Over the last 20 years, Americans saving for retirement have
poured more than $600 billion into target date funds. On the surface, these
funds may look simple: You pick a fund aligned to the year you plan to retire
and a professional fund manager handles the investment choices. But under the
surface, things are more complex—target date funds can be managed very
differently and may produce very different outcomes.
All target date funds start with a pretty significant
investment in stocks, which have historically delivered greater growth than
bonds or cash but also have had more volatility. Over time, target date funds
reduce the stock portion of the portfolio, shifting to bonds and cash while
trying to balance market risk and growth potential. But there is a major debate
in the industry over just how to do that.
One approach, called the “to” strategy, grows more
conservative up to the target retirement date, then holds the stock allocation
constant. This approach helps reduce market risk around the age of retirement.
Another approach, called the “through” strategy, reduces the stock portion more
gradually through the early years of retirement. A “through” approach may allow
for more volatility, but seeks greater growth potential.
New Fidelity research finds that an investment strategy
built to last through rather than to retirement is likely to lead to more
wealth—both at the start of retirement and over the course of a lifetime. This
may be especially important because people leaving the workforce today may need
to fund decades of retirement.
How to change your
mix over time
The way a target date fund adjusts the mix of investments
over time is generally called its glide path. You can see below how both the
“to” and “through” approaches start out with most of the portfolio in
stocks—averaging close to 90% for a hypothetical person age 25.
But as time goes on, the two approaches differ. In general,
a fund that uses a “through” approach keeps more in equities as you near and
enter retirement than a plan built “to” a retirement date. Many “to” funds drop
their stock allocation below 40% by age 60, and leave it there. Later in
retirement, however, many “to” funds have more money in stocks than the Freedom
Funds, which continue to grow more conservative.
Volatility and wealth
We measured the potential difference in wealth between the
“to” and “through” strategies shown above using a metric we call the wealth
buffer. Our research compared the “to” and “through” approaches using both
actual and hypothetical market environments that an investor could experience
over his or her working and retirement years. In our analysis, we assumed an
individual followed a “to” or “through” investment strategy from age 25—common
for retirement investors today—to retirement at age 65, and we measured the
size and direction of the wealth buffer.
Based on the assumptions in our study, we found that in the
vast majority of actual and hypothetical market environments an investor could
experience over his or her lifetime, a “through” strategy appears to have more
potential to accumulate greater wealth at retirement than a “to” approach. The
total wealth at age 65 for the "through" glide path is greater than
the wealth for the "to" glide path in 90% of simulated macroeconomic
environments.
Market risk
But what about market risk around retirement? To answer this
question, we looked at what would have happened in the event of a major market
downturn around the age of retirement for a “through” and “to” approach. For
the analysis, we used the average of the 20 largest U.S. stock market declines
in the last 100 years. As shown in the chart below, regardless of whether the
stock market decline occurred at age 55, 60, or 65, a wealth buffer provided a
cushion against most of the worst U.S. stock market declines. The only
exception was the market drop that occurred during the Great Depression of the
1930s.
The ability to withstand a downturn comes from the fact that
investors have a long time to build their retirement savings while working, and
some may have another 20 to 30 years of investing to meet their retirement
income needs even when they reach their retirement age. The advantage of having
so much time to invest is that individuals may be able to invest in more
stocks, ride out the volatility, and try to take advantage of the growth
potential.
Bottom line
It’s important to keep in mind that no investment strategy
is likely to be successful if you do not save enough. Fidelity thinks that most
people need to save at least 10% to 15% of their income to meet their
retirement goals. But while saving enough is necessary, it’s not sufficient;
you also need to get your asset allocation right.
Fidelity’s target date fund research suggests that while
leaving more of a portfolio in stocks around the retirement age may create the
potential for more volatility, most of the time a “through” strategy may leave
you in a better position than a “to” strategy to fund a long retirement. In
fact, we find that focusing on reducing market volatility risk at retirement
can increase the risk that you will run out of assets in retirement.
Click
here to access the full article on Fidelity.