Revisiting Target Date Retirement Income Funds

My January 2016 column discussed target date retirement income funds. Today I’ll dig a little deeper and explain why advisors to retirement plans may wish to consider offering a series of target date retirement income funds and provide an update about a development.

Retirement Income Security The Employee Retirement Income Security Act of 1974, as amended, is the exclusive federal law that governs retirement plans. It's possible that of those serving the plan marketplace not many really think of the overall goal of ERISA: helping plan participants achieve retirement income security.

All those servicing this marketplace should help participants work toward, and hopefully achieve, this goal. The fiduciary wars that have raged for a decade now have clearly exposed the fault line between those following a fiduciary business model that are legally required to work in the "sole interest" of plan participants and those following a nonfiduciary business model that, in the words of Bob Veres, sees participants as "prey" and those servicing them as "predators."

Although achieving retirement income security is the goal for plan participants, the means by which to accomplish it obviously requires them to first focus on maximizing contributions to their plan accounts in order to help accumulate the largest sum possible prior to retirement. While an annual return of, say, 58% is always nice, it's irrelevant if the annual contribution to a plan account is, say, only $8.

The effect of contributions can, in many cases, turn out to be much larger at retirement--and even through it--when investment costs have been kept low, and diversification has been kept broad and deep to reduce risk.

When asked, I tell participants to contribute to their plan account until it hurts--at least just a bit anyway. That doesn't mean they need to go on a diet of bread and water for the rest of their working lives. However, when advised properly, many plan participants realize that they can increase their contributions at the very least by a few not-too-painless percentage points. And that can make a whale of a difference in the size of accumulated wealth at retirement (and because of that, through retirement as well) if those small increments compound long enough.

A Big Plan Balance Doesn't Necessarily Translate to Retirement Income Security Whatever the asset allocation of their retirement plan accounts, typical plan participants who begin to focus seriously on their retirement date--however far off--will tend to start investing in a more and more "conservative" portfolio of investments as they draw closer to retirement.

This often takes the form of increasing the portion of the portfolio invested in fixed-income investments and decreasing the portion invested in stocks. The thinking is that this is a "less risky" portfolio asset allocation will better protects an accumulated nest egg, thereby leading to a "safer" (and presumably happier) retirement.

The problem with this kind of thinking is that it can lead to a nightmarish retirement scenario, because it fails to identify the real risk facing plan participants in retirement. That risk is the volatility in the value of their retirement income stream, and not, as is commonly thought, the volatility in the value of the accumulated nest egg itself.

Consider two simple examples. Suppose that a risk-averse couple at retirement holds a $500,000 portfolio of certificates of deposit paying 3.5%, which generates annual income of $17,500. At some point, interest rates decrease to 1%, reducing their annual income to $5,000. That's a 71% drop in income, which can be catastrophic. Adding to this is that the nominal--that is, the stated, noninflation-adjusted--value of the portfolio remains at $500,000.

It's important to understand that even though the nominal value of the "ultrasafe" nest egg in this example has been protected--hey, at least we still have $500,000 of CDs in our portfolio!-- the retirement income stream it generates has been decimated. In this example, "protecting" the value of a portfolio by investing in safer investments didn't protect the income stream it generates.

Consider another example. Suppose that an inflation rate of 2% running for five years reduces the real --that is, inflation-adjusted--value of the retirement income stream generated by a different couple's $300,000 portfolio by 9%, or an inflation rate of 5% over five years reduces the real value of the income by 22%.

In addition to the drops in real income shown in this example, it's also important to understand that the value of the portfolio itself has dropped to $235,000 (or by 9%) or to $272,000 (or by 22%) as a result of inflation.

(Inflation is now on the march again running at an annual 2%-3%. Many commentators tut-tut that this is no big deal and, in any case, it's not a threat in the short term. However, an annual inflation rate of 3% compounded over 20 years results in a 45% loss in the purchasing power of a retirement income stream, while a rate as low as 2% results in a loss of 33%. Many folks will be in retirement for 20 or 30 years, and a one half or even one third loss in the purchasing power of their income stream could, in many cases, be upsetting to say the least. This is why inflation is often referred to as the "silent tax.")

These two examples illustrate why a greater focus on increasing the amount of "less risky" or "safer" portfolio investments--such as CDs, bonds or Treasury bills--as retirement looms ever closer are wrong-headed. While a greater proportion of such investments in a retirement plan account tends to stabilize its value, that very achievement can, unexpectedly, lead to significant instability in the retirement income of a nest egg.

