Are Target Date Funds Dead?

I honestly do not know why the “holy s*&t Target Date Funds must have had an awful period” just came to my mind.

I wrote a post on the infamous the Cederburg’s paper, A Critical Assessment of Lifecycle Investment Advice, not a long time ago. One of the (few?) reasonable conclusions of the paper was that bond portfolios rarely recover after an inflation shock.

So I went to check how the Vanguard 2020 TDF has performed in the last 5 years. Vanguard, like many other TDF providers, does not offer a fund for every possible retirement year. Considering that the inflation shock happened in 2022, the 2021 class of retirees might have suffered the hardest hit but Vanguard doesn’t have a fund exactly designed for that cohort. So I had to use 2020 as a proxy. [If you are planning to retire in 2027, you can create your own TDF by allocating 60% to the 2025 one and 40% to the 2030 one…if my math is correct? Anyway, the point of this post, spoiler alert, is that TDF are bad products so…not really something worth pondering about]

What’s inside this fund?

It is a mix of global stocks and bonds, no surprises. There’s a nod to the inflation risk, represented by that c13% allocated to TIPS.

If you do not know, or do not remember, TDFs are designed to gradually shift their allocation from stocks to bonds as the target retirement date gets closer. This shift is not completed during the target retirement year but will continue for some years after retirement. The 2020 TDF will arrive at this target allocation:

A 30 stock /70 bond allocation.

How our hypothetical retiree would have done from 2019 onwards? Here is a simulation with PortfolioVisualizer (old habits..), where I compare an investment in the Vanguard TDF with the classic 60/40. I assume a 4% withdrawal rate adjusted for inflation each year:

The timeframe considered is not great but this is what we have. The critical point is what happens to the two portfolios after the stock market starts to recover in 2023. In a bit more than a year, the 60/40 is back in REAL TERMS above the level when the retiree started to live out of their savings: this is net of the 4% yearly withdrawals. The TDF is still below and….we will only see it in another five years…I do not think it will ever get back above that line.

We are asking a 70% bond portfolio to generate close to a 4% yearly real return; close because we do not want to do it in perpetuity, but probably close enough considering that we are all living longer and longer (or not. Mortality rates stopped improving in the US and the UK lately). The issue with “close but close enough” is that once you start to eat your principal, things get bad slowly…and then all of a sudden. Even if the portfolio generates the same % yield, the amount working for the retiree gets smaller each year, so each year they have to consume more principal, snowballing the problem to catastrophe.

This is where the V glide path strategy shines. I wrote about it two years ago and it looks like the premonition is coming to bite us all. Retirement portfolios following the V-strategy (nothing to do with The Boys) start to increase their stock allocation around five years post-retirement: this gives the portfolio at least the chance to recover after a drawdown, by allocating to the asset that has the highest chances to beat the 4% real withdrawal rate.

Failed Strategy

The initial failure of the TDF strategy is that it relies on stock/bond diversification to side-step drawdowns: as we all know, 2022 and inflation brought us a different plot compared to what the TDF was expecting.

Here is how a three-leg strategy, the Model Portfolio, would have performed in the same period:

The timeframe is a bit squeezed because DBMF was launched in mid-2019.

The glide path and the higher bond allocation were meant to do what trend following did. Now, they are adding insult to injury, especially if inflation continues to stay with us. Unless we see inflation go down, and stay down (which is always a possibility), bonds have to increase their term premium to generate sufficient returns. But if that happens, current investors would see the value of their holdings reduce even more.

TDFs risk a one-two punch: first by not avoiding the drawdown and then by the overallocating to the wrong asset. All of this while TDFs were sold as the benchmark retirement solution to plenty of investors in the last 10 years. What happens when they realise the dream is broken?

The V-glide path might not be the solution either. The idea to start buying stocks at these valuations… Actually, it might not be that bad if the stock market dives soon, since the hypothetical smart-TDF would buy while stocks get cheaper and cheaper. The nightmare scenario is if stocks do not move from here: the smart-TDF would sell a 4.7% yielding asset (bonds) to buy a 1.88% one (the current ACWI dividend yield).

Path to Nowhere?

The purpose of a glide path is to manage risk and optimize returns as the investor approaches a specific target date of time horizon, such as retirement. Essentially, a glide path is a plan for how an investment portfolio will shift from a more aggressive investment strategy to a more conservative one over time.

Even a static 75/25 allocation might be fine post-retirement. The issue is that is not aggressive enough to get there.

Let’s assume we start with $10k and we add$10k/year, inflation-adjusted, for the next 35 years:

The difference in terminal value is absurd. Ok but this is just one period, what about a Monte Carlo simulation?

Luckily, PortfolioVisualizer still works for that; I used the same ingredients as before. Here is the 75/25 portfolio:

Here is the 100% stock portfolio:

Starting from the 50th percentile, the difference in terminal value is material.

It looks like having a glide path is better than not. [Unless we use a different pool of asset classes and leverage but good luck finding where to Monte Carlo test that].

Benefits of TDF

TDFs relieve investors of the burden of choosing the allocation between equity funds and bond funds in their portfolios, replacing that decision with an automatic age-dependent rule. They also provide the discipline of rebalancing that many investors fail to exhibit when self-managing a portfolio. 

Research papers show that retirement savers in TDFs (and similar auto-rebalancing strategies) have become contrarian traders who reduce market fluctuations even in times of extreme market stress and volatility (such as during the COVID-19 crisis). TDFs are so big that there are now studies showing how they are destroying momentum strategies (the momentum premium arises from mistakes in human reasoning).

The issue with TDF seems to be that they reduce stocks exposure too much and for too long (and also that they are not diversified enough ;)). Let’s talk again in a five-year time.

p.s. NO RESULTING 😉

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