Dimensional Fund Advisors (DFA) takes a more direct approach to immunizing retirement liabilities through their target-date retirement income funds. These funds provide a useful case study for understanding the role bond funds play in meeting retirement expenses.
One of the defining distinctions for retirement income planning as opposed to traditional wealth management is that the focus shifts to meeting an ongoing spending objective. Traditional target-date funds (TDFs) are designed to increase nominal account balances while managing account balance volatility—they are not built to meet a spending objective.
They provide an assets-only investing framework. However, a stable account balance does not necessarily translate to stable income thanks to daily fluctuations in interest rates. DFA bridges this divide by providing a target-date fund with a more complete risk management framework that manages volatility of expected affordable retirement spending.
The essential point to understanding how target-date retirement income funds differ dramatically from traditional target date funds is to realize that controlling account balance volatility and spending volatility are two entirely different matters.
It is easy to overlook this point in our world, where something like the 4% rule tends to be the default retirement strategy. Its success is justified because it worked historically or can be expected to work on average – not because of how current interest rates or capital market expectations relate to sustainable retirement spending.
Traditional target-date funds focus on controlling portfolio volatility as the target date (retirement) approaches.
This focus may be due either to the belief that capital preservation becomes the primary concern of the retiree near their target date, or a naïve belief (because something like the 4% rule is in the back of one’s mind) that reduced portfolio volatility is equivalent to sustainable and non-fluctuating spending power.
To understand why a stable account balance does not necessarily translate into sustainable income, we must take a step back to view the spending objective for retirement.
Target-date funds, by design, must be generalized to provide a reasonably close approximation of typical investor needs, so first, DFA sets the spending objective for their target-date income fund of providing support for twenty-five years of inflation-adjusted spending beginning at the target date.
Twenty-five years extends beyond the life expectancy for sixty-five-year-olds, but plenty of people live past the age of ninety. However, lengthening time frames requires spending less to stretch assets further, and DFA views twenty-five years as a reasonable compromise between supporting longevity and supporting higher income for the typical investor.
Note that defining the retirement goal in this way will allow for a duration to be calculated on the retirement liability. This is an essential ingredient to matching durations and immunizing interest rate risk.
The next step is to recognize which variables have the largest impact on the amount of wealth needed to support twenty-five years of inflation-adjusted spending. General market volatility may be the common focus, but it is important to also assess interest rates and inflation.
This is where traditional target-date funds fail to support a retirement spending objective. They rarely coordinate investments sufficiently to provide proper hedging for interest rate and inflation variability.
DFA illustrates this situation by comparing a portfolio of Treasury bills with a portfolio of Treasury Inflation-Protected Securities (TIPS). The former are short-term nominal investments, while the latter—as we discussed earlier—are specifically designed to have a duration that matches the duration of the twenty-five-year spending objective.
For a portfolio of Treasury bills, nominal wealth remains fairly stable, with growth provided through short-term interest rates as they fluctuate over time. However, volatility is clearly present when you look at the amount of real retirement spending a portfolio of Treasury bills can sustain.
Rising inflation and decreasing real interest rates will decrease the amount of real spending the portfolio can support over twenty-five years. High inflation means that required spending may grow faster than the portfolio balance, and decreasing real interest rates increase the present value of the spending stream.
Since the value of Treasury bills does not grow sufficiently when interest rates drop, sustainable spending falls. Though Treasury bills can keep nominal wealth stable, the real spending they can support is actually quite volatile.
Contrast that with a portfolio of TIPS with the same duration as the spending goal. TIPS provide inflation protection, so if inflation rises, they support greater income to match what is needed for the real spending goal.
When the TIPS portfolio has the same duration as the spending objective, interest rate fluctuations are also hedged. When interest rates decrease, the cost of the spending objective increases and the value of the TIPS portfolio rises accordingly.
If interest rates rise, then the TIPS portfolio loses value, but the cost of meeting the spending objective also decreases.
For a portfolio of long-term TIPS, the account balances may be quite volatile as inflation and interest rates fluctuate, but the sustainable amount of inflation-adjusted spending remains reasonably level.
Exhibit 1 illustrates these ideas: Treasury bills support low wealth volatility but high spending volatility, while TIPS support low spending volatility but high wealth volatility. TIPS users accept price risk to meet the spending goal.
Tradeoffs in Retirement
The next step is to understand the objectives of the retirement saver. As our world has transitioned from defined-benefit pensions to defined-contribution pensions, the focal point of retirement has gone from a monthly or annual income amount to portfolio value.
The typical target-date fund investor seeks a sustainable income in retirement, but the number they see on their financial statements is the aggregate wealth in their account.
As we just reviewed, aggregate account balances do not directly translate to sustainable spending. The portfolio can remain quite stable, while sustainable income fluctuates in ways most investors do not realize.
But without the efforts to provide inflation protection or duration-matching through the growing fixed income portion of the portfolio, the ability for an account balance to support the spending objective is hampered.
This is where DFA’s target-date retirement income funds enter the scene as an alternative to traditional TDFs. These funds share the same philosophy as TDFs pre-retirement in terms of accounting for the relative size of human capital and financial capital over time and reducing the stock allocation as human capital decreases with age.
A globally diversified portfolio of stocks and bonds is designed to grow the portfolio and the sustainable income base.
But rather than transitioning from stocks into duration-mismatched nominal bonds as the target date approaches, DFA’s funds transition into a portfolio of TIPS with the same duration as a twenty-five-year real spending objective beginning at the target date.
This allows the investments to better lock in an inflation-adjusted income stream for retirement. It also provides a more effective way for the typical TDF investor to support their retirement spending by managing the risks related to inflation and interest rate fluctuations, while still leaving some assets to focus on growth.
Exhibit 2 provides a generalized illustration for the allocation of household wealth over the investor’s lifetime using target-date retirement income funds. When the investor is far from the target date, household wealth is presumably held primarily as human capital—that is, future labor earnings.
For the smaller investment portfolio, the asset allocation focuses on growth, primarily with global equities.
For example, at the end of 2016, DFA’s 2060 target-date retirement income fund was invested 94% in global equities and 6% in global bonds and other assets. As the retiree gets within twenty-five years of the target date, global equities begin to give way to more fixed income, and this is when the TIPS investments play a larger role.
For instance, DFA’s 2030 target-date retirement income fund had an allocation of 60% global equities, 15% global bonds and 25% TIPS by the end of 2016. At the target date, asset allocation is designed to be 25% global equities and 75% TIPS.
There are no global bonds at this point. Human capital is also depleted, and household wealth is primarily held in the investment portfolio. The equity allocation still seeks wealth growth to support more future income, while the fixed income assets are specifically designed to support a twenty-five-year inflation-adjusted spending objective.
Lifetime Allocation of Household Wealth
DFA’s target-date retirement income funds have grown out of efforts to provide a seamless way for investors to receive a defined-benefit styled income from their defined-contribution account using a mutual fund. This gives us a clear example of how to use bond funds to try to immunize interest rate risk for retirement planning.
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