Hit Or Miss – Do ‘Target Date’ Funds Introduce More Investment Risks Than They Counter?
By Kevin Murphy Building in a margin of safety may be an integral part of value investing – as we noted most recently in Eyes front – but one also sees plenty of instances of it in everyday life. Most people, for example, prefer to turn up to a station a few minutes early rather than risk missing their train and most people will buy a few extra bottles for a party rather than risk seeing their guests go thirsty And almost everyone, we imagine, would be happy to admire a clifftop view from a few feet back rather than stand on the very edge and risk a long drop down. What then should we make of a type of investment fund that arguably not only verges upon this sort of brinkmanship but towards which U.K. consumers are now being encouraged to direct their money? ‘Target date’ funds, also known as ‘lifestyle funds, are portfolios whose asset mix grows progressively more conservative – essentially moving more towards bonds and cash – as the target date approaches. According to BrightScope, more than $1.1 trillion (£724bn) is now invested in these funds – a 280% increase in just five years – and the research firm predicts that figure will top $2 trillion by 2020. A significant factor in this growth was the introduction in the US of the 2006 Pension Protection Act, which obliges employers to identify a default option for staff who do not choose a specific fund for their pension contributions. Target date funds were deemed suitable candidates for this because of their evolving asset mix and the introduction of auto-enrolment in the U.K. has led to a similar trend here. Target date theory A target date fund – so the theory goes – offers greater exposure to equities for a younger investor, who may be expected to have a higher tolerance for risk. As an investor grow older, the equity allocation is scaled back in favor of increasing levels of bonds and cash so that, at the target date (usually the point of retirement), the portfolio – so the theory goes on – is effectively ‘de-risked’. But is it really? Investment risk can take many forms and, by paring back equities in favor of bonds and cash as retirement approaches, a target date fund may indeed reduce some risks for some investors. Yet we would argue this sort of fund also serves, perversely, to increase some risks for some investors – and certainly enough to raise some question marks over the vehicle’s current ‘default’ status. The principal risks that target date funds aim to address are volatility and date risk. A less volatile portfolio that offers an increasing level of, if not certainty, then at least reassurance about the eventual size of a pension pot can undeniably be helpful to certain types of investor – most obviously those planning to use that pot to buy an annuity. Anyone in that position would naturally wish to protect the pot they have built up over decades from the risk of, say, a 30% fall in equities in the months before they plan to cash it in. The problem is, now U.K. law has changed and people are no longer obliged to buy an annuity on retirement, a target date fund that moves from equities into bonds and cash is arguably not de-risking so much as ‘up-risking’. New risk considerations To our minds, target date funds bring into play two risk considerations in particular – longevity risk and inflation risk. We could discuss the first point – how long we might reasonably expect to live – in a number of ways but will restrict ourselves to just a couple. One relates to averages, the other to probability. Both bolster the case for building a margin of safety into your retirement planning. It is widely