Target date funds that have reached the end of their glide path and have a 30% stocks, 70% bonds allocation may produce essentially no return on an inflation-adjusted basis over the next ten years.
Target date funds operate under the assumption that someone’s asset allocation should follow a glide path, automatically shifting a portfolio to favor bonds over stocks as a person gets closer to their expected year of retirement.
The rationale for offering target date funds is presumably altruistic: help investors facing a long retirement to avoid investment mistakes that may deplete their nest egg.
However, the inflexible nature of the glide path’s embrace of bonds could reintroduce short-fall risk if fixed-income returns are too small to materially make up for account withdrawals and the expected rising cost of living.
In examining the potential for that risk, Horizon Investments followed a two-step process. First, we collected the projected ten-year returns for global markets published by 12 of the leading investment managers in the industry – the average of their projections is detailed below.
Using these projections, and three representative portfolio allocations found in a typical target date fund glide path, Horizon then calculated annualized returns for people who are:
- Far from retiring with a mix of 90% stocks, 10% bonds
- Nearing retirement with a mix of 60% stocks, 40% bonds
- In retirement with a mix of 30% stocks, 70% bonds1
Based on industry forecasts, retirees with money in a target date fund that’s reached the end of its glide path is expected to produce an average annual return of essentially 0% for the next decade when factoring in the Federal Reserve’s quest to target an inflation rate of 2%. (Note: a retiree’s annual rate of inflation may exceed the Fed’s 2% target. For example, healthcare costs alone are projected to rise by 5.9% per year during a 25-year retirement, according to Healthview Services.2)
Horizon, as a goals-based investment manager that utilizes active portfolio strategies, believes financial planning in a low-yield world should proactively seek to offset the potentially corrosive impact of both historically small bond yields and rising inflation as a retiree pursues their objectives for current income and legacy wealth.
We also believe that advisors may want to take an active approach to managing those parts of a client’s portfolio that involve glide path strategies given the potential short-fall risks (see our Q2 FOCUS magazine article on active financial advice being the new reality).
Horizon believes that advisors and their clients may want to consider active fixed-income investment management, bond-like alternatives and a larger tilt towards equities to provide the income and growth that today’s retirees will likely need over the course of a long retirement. See the Real Spend® product page for details on Horizon’s distribution strategies that seek to address both short-fall and longevity risks.
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Further reading:
Junk-Bond Yields Don’t Provide Much of a Cushion Against Inflation
Abnormally Low Interest Rates to Remain Even If Fed Hikes in 2023
If Inflation Returns, Bond’s Diversification Power May Disappear
Essentially Nothing. That’s How Much Bonds May Return Over Next Five Years
Home Prices to the Moon? Americans Say `No Thanks’
Bond Market Bears Growling as 10-Yr Yield Tops 1%
It’s Getting Harder to Fund Retirement Using Bonds
7.9 Trillion Reasons Not to Fight the Fed, ECB, BOJ or BOE
1 To calculate the projected returns, Horizon assumed the equity allocation was comprised of 75% U.S.large-cap stocks and 25% international stocks (comprising 80% developed market, ex-US stocks and 20% emerging market stocks) with the bond portion allocated to U.S. Treasuries.
2 Source: Healthview Services, “2021 Retirement Healthcare Costs Data Report’’
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