Many participants in retirement plans ponder the (small or large) lump sum nest egg in their plan account and don't know how to morph it into an income stream in retirement. They need to have a mechanism by which to gain an understanding prior to retirement, at retirement, and during retirement of what they can reliably expect their retirement income to be.

Years ago, I advised a plan participant who had escaped Iran during the 1979 revolution. He had thrived in America through hard work and perseverance. He and his wife had gotten all the kids through college and out on their own, the house was paid off, they had rental properties, a high balance 401(k)--and the couple was frugal, to boot. Any advisor would have concluded just looking at his profile that he and his wife would have a very comfortable retirement.

But one question I couldnpt answer for him: How much retirement income he could expect from the lump sum of his 401(k) plan. In answer, I could provide only crude estimates with my trusty HP 12c calculator based on prevailing interest rates and inflation at the time. However, both of these factors can fluctuate greatly over time. Without understanding how the underlying lump sum was invested, and whether it was structured to consider the risks associated with the volatility of an income stream, there was no way for me to produce meaningful estimates of income. This plan participant would have been a perfect candidate for a target date retirement income fund, which considers all the risks relevant to the stability of an income stream such as inflation, interest rate, and stock market risks.

The lesson: focus more on stabilizing the retirement income of a plan account as retirement nears and less on stabilizing the value of the lump sum-account generating that income. This fits hand in glove with the overall goal of ERISA: helping plan participants achieve retirement income security. Having a large plan account balance on the verge of retirement (or at any other point in time prior to that) doesn't necessarily mean that retirement income security or stability will be achieved.

Risks to Retirement Income Security: Unexpected Changes in Inflation and Interest Rates The risk factors explained in the preceding examples--unexpected changes in inflation, interest rates, and stock markets--can each negatively impact the stability of a retirement income stream (as well as the value of the portfolio generating it). They illustrate why it's so critical to take steps to protect the integrity of retirement income even in cases where a relatively healthy portfolio has been accumulated at (or even prior to) retirement.

While these risks are well known and understood by investment professionals, no one can know when they will happen, in what magnitude they will occur or how long they will last. But these investment risks can be managed to provide more stable income for plan participants in retirement.

Target Date Retirement Income Funds A way that plan participants can manage these risks prior to, at, and after retirement, is to invest in a target date retirement income funds Although there are others on the market (BlackRock's CORI), I'll discuss the nature of the 13 funds first made available by Dimensional Fund Advisors three years ago, because they're the ones with which I'm most familiar.

Each DFA fund is a mutual fund registered under the Investment Company Act of 1940 ('40 Act). In addition to being offered as a series of investment options in retirement plans, the DFA funds can be used for IRAs, taxable accounts, etc.

Bear in mind that a target date retirement income fund does not "guarantee" a lifetime income; it's not an insurance product. Nor is it a traditional target date fund. As retirement begins to get closer, a target date fund focuses on controlling fluctuations in wealth by investing a greater proportion of the fund in "safer" investments while a target date retirement income fund focuses more on controlling fluctuations in income. However, as noted, creating a less volatile account doesn't necessarily translate to more stable retirement income. A target date fund is not designed to focus on creating a stable retirement income stream like a target date retirement income fund. This can lead plan participants away from, not toward, retirement income security.

Target date retirement income funds are monitored and rebalanced periodically and are created to correspond to a specified year around which an investor may expect to retire. For example, a 25-year old would likely invest in a 2060 fund--approximately 40 years into the future when he or she turns 65 and would be expected to retire and stop making contributions. The 13 DFA fund are offered in five-year increments: 2060, 2055, 2050, etc.

Each has a glide path (a changing asset allocation) built into it. For example, a 25-year old holding DFA’s 2060 fund would have 95% of the portfolio allocated to income growth assets--U.S. and international stocks and bonds--that have a higher expected return. At about age 45--or 20 years before retirement--any increase in the value of the income growth assets begins to be invested in income risk management assets gradually over the next 20 years to retirement by DFA.

The income risk management assets used by the DFA funds are Treasury Inflation-Protected Securities. TIPS, backed by the full faith and credit of the U.S. government, have been identified by academics as the best and lowest-cost hedging instrument available to a '40 Act-registered mutual fund. TIPS are similar to bonds except that the U.S. Treasury increases their value when inflation increases. That protects a target date retirement income fund's income stream from unexpected inflation.

TIPS also protect the income stream of a target date retirement income fund against unexpected changes in interest rates (interest-rate risk). The price of a fixed-income investment such as a bond fluctuates with changes in interest rates. When rates go up, bond prices go down and when rates go down, prices go up. Duration measures the sensitivity of a bond's price to changes in interest rates. The longer the duration of a bond, the more sensitive its price is to such changes. For example, in response to a 1% rise in interest rates, the price of a bond with a five-year duration would fall about 5% while the price of a bond with a 10-year duration would fall by about 10%.

