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The Case for Higher Equity Exposure in Target-Date Funds

Harry Milling

Harry Milling: This is Harry Milling, mutual fund analyst with Morningstar. I'm here with Jerome Clark. He is the head of T. Rowe Price's target date funds. Welcome, Jerome.

Jerome Clark: Thank you.

Milling: These funds have an above-average equity allocation and that resulted in some underperformance in 2008. Of course, they roared back in 2009 along with the stock market.

My question is, though, for the long term, why should an investor take that added equity risk with their target date funds?

Clark: Well if you look at the 2008 market, it's true those funds that had a high equity allocation did have challenging times. But if you look at 2009, they actually had the opposite thing occur with up markets, those with higher equity allocation did quite well.

If you look at each of those years, year by year, and you were to design a strategy based upon that year, you would have very different approaches based upon these very short, certain market situations.

I think that any provider of a target date fund will tell you it's an advocate of coming up with a long-term strategy based upon a long-term outlook, because it's years of investing for retiring, and once you retiring, years of utilizing those assets to support your retirement.

So, it's really about coming up with a long-term strategy. What our analysis shows is for a higher equity allocation does quite well over a longer time period.

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Milling: Right and that is, I guess, speaking to the fact that historically equities have outperformed fixed income investments. Also, two other things come to mind. One, that the withdrawal rates after age 65 are much higher than first thought. I think that the industry thought it was 4%. It's really around 8%, your studies show?

Clark: Well, the recommendation is 4% for these long time periods. If you're thinking of a long retirement, you should be thinking 4%.

You're right. When in actuality, reality is when you look at investor behavior once they hit retirement it's much closer to 9%, even closer to 10%.

So, what you need is an asset allocation strategy that's very robust and can do well in various types of withdrawal strategies because you never know what type of circumstance you're going to have once you hit retirement.

Milling: Right. So, that helps account for your higher equity allocations.

Clark: Right. Our studies show that actually the higher the withdrawal that you take out, the more requirement that you put on those assets in retirement, that the higher equity allocation actually does better.

Milling: So, I'm 55, let's say I'm not really, and the target dates typically have an end point of age 65, target date funds envision a multi-decade relationship, why would I go in to T. Rowe's target date funds if I'm 55?

Clark: Well ... it's a retirement date, but not the end date. We think of the end date as your life expectancy, so we're thinking from our perspective, not retirement but 30 years longer.

If you look at statistics, for example, a 65 year old couple today has a 50% chance of one of them living to the age of 90, a 25% chance of one of them living to the age of 25.

For even a younger couple, for example, the example you just gave a 55 year old, it's even going to be longer than that.

So, because of these long life expectancies, it is still very appropriate if you want to have an income stream that's going to support you over those multi-decades in retirement, even after you hit retirement, that a higher equity allocation will do that better for you.

Milling: Right, and it seems that T. Rowe has a much higher equity allocation. I shouldn't say "much higher" but certainly an above-average equity allocation versus their peers after the age 65, because you do tactical allocation for a good 30 years after the retirement date.

Clark: Yes. There's a difference. Tactical is making decisions based upon short-term environments.

We do continue our glide path going from a 55% equity allocation. We do continue to move out of equities into fixed income for principal protection over a 30-year time period until the expected age of 95.

Milling: Right. And just to give viewers a sense of the difference, it's around 55% [equities] at 65, right?

Clark: Yes.

Milling: And others can be as much as 80% fixed income and 20% equity, just to let them know the difference.

But lastly, alternative investments have crept into target date lineups more and more for purposes of hedging against inflation, having assets that are not as correlated to the equity market. T. Rowe Price doesn't have any. What's going on there?

Clark: Well we do believe in diversification. I think that what you're seeing is in a theme among target date providers of increasing diversification, if it makes sense.

So, you're always looking to see is there a way to maybe help your expected returns long-term or decrease your volatility.

A big focus for us has been focusing in on, what if we hit a certain inflationary environment, high inflation, or a rising-inflation environment?

When we look at different asset classes, alternative asset classes, we look at TIPS, we look at REITs, at commodities, natural resources.

When we look at those things, we do see a case to be made for them. So, we've done extensive studies on that, and we're presenting those findings to management along with a recommendation. I have to leave it at that.

Milling: OK. Well then we'll leave it at that. Thanks very much, Jerome.

Clark: I appreciate it.

Milling: All right.