accepted that life expectancy is, on average, increasing. It is hardly prudent financial planning, however, to base the length of time you will need your pension pot to last on an average. By definition, a significant number of people live longer than average and it make sense to work on the basis that you could well be one of them. To frame this point in a different way, the following table aims to give an indication of just how people can live longer than average. It shows the percentage chances of someone in the U.K. making it to their 100th birthday, depending on their age today. So a 65-year-old man now has a roughly one-in-12 chance of living to 100 while, for a 65-year-old woman, it is closer to a one-in-eight chance. Males Females Total Age in 2011 Population in 2011(‘000s) Chance of reaching age 100 Number to reach age 100 (‘000s) Population in 2011 (‘000s) Chance of reaching age 100 Number to reach age 100 (‘000s) Number to reach age 100 (‘000s) 0 397 25.7% 102 378 33.4% 126 228 1 398 25.5% 101 379 33.1% 126 227 2 401 25.1% 101 383 32.8% 125 226 3 404 24.8% 100 386 32.4% 125 225 4 388 24.4% 95 370 32.1% 119 213 5 375 24.1% 90 359 31.7% 114 204 6 367 23.8% 87 351 31.3% 110 197 7 362 23.4% 85 345 31.0% 107 192 8 350 23.1% 81 333 30.6% 102 183 9 340 22.7% 77 325 30.2% 98 176 10 340 22.4% 76 326 29.9% 97 174 11 350 22.1% 77 332 29.5% 98 175 12 359 21.7% 78 343 29.1% 100 178 13 365 21.4% 78 349 28.8% 101 179 14 377 21.1% 79 358 28.4% 102 181 15 375 20.7% 78 356 28.1% 100 178 16 379 20.4% 77 359 27.7% 99 177 17 390 20.1% 78 370 27.3% 101 179 18 401 19.8% 79 381 27.0% 103 182 19 421 19.4% 82 401 26.6% 107 189 20 436 19.1% 83 412 26.3% 108 192 21 436 18.8% 82 415 25.9% 108 190 22 442 18.5% 82 426 25.6% 109 191 23 457 18.2% 83 439 25.2% 111 194 24 458 17.9% 82 438 24.9% 109 191 25 459 17.6% 81 446 24.5% 109 190 26 468 17.3% 81 447 24.2% 108 189 27 457 17.0% 78 431 23.9% 103 181 28 442 16.7% 74 414 23.5% 97 171 29 423 16.4% 69 411 23.2% 95 165 30 430 16.1% 69 417 22.8% 95 165 31 425 15.8% 67 414 22.5% 93 161 32 401 15.6% 62 397 22.2% 88 150 33 379 15.3% 58 379 21.9% 83 141 34 373 15.0% 56 372 21.5% 80 136 35 383 14.8% 57 382 21.2% 81 137 36 392 14.5% 57 392 20.9% 82 139 37 400 14.2% 57 402 20.6% 83 140 38 417 14.0% 58 422 20.3% 86 144 39 435 13.7% 60 446 19.9% 89 149 40 448 13.5% 60 457 19.6% 90 150 41 446 13.2% 59 451 19.3% 87 146 42 455 13.0% 59 464 19.0% 88 147 43 460 12.7% 58 465 18.7% 87 145 44 469 12.5% 58 475 18.4% 87 146 45 463 12.2% 57 476 18.1% 86 143 46 464 12.0% 56 478 17.8% 85 141 47 457 11.8% 54 474 17.5% 83 137 48 448 11.5% 52 467 17.3% 81 132 49 437 11.3% 49 453 17.0% 77 126 50 427 11.1% 47 441 16.7% 74 121 51 410 10.9% 45 423 16.4% 69 114 52 402 10.7% 43 413 16.2% 67 110 53 396 10.5% 41 405 15.9% 64 106 54 380 10.3% 39 390 15.7% 61 100 55 365 10.1% 37 376 15.4% 58 95 56 355 9.9% 35 365 15.2% 55 91 57 354 9.7% 35 365 14.9% 55 89 58 347 9.6% 33 358 14.7% 53 86 59 342 9.4% 32 356 14.5% 51 84 60 341 9.2% 32 358 14.2% 51 82 61 348 9.1% 32 367 14.0% 51 83 62 357 8.9% 32 376 13.8% 52 84 63 381 8.8% 33 402 13.6% 54 88 64 397 8.6% 34 420 13.4% 56 90 65 319 8.5% 27 340 13.2% 45 72 66 308 8.4% 26 330 13.0% 43 68 67 300 8.3% 25 320 12.8% 41 66 68 284 8.2% 23 308 12.6% 39 62 69 254 8.1% 20 277 12.5% 35 55 70 235 8.0% 19 259 12.3% 32 51 71 241 7.9% 19 268 12.2% 33 52 72 236 7.8% 18 266 12.0% 32 50 73 229 7.6% 17 260 11.7% 30 48 74 218 7.5% 16 251 11.4% 29 45 75 206 7.3% 15 242 11.1% 27 42 76 194 7.0% 14 231 10.7% 25 38 77 178 6.8% 12 219 10.3% 22 35 78 170 6.6% 11 213 9.8% 21 32 79 162 6.3% 10 208 9.4% 20 30 80 152 6.1% 9 203 9.0% 18 28 81 138 5.9% 8 192 8.7% 17 25 82 124 5.8% 7 179 8.5% 15 22 83 110 5.8% 6 164 8.4% 14 20 84 100 5.9% 6 