The TIPS allocation in a DFA target date retirement income fund is designed to match the duration of a retirement income goal, which hedges the risk to that goal posed by fluctuations in interest rates. When interest rates fall, the cost of meeting an income goal rises but that’s not a worry because the value of the TIPS allocation rises as well. When interest rates rise, the TIPS allocation loses value but that's not a worry either because the cost of meeting an income goal decreases as well, thereby hedging the risk of unexpected changes in interest rates.

After about age 55, TIPS become the primary holding in a DFA fund (There's no single point in time when all TIPS are converted in a target date retirement income fund, unlike investing in, say, an annuity when the conversion to the annuity happens all at once.) By retirement at age 65, TIPS comprise about 75% of the its value, with global stocks and bonds making up the balance of 25%. (Note that the DFA target date retirement income fund's initial asset allocation of 95/5 is more aggressive than the great bulk of traditional target date funds and the 25/75 allocation at retirement is less aggressive.)

During retirement from ages 65 to 75, the allocation of the target date retirement income fund remains 25/75, and even in this phase, the gains from the 25% allocation to stocks are used to increase the expected income to age 90. The 25% allocation to stocks declines to 20% between the ages of 75 and 80 to potentially accommodate for additional years of income beyond age 90. By limiting the allocation of stocks in the fund to 25% at retirement and then 20% after age 80, DFA manages stock market risk--that is, the stock market unexpectedly going down in value sometimes a lot and/or for a long time. The investment objective of a DFA target date retirement income fund is to provide a stream of stable retirement income protected from unexpected stock market volatility, inflation and changes in interest rates from retirement at age 65 to life expectancy, which DFA assumes to be 90 years old--and at which point the fund will be liquidated. Still, in the age 75-to-90 phase, the allocation to stocks is harvested to fund income for additional years after age 90. This helps hedge longevity risk (running out of money in a long retirement).

Each of DFA's target date retirement income funds is designed to manage the uncertainty of a future retirement income stream while seeking to increase portfolio value to afford larger income in retirement. The aim of this is to give every plan participant the best chance possible of maintaining a smoother, more certain and sufficient inflation-adjusted standard of living in retirement.

Standard & Poor's Shift to Retirement Income and Decumulation (STRIDE) Index Advisors may be interested in a development that occurred shortly after my column nearly three years ago. Standard & Poor's released a series of indices--Shift to Retirement Income and Decumulation--that are consistent with the methodology behind DFA's target date retirement income funds.

When DFA came to S&P with its concept, S&P recognized that the funds solve the right problem--the instability of retirement income--with the right solution: managing the unexpected risks (changes in inflation, interest rates and stock markets as well as longevity risk) which create that very income instability.

DFA worked with S&P to create a target date series of indices. It's important for any fund provider to have a relevant, transparent benchmark for its funds that's established by an independent third party. The development of STRIDE is noteworthy for at least two reasons: Typically, target date funds don't have a third party benchmark, and previous to STRIDE there was no benchmark that provided data in terms of income. This provides plan sponsors as well as advisors with some key advantages: a framework for evaluating the performance of target date retirement income funds relative to income goals and data streams for benchmarking income-focused investments such as DFA's target date retirement income funds.

The indices focus on managing income growth early in the accumulation stage and then transitioning to income risk management for the decumulation stage closer to, and throughout, retirement. STRIDE is comprised of existing S&P stock and fixed-income indices. (It should be noted that an index is not an investment. A mutual fund tracking an index or a fund that uses an index as a benchmark is an investment.)

More specifically, STRIDE:

• considers both real retirement income risk and nominal wealth risk
• provides information that allows plan sponsors (and their advisors) to assess intelligently the health of a retirement plan
• provides information that allows plan participants to make good savings decisions in anticipation of their retirement, thereby improving their retirement readiness
• provides an asset allocation based on balancing the right trade-off of income growth versus income risk, and on managing income risk
• provides a seamless transition not only to retirement but through it as well (a "cradle to grave" solution).

Target date retirement income funds can improve the retirement readiness of plan participants, and a way for participants to monitor if they're on track to meet their retirement goals is to consult STRIDE.

Access Scott’s previous articles here. W. Scott Simon is an expert on the Uniform Prudent Investor Act and the Restatement 3rd of Trusts (Prudent Investor Rule). He provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. For more information, visit Prudent Investor Advisors, or email ssimon@prudentllc.com. The views expressed in this article do not necessarily reflect the views of Morningstar.