Embracing Target Date Funds

For retirement’s ‘second-act’, a challenge to traditional income thinking

by Randy Welch

Target date funds (TDFs) are a popular tool for investors using an employer sponsored plan to save for retirement. While TDFs have been around since 1994 and have evolved quite significantly in the past two and a half decades, one reason they’ve grown so popular over the years remains consistent: they make it easier for everyday workers to make choices about their investments for retirement.

But market dynamics are changing quite quickly—and the next generation of retirees might need to change how they prepare for retirement accordingly.

Refreshing The Income Approach

With interest rates near historic lows—and equity markets near historic highs—retirement savers may need a refreshed investment approach to build a nest egg that takes them through their second act.

Over the long term, these new and testing market dynamics may translate to lower-than-expected returns across all major asset classes. And that presents a challenge for today’s retirement investors and the financial professionals helping them navigate this new ground. How can we effectively manage a wide range of new and emerging risks while staying true to the hallmark simplicity of TDFs that have led investors to allocate approximately $1.8 trillion to these strategies?^[1]

As long-time TDF managers, my team and I are tasked with steering the retirement investments of millions of workers. In turn, we’ve developed a vantage point on the needs of retirement savers.

In recent years, target date fund investors have been a compelling story. While we have and can still learn a lot from this story, we also must continuously evaluate and enhance our asset allocation strategies and their ability to help meet and exceed investor expectations.

Our research and analysis in the last year has provided additional perspective to the strategies that support the next generation of retirees.

Adjusting Equity Exposure In Portfolios

Specifically, across the full spectrum of retirement savers, we’ve identified multiple adjustments that we believe will strengthen the performance of retirement portfolios.

• First and foremost, younger investors should maintain a static level of total equity exposure while they are more than 25 years from retirement with a goal to improve their retirement savings.

The early years of saving for retirement are suited for new investors to be “risk on.”

The “de-risking” of a TDF is driven by the shape of the glide path, or the roadmap guiding a careers-long investment strategy that evolves gradually from your first paycheck through retirement.

A glidepath within a retirement portfolio should closely mimic the trade-off in the present value of future earnings with the buildup of retirement savings. Over the course of an individual’s career, this trade-off evolves and, as a result, the glide path naturally de-risks.

Practically speaking, the dynamic looks like this: The transfer of “human capital”—or the economic value of a worker’s experience and skills—to invested capital is quite slow for a young worker. Therefore, maintaining a static, or higher, level of equity exposure longer may result in better retirement outcomes later in life (as an individual’s human capital more directly translates to invested capital).

• An increased equity exposure isn’t just paramount for those at the beginning of their career. For mid-career investors who are more than 10 years from retirement, an increased level of equity exposure—albeit lower than the exposure for younger workers—could also lead to desired retirement outcomes.

Forecasted returns for both equities and fixed income have come down significantly after more than a decade of sharp “up and to the right” returns. That shift makes it more challenging to achieve retirement goals, especially for those in their highest earning years.

In practice, within our TDF strategies, we increased exposure to equities for funds that are 10 years from retirement from 2% to 10%. This is quite a dramatic change from the early TDFs, but it’s part of an ever-evolving process to help achieve desired retirement outcomes.

• Finally, investors age 65 and up can benefit from an increase in equity exposure balanced by a glide path that reaches the most conservative equity allocation sooner. This shift in thinking more closely aligns portfolios with current workforce trends.

We are seeing that investors are more tolerant of market pullbacks than they used to be and, at the same time, many are willingly staying in the workforce longer. Some people are continuing to work until they hit ages 65-70 and beyond; even more are taking a “phased” retirement approach.

As workers save and invest in their target date investment options longer, adjusting equity exposure to align portfolio management to this new reality may help to accumulate more savings and reduce longevity risk—which could help mitigate a potential shortfall in retirement.

Mitigating Inflation Risk

Beyond equities, there is one big headline today’s retirement savers can’t ignore—the threat of inflation and its impact on purchasing power in the years to come. The years leading into and immediately after retirement can have an impact on investors, who are facing real inflation risk not seen for many years.

Based on our research and modeling, we believe there are two risk reduction strategies that are positioned to help: increasing exposure to Treasury Inflation-Protected Securities (TIPS) and adding real asset exposure leading up to retirement to help mitigate inflation risk.

From five years before retirement and through retirement, an increased exposure to TIPS to around 10% of the overall fixed income asset class allocation can be a proactive way to potentially help portfolios keep up with rising costs.
In addition to TIPS, using a diversified real asset strategy to help manage unexpected inflation shocks to a portfolio creates an opportunity to minimize an investor’s risks to areas of the market that are sensitive to inflationary pressures.

Looking At The Future For Retirement Investors

Retirees are facing headwinds across the board spanning markets with persistently low forecasts for fixed income returns to more macro issues such as increases in both life expectancy and health care costs.

At Principal, as we continue to create solutions in the face of changing market trends, we will make further enhancements to our target date suite. As financial professionals, we want to help people have more for retirement no matter the challenges in the current market environment.

Today, we find ourselves at an important inflection point. As the marketplace moves and investor behavior shifts, it couldn’t be more important to challenge our long-term views and embrace new strategies.

Investing involves risk, including possible loss of principal. Equity investment options involve greater risk, including heightened volatility, than fixed-income investment options. This material covers general information only and does not take account of any investor’s investment objectives or financial situation and should not be construed as specific investment advice, a recommendation, or be relied on in any way as a guarantee, promise, forecast or prediction of future events regarding an investment or the markets in general. Expressions of opinion and predictions are accurate as of the date of this communication and are subject to change without notice. There is no assurance that such events or projections will occur and actual conditions may be significantly different than that shown here. This material may contain ‘forward-looking’ information that is not purely historical in nature and may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass.  Reliance upon information in this material is at the sole discretion of the reader.

Target-date portfolios are managed toward a particular target date, or the approximate date the investor is expected to start withdrawing money from the portfolio. As each target-date portfolio approaches its target date, the investment mix becomes more conservative by increasing exposure to generally more conservative investments and reducing exposure to typically more aggressive investments.

Principal Global Investors leads global asset management at Principal^®

[1] As of June 30, 2021, according to the Investment Company Institute’s resource center