8% by volatility. Within each group there are standouts with higher returns. Below we take a closer look at these three funds.
Among the conservative funds, Dimensional Retirement Income (deficit) stands out with a five-year return of 3.5% and a standard deviation of 5.1%. (TDIFX)This member of the DFA’s Target Date series, which scores Neutral on Morningstar’s analyst ratings, has just 20% of its assets in equities and avoids high yield bonds entirely. That stance certainly limits its growth potential, pushing the average income rate to just 2%. That would be too low for some retirees’ plans, while his 7.2% drawdown from 2022 to Aug. 31 puts him among the 35 funds in this category. It’s the second lowest, and a key part of why its long-term returns stand out. This is the type of fund built for investors who dislike sizeable nest eggs, relatively modest income requirements, and negative returns.
In the mid-volatility group of funds, the Prudential Day One Income (PDAJX) had the highest return in the last 5 years (orange). This unrated fund’s 4.1% annual return and 7.1% standard deviation makes sense given its asset allocation. The company has so far devoted less than 30% of his assets to equities. This is in the middle of nowhere for this category. It also stands out in several ways. First, of the 54% the company spends on bonds, only about 3% of its fixed income assets are spent on high-yield fares. We are not growing for yield. Second, its 10% “other assets” weighting is the highest in this category. This is largely due to his 5% holding in the commodities portfolio, which in 2021 he is up more than 25% and 2022 so far. That’s one reason the fund has retreated only 9.2% of his in the first eight months of 2022. It aims to attract a broad group of retirees by striking the right balance between growth and protection.
Finally, among the more volatile group of funds, Pimco Realpass Blended Income (PBRNX) The 5-year return is 4.2% (yellow). Note that this member of Pimco’s Gold-Rated RealPath Blend Target Date suite also has the second highest standard deviation he has at 9.0%. His 44% stake in the company is the highest in its category, and its high-yielding weight of 16.6% places it in the heaviest quartile. This configuration generates more income than most of its peers. His two companies are the only competitors with five-year average income returns higher than his 3.6%. That said, the strategy lost him the most in the category at 14.6% in the first eight months of 2022. The Pimco Realpath Blended Income is a type of fund designed for aggressive investors seeking to maximize income and be able to handle the losses of inevitable stock price declines. As for that group, it serves its intended purpose if used properly.
Investors looking to put together a game plan should ponder the following:
- What are your needs and preferences when it comes to capital preservation? Stocks are down 30% or more in many bear markets. Can 25% of your portfolio handle such a drawdown?
- What level of growth will make you comfortable? The longer you live and the more reluctant you are to cut your retirement spending, the higher the equity weight you need.
- What are your income requirements? Some with big nest eggs can deal with lower and safer yields from a 100% high quality bond portfolio. Others need or want higher income levels.
Because if these sound like hard decisions, they absolutely are. Being thoughtful and understanding your priorities will help you reach the most beneficial conclusions. The good news here is that target-dated retirement is not a one-size-fits-all solution. The range of different allocations and sub-allocations means that with a little attention to the fundamentals (portfolio composition), you are likely to find a combination that suits your tastes and needs.
