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TDFs: Shielding Investors from Market Extremes – and Themselves

There’s no shortage of headlines to make investors skittish these days, but target date funds are constructed to endure ups and downs and eliminate misguided attempts at timing the market.

Nearly $0.70 of every $1 that is committed to a target date fund (TDF) goes into an index-based TDF. No firm is more closely associated with innovative and low-cost index investing than Vanguard, and 15 years after the launch of its first TDF, we sat down with Vanguard’s John Croke, Head of Multi-Asset Product Management, and Scott Donaldson, Senior Investment Strategist for Multi-Asset Solutions, to discuss how TDFs have evolved and the role they play in portfolios today.

What have been the biggest benefits of TDFs to investors both inside DC plans and those who’ve chosen them for their personal investing?

Scott Donaldson: In short, simplified decision-making. The process of investing is often inhibited by hesitation over portfolio construction and asset allocation. With TDFs you pick the date you plan to retire, and then professional money management and rebalancing of investment allocations automatically occur on an ongoing basis. Investor risk profiles have become much more age-appropriate and portfolios are better diversified. What’s more, TDFs have lowered the hurdle of choice and put millions of investors well on their way to saving for retirement.

John Croke: We’ve also seen a trend in TDFs that in many ways is an amplification of broader investment trends, in terms of the movement from high-cost active strategies to low-cost index-based strategies. TDFs allow investors who lack the time, willingness, or ability to make and manage ongoing investment decisions to still be set up for success by having an asset allocation strategy they stick to no matter the ebbs and flows of the market. They also give investors control over one of the few things they can control in investing – their costs.  

Plan participants and sponsors are seeing things in the news that may be new to them – tariffs, inflation, rising interest rates, and so forth. How should investors think about these issues and their TDF investments?

Donaldson: Market events are going to occur. TDFs keep investors focused on the target, behaviorally speaking, and help them avoid the moments of “Oh, boy, the markets are down, it’s time to bail out.” Because of their professionally designed asset allocation and diversification, TDFs keep investors from making those harmful timing and behavioral mistakes that, over the long run, could cause them to miss their investment objectives. TDFs have this mechanical adherence to predefined targets built into them that automatically helps investors to remain diversified. This helps put investors in an appropriate position to meet their long-term goals.

Croke: When you look at the behavior of target date fund investors during the deepest, darkest days of 2008 and 2009, you see inactivity to an overwhelming degree. Those TDFs were rebalancing, selling bonds and buying equities, as the equity market went down – generally exercising a time-tested discipline that most self-directed retail investors fail to do on their own. In the subsequent recovery, those TDF investors who stayed put came out fantastically well, and better off than those that made poor risk-decreasing decisions during that volatile period.

TDFs appeal to such a wide range of people across all ages and walks of life. As the industry approaches the $2 trillion threshold, what should plan sponsors be thinking about in the near-term, say the next three years?

Croke: When we hit these big, round numbers it tends to kick off these types of conversations. It is true that TDFs appeal to all walks of life. From the data that we’ve tracked over many years at Vanguard we know that only about half of investors in target date funds were automatically enrolled into these strategies. The other half of target date investors proactively decided to allocate to these strategies, hand it over to a professional and perhaps spend their time focused on other things – hopefully saving more and engaging in other activities that are going to really move the needle in terms of retirement outcomes.

A lot of that growth you mentioned in the TDF industry is driven by the good things that plan sponsors in particular have been doing outside of target date funds – simplifying their investment menus, adopting automatic enrollment, adopting automatic escalation, revisiting their match formulas – all with the objective of getting people to save more and in a way that is balanced, diversified, and gives you an age-appropriate asset allocation. We’d like plan sponsors to know they’ve already done a lot to set up their participants for success, and to worry less about what’s going to happen with tariffs, trade wars, geopolitical events or whatever the topic du jour happens to be. Focus on what you can do within your plan design and how you’re interacting with and engaging participants with education and support.

Let’s go back to 2003, when Vanguard first entered the TDF space. How have the bond and equity markets changed during that time? How have Vanguard Target Retirement Funds changed? For a reference point, the S&P 500 was close to bottoming from the dotcom bust, trading around 900 in January 2003. The 10-year Treasury was yielding around 4 percent.

Donaldson: The fixed income markets have changed in makeup and size on a global basis since the 2008-’09 financial crisis. How have our funds changed to react to that? Interestingly, our philosophy and methodology are in general a market cap-weighted strategy within each asset class. All of our target date funds, therefore, track the changes of the market as designed. Their composition changes according to how the equity and bond markets change. We think that is an appropriate strategy to provide and maintain diversification.

So, while the equity market has gone from 900 to where it is now, and yields from four to sub-two percent, and now working their way back – with all those changes, our funds have not changed that much, and that’s by design. TDFs are long term-oriented products, in our view. Theoretically, there shouldn’t be a lot of changes expected, but we have altered the construction of the glide path a little bit over time, primarily by becoming more globally diversified as investors have become more comfortable with that, and as the global markets have become more liquid and more transparent. We think it has been a great advantage to be able to add non-U.S. exposure at a very low cost.

At Vanguard, we have constant debate about what should be included target date funds, or how they should be constructed. But we don’t advocate constant change.

Looking ahead, how will plan design adapt to address the needs of the youngest Boomers and the oldest GenXers? What can the industry do to help retirees convert wealth to income?

Croke: The greatest opportunity is in evolving the overall mindset in relation to DC plans, moving beyond the perception of plans solely as savings and accumulation vehicles. We’re starting to see DC plans evolve into true retirement plans, and that requires changing plan design features around distribution, investment menus and the potential for advice beyond pure asset allocation. We continue to observe a lot of plans where, if you take a dime out, you’re compelled to take everything. And, you’re automatically forcing a participant into the retail IRA world.

There are opportunities to allow participants to set up systematic withdrawals, or rules-based withdrawals, in a way that aligns to what the participant believes they need to meet their basic and discretionary income needs in retirement.

We do think advice is going to be part of the evolution, too, and perhaps to a greater degree as we look out over the next decade and beyond. We see the opportunity to deliver advice in different ways to allow participants to navigate the retirement income challenge and accommodate the wide variety of circumstances, lifestyles, health statuses, and household structures – things that vary so much from person to person that they need something beyond one-size-fits all solutions. The plan design improvements we’ve observed across our industry over the past decade – of which target date funds have been a big part – represent a great platform for the continued evolution of DC plans from accumulation into broader, more holistic retirement platforms.

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Notes:

  • For more information about Vanguard funds, visit vanguard.com or call 800-523-1036 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.
  • Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.
  • Diversification does not ensure a profit or protect against a loss.
  • All investing is subject to risk, including the possible loss of the money you invest.
  • Investments in Target Retirement Funds are subject to the risks of their underlying funds. The year in the fund name refers to the approximate year (the target date) when an investor in the fund would retire and leave the workforce. The fund will gradually shift its emphasis from more aggressive investments to more conservative ones based on its target date. An investment in a Target Retirement Fund is not guaranteed at any time, including on or after the target date.
  • Please remember that all investments involve some risk. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
  • Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk.

© 2018 The Vanguard Group, Inc. All rights reserved. Vanguard Marketing Corporation, Distributor.

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