A Researcher's Argument Against TDFs

Baby Boomers and Millennials stand at opposite ends of the career pathway. Does this mean their retirement investments should be opposites as well?

Not necessarily, says Noah Beck, who conducts quantitative equity research and portfolio support for investment services firm Research Affiliates. In a recent analysis, Beck suggests the plethora of portfolio risks confronting Millennials and Boomers are not so different, meaning both demographics may benefit from sticking to more conventional portfolio strategies invested in mainstream stocks, mainstream bonds, and diversifying inflation hedges.

This thinking leads Beck to a hawkish stance on target-date funds (TDFs). He suggests “two-thirds of a trillion dollars in assets are now invested on the untested premise that young people can and should take more risk than their middle-aged colleagues, in glide path products known as target-date funds.”

How are Millennials and Boomers alike in their retirement investing needs? Beck observes that young workers are more likely than older ones to lose their jobs in an economic downturn, and could be more tempted to draw on their 401(k) assets to meet basic living expenses while unemployed. Boomers have an impending need to draw on accumulated assets for daily living in retirement, meaning both groups of investors should be thinking deeply about capital preservation.

Both have a need for growth and some measure of risk-taking. Millennials lack substantial retirement savings and have the opportunity to leverage the time-value of money, while older workers face lengthening retirements, as well as long-term inflation and increasing costs for health care. Given these facts, Beck says Millennials’ early-phase concentration in equities is usually too strong under the typical TDF. (Morningstar says the average 2050 TDF has 90% equity exposure, with many as high as 95% equity.)

“Conventional wisdom tells us to put retirement investments on a glide path, with decreasing equity risk as our retirement date draws near,” he notes. “We’ve garnered considerable attention and ruffled a lot of industry feathers by showing that this conventional view is seriously flawed. Even so, TDFs are typically offered as a one-size-fits-all investment vehicle that employees can select in their defined contribution retirement plans. In many cases, they are the default option.”

Apart from the potential equity over-extension TDFs bring to Millennials, Beck says the asset class is also problematic because TDFs operate under the tacit assumption that they are the only asset in an employee’s retirement picture. “That assumption is almost always false,” he suggests.

TDFs may also be the wrong choice for Boomers, Beck argues, mainly because a TDF is rarely the only retirement asset that Baby Boomers own. This means income from the investment will make up only a portion of total income picture at age 65. There are also defined benefit pensions to consider, he says, as well as home equity and any other assets the individual accumulates in a lifetime of work.

“Social Security checks account for over a third of the average retiree’s income,” Beck notes. “This income is virtually guaranteed and adjusts for inflation as the recipient ages. If we had to categorize all assets and income streams as ‘stock-like’ or ‘bond-like’ in terms of expected future cash flows, the income from Social Security is very similar to owning an inflation indexed bond.”

Because income from Social Security depends on how many years a person worked, Boomers therefore already have a substantial allocation of their total retirement pool to Social Security “bonds.” Do they need more bonds in their TDF holdings? Beck is not so sure.

This same line of thinking leads Beck to ask whether Millennials’ very high equity concentrations make sense, given that this group has worked fewer years and so has accrued less value in the Social Security portion of their total retirement asset pool.

Pension distributions make up another sixth of the pie for current retirees, Beck says, noting that pension distributions are also bond-like in nature. Pension plans are becoming increasingly rare for new employees, he admits, but even for Millennials who are lucky enough to have one, the present benefit value would currently be quite low. Boomers with pensions, however, have a second substantial bond-like asset in their overall retirement portfolios.

A third asset is crucial to retirement preparedness, Beck says, in which Millennials actually have an advantage over their parents: their own human capital. In terms of expected return cash flows, human capital is actually much more like stock—a stock in which the Millennial has a very high concentration, and the Boomer, relatively little. 

“Lastly, retirement assets like Social Security, pensions, and human capital, are only one side of an individual’s personal balance sheet,” Beck notes. “It is also important to consider debt. In most cases, Millennials just beginning their adult life are saddled with debt from investing in their education and buying that first car or house.”

As people age, they make payments toward those liabilities, Beck explains, in effect buying back their own bonds and deleveraging their balance sheet.

“Retirees generally have very little debt remaining,” he says. “Some even have none left at all and live rent- and mortgage-free in their own home. Should Boomers that are buying down their debt also be compelled to buy additional debt securities in a TDF?”

Beck combines all this to suggest many Baby Boomers have built up a sizable bond-like portfolio in the form of Social Security and pension income, which accounts for more than 50% of income for today’s retirees (and much more for lower-income individuals). Millennials’ largest asset is their ability to earn a paycheck, he adds, presumably for decades to come, “an ability that is like a dividend-paying asset, which will ebb and flow with the economy like a common stock.”

So how should Millennials and Boomers invest their individual accounts and DC assets?

“The answer depends on their individual Social Security, pension, and employment situation,” Beck says. “On average, the two generations should be investing in portfolios that are much more alike than the TDF scheme prescribes. For example, Baby Boomers who expect to receive 40% of their retirement income from bond-like sources such as Social Security and defined benefit distributions might consider dividing their remaining assets more or less equally among mainstream stocks, mainstream bonds, and a third pillar of inflation-hedging assets, such as TIPs, high-yield bonds, and low-volatility equities.”

Beck points to another recent Research Affiliates analysis, by Rob Arnott and Lillian Wu, which suggested that Millennials’ early forays into investing would potentially also be well served by similar allocations across those three classes—mainstream stocks for growth, mainstream bonds as a hedge against a temporary impairment of human capital (a.k.a. unemployment), and a third pillar of inflation hedges that might be expanded to include emerging market stocks, bonds and currencies.

“Specific asset mix decisions, both over the course of a life at work and in retirement, importantly depend on the individual’s total financial situation,” Beck concludes. “Boomers with large DC portfolios may want to hold more bonds or third-pillar assets, while low-income seniors who expect the preponderance of their income to come from Social Security may want to invest their modest retirement funds entirely in stocks with sustainable dividends. There is unfortunately no one-size-fits-all portfolio for any given target retirement date.”

Beck’s full analysis, along with links to related research, is available here.