Is Your Target-Date Strategy Ready for a New Investment Regime?

Introduced in the mid-1990s, target-date strategies have become a mainstay investment vehicle for defined contribution (DC) retirement plans, providing a boon to participants’ retirement-savings efforts. But target-date design can’t stand still, and a major shift in the investment regime should prompt plan sponsors to take a fresh look at target-date design.

Target-date strategies are now available in 87% of 401(k) plans in the US. They account for a combined total of $3.7 trillion in savings—nearly 10% of all public and private US retirement assets—according to the Employee Benefit Research Institute.

Demand for traditional target-date strategies has surged over the last 10 years, thanks to a favorable market environment. The decade featured an epic bull market for stocks, with occasional bouts of volatility that were effectively balanced by bonds’ negative correlations. This climate was ideal for target-date funds with a simple mix of global stocks and nominal bonds, such as government bonds whose yields don’t adjust for inflation. While this classic stock-and-bond mix remains the go-to solution for most DC plan participants, we believe it may not be enough for what’s ahead.

Diversifying Beyond Classic Balanced Approaches

2022’s historic market stresses challenged most investment strategies, with simple target-date solutions that mix broad stocks and nominal bonds hit particularly hard. The highest inflation in 40 years, surging interest rates and geopolitical tensions created one of the worst years since 2008. Stocks and bonds both suffered losses for the first time since 1988, hurting their diversification benefit. Many target-date strategies built from broader stocks and nominal bonds lacked the asset-class depth to navigate the unforgiving landscape effectively.

More comprehensive, diversified target-date strategies, on the other hand, were better positioned in 2022. We can see evidence of this by comparing two target-date approaches at similar points in time on their respective glide paths. In this case, both approaches reflected the allocation design for a participant approaching retirement—someone requiring meaningful growth potential but also strong volatility control and inflation defense.

A simple target-date strategy used a traditional 60/40 mix of broad stocks and nominal bonds at this point; a more diversified approach would have incorporated a wider spectrum of growth and defensive assets, including defensive equities, equity and bond diversifiers, inflation-resilient real assets like real estate and commodities, and Treasury Inflation-Protected Securities (TIPS). By tapping into more corners of the market to address inflation, interest-rate and market risks, the more diversified target-date strategy was able to cushion its 2022 losses by a 4% margin over a simple-allocated target-date strategy with a mix of only broad stocks and nominal bonds (Display).

Broader Diversification Helped in 2022

Diversifying Beyond the Traditional Stocks and Nominal Bonds

Target-date strategy allocations can be bolstered with further diversification, which became especially obvious in 2022.

Bond yields steadily rose, hurting returns, so fixed income couldn’t offer its usual refuge from the reeling stock market. Participants near or in retirement were most vulnerable, given that they’re preparing to translate their savings into retirement income that will need to last a lifetime—perhaps 20 years or more.

In this environment, diversifying asset exposure offered vital alternative return sources and risk controls. For example, more defensively oriented low-volatility stocks, long/short equity strategies and nontraditional bonds, typically those less correlated with the overall fixed-income market, were among the differentiators that tipped the 2022 advantage to the more- diversified target-date strategy in our comparison.

Building Inflation Defenses

Inflation seemed unstoppable in 2022, topping 9% year-over-year at one point, and central banks hit back with the sharpest interest-rate hikes in decades.

Because rising price levels can reduce the purchasing power of income, inflation-sensitive exposures are valuable additions to a target-date strategy—as 2022 showed. In addition to TIPS, real assets, such as real estate and commodities, can bolster resilience to inflationary forces. The well-diversified target-date strategy had a combined allocation of nearly 20% to these two asset types near retirement.

No single investment strategy wins every time, and a diversified target-date approach could trail a broad stocks and nominal bonds strategy in certain environments, such as a long bull market. But the goal of target-date design is to build assets over the long run, which requires navigating both the ups and downs of markets. Given that 2022 may have heralded a more challenging investment regime, we believe that diversifying allocations is critical.

In a New Era, Target-Date Design Should Be Under the Microscope

2022 was a uniquely challenging year for markets, and some of the risks will likely linger if not intensify—inflation, recession, geopolitical shocks and volatility. A strong start in 2023 provided a measure of relief, but we think it’s unlikely that the benign climate investors enjoyed for the last decade will be repeated.

That makes 2023 a watershed year in a transition to a new investment regime—one dotted with converging risks and moderating expectations. It makes sense for plan sponsors to put target-date design under the microscope, identifying tools to better position participants to achieve their savings and income goals across all phases of the glide path. In our view, incorporating diversified exposures beyond broad stocks and nominal bonds and building inflation defenses would represent a big step forward.

Authors
Christopher Nikolich
Head of Glide Path Strategies (US) —Multi-Asset Solutions
Elena Wang
Portfolio Manager—Multi-Asset Solutions

“Target date” in a fund’s name refers to the approximate year when a plan participant expects to retire and begin withdrawing from his or her account. Target-date funds gradually adjust their asset allocation, lowering risk as a participant nears retirement. Investments in target-date funds are not guaranteed against loss of principal at any time, and account values can be more or less than the original amount invested—including at the time of the fund’s target date. Also, investing in target-date funds does not guarantee sufficient income in retirement.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

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