155 8.4% 13 19 85 89 6.0% 5 145 8.5% 12 18 86 77 6.2% 5 132 8.7% 11 16 87 66 6.5% 4 120 8.9% 11 15 88 56 6.9% 4 108 9.3% 10 14 89 49 7.4% 4 99 9.8% 10 13 90 42 8.1% 3 91 10.4% 9 13 91 32 9.0% 3 73 11.3% 8 11 92 22 10.2% 2 51 12.6% 6 9 93 14 11.9% 2 36 14.5% 5 7 94 11 14.4% 2 29 17.2% 5 6 95 8 18.2% 1 23 21.1% 5 6 96 6 23.8% 1 18 27.0% 5 6 97 4 32.3% 1 13 35.8% 5 6 98 2 45.5% 1 9 49.0% 5 6 99 2 66.3% 1 6 68.9% 4 5 Source: Department for Work and Pensions, April 2011 In terms of significance of impact, we are closer here to a clifftop fall than a missed train. When it comes to planning a comfortable retirement, of course you build in a margin of safety – and that means considering the outliers. Today, 35-year-old men and women have, respectively, a one-in-seven and a one-in-five chance of reaching 100. Prudent financial planning As we illustrated in Mean well , averages are not as simple as one might imagine. In the context of ‘average’ life expectancy, we would all do well to think in terms of the ‘median’ or ‘mode’ rather than the necessarily shorter ‘arithmetic mean’. Simply put, to lessen the chances of your money running out, it would seem prudent to factor the possibility of a ripe old age into your financial planning. A second important point is that you do not want to plan your retirement in such a way that you reach 65 with the prospect of living decades longer while holding a pension pot that has actively worked to minimize almost all hope of growing your money over that time. This, of course, leads to our other major concern about target date funds – inflation risk. ‘De-risking’ a portfolio by moving into bonds and cash may have become the perceived wisdom in some circles on both sides of the Atlantic, but it totally ignores the potential impact of inflation. Sitting for any significant amount of time in assets – including bonds and, especially, cash – that offer little or no protection against inflation is, frankly, not responsible financial planning. Say you need an annual income of £10,000 in retirement and inflation holds steady at 3% – if your assets see no growth then, were you to make it to 100, inflation would have effectively eroded that £10,000 down to some £3,500. So how do you go about protecting your retirement income from the risk of inflation? If you want to retain your purchasing power over the coming years, and possibly decades, you will need your pension pot to increase, on average, at least by the rate of inflation. A growing income Since temporary fluctuations in the size of their pension pot are likely to be of less concern to most people than seeing their income steadily eroded by the effects of inflation, a portfolio of equities that is prudently managed with a view to generating a growing income over time has to be a consideration for a section of the population that has particular reason to be worried about longevity and inflation. Here on The Value Perspective, we can see why target date funds have been held out in recent years as a solid default option for – and consequently embraced by – employers and pension schemes. Do not forget, however, that any duty of care they owe you stops the day you retire – at which point, unless you are in a position to obtain financial advice, you are pretty much on your own. A real income strategy is, we believe, better able to offer more people a greater margin of safety – and thus comfort – as they save for and then live through their retirement than the target date funds that, in some quarters, are now held out as the way ahead for employers and pension schemes. Standing at the top of a cliff is not the only time you need to be wary about any sort of ‘great leap forward’.