Nevertheless, this is not to dismiss them. TDF have some notable advantages e.g. they have an inbuilt advice model. TDF automatically de-risk the portfolio with the age of the investor by down weighting the equity allocation and increasing the allocation to cash and fixed interest. This is attractive to those who are unable to afford investment advice or are not interested in seeking investment advice.
Nevertheless, it is important to understand their short comings given their growing dominance international. (According to the FT “Assets held in US target date mutual funds now stand at $1.1tn, compared with $70bn in 2005, according to first-quarter data compiled by the Investment Company Institute, a trade body.”
Locally, TDF have also been raised as a possible addition to the KiwiSaver landscape as a Default Fund option. They are very much part of the investment landscape in Australia.
In my mind TDF don’t address the inherit weaknesses of current investment products that overly simplify the retirement investment solution by focusing on:
- Accumulated wealth as the primary goal; and a
- Formulaic (prescribed) approach of adjusting allocations to equities over the period up to retirement based on age.
TDF may not be the investment solution that addresses key retirement issues, just as Annuities are also not the solution. Arguably, TDF don’t have an investment objective.
Improvements in the investment solution and a more robust portfolio can be developed by engaging in a more goal orientated investment approach that:
- Has a focus on the generation of retirement income as an investment goal; and
- Employs a more sophisticated cash and fixed interest solution that generates a more stable level of retirement income (much like insurance companies employ to meet future liabilities (insurance claims).
The investment knowledge is available now to implement these investment solution enhancements.
This new approach will bring more rigor to the investment strategy and a move away from rules of thumbs such as the 4% Rule and adjusting the equity allocation based on age alone.
At the centre of a more robust approach is the focussing on the generation of retirement income.
Accumulated wealth is important, you can say you are rich with a million-dollar investment portfolio.
However, this million-dollars does not tell you the standard of living you may be able to support in retirement. Some may well say a very good one! And that may well depend on whether you live in Auckland or Gore.
How about the volatility of income in retirement?
By way of example, prior to the Global Financial Crisis (GFC) a New Zealand investor could get 7-8% on cash at the bank, lets say $70k in income on your million dollar investment.
Current term deposit rates are around 3.5%, that’s a 50% fall in income!! And interest rates have been at these levels for some time and if the Reserve Bank of New Zealand is right they will continue to remain at these levels for some time.
Of course, these issues are not the concern of the ultra-wealthy. They are nevertheless vitally important for the less wealthy. They could have a detrimental impact on the standard of living in retirement for many people.
Furthermore, with an income focus, as interest rates rise (they will some day!) more informed investment decisions can be made and importantly investment strategies can be undertaken to help minimise the volatility of income in retirement.
Therefore, we should not just focus on the generation of retirement income as the investment goal but also consider how we can manage the volatility of income in retirement. As I say, the knowledge to do this is already available.
This FT article on the short comings of TDF may be of interest.
The article highlights the risk to the industry.
The following section of the FT article is most relevant to the discussion above:
…….. “This underscores the importance of crafting investment products that generate sustained income for retirees, says Lionel Martellini, a professor at Edhec currently seconded to Princeton.
Prof Martellini says the key shortcoming with target date funds the group has identified is the fact that the bond allocation, intended to be the safe portion of the portfolio, is often risky. This risk hinges on the fact that bond portfolios offer — but do not guarantee — income, according to the researchers.
The fixed income allocation should look more like an annuity, Prof Martellini says, a financial product that pays a steady stream of income to the holder. But it must avoid the pitfalls of annuities, namely a lack of flexibility that means they cannot be passed on to a next of kin, for example.
“That’s what we’re talking about — a bond portfolio that is a good proxy for the cash flow that people need. Such a simple move will add a large benefit to how much replacement income you can generate,” Prof Martellini says. Critics say target date funds fail to achieve this because their fixed income portfolios are composed of short-term bonds that are beholden to market risks and do not take into account retirees’ different income expectations.” ………………..
The final comments are consistent with the point made above with having a more sophisticated cash and fixed interest investment solution.
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