Meeting Retirement Goals With Dimensional’s Target-Date Retirement Income Funds
June 28, 2016
by Wade Pfau
Since the financial crisis, Warren Buffett's Berkshire Hathaway has had significant exposure to financial stocks in its portfolio. Q1 2021 hedge fund letters, conferences and more At the end of March this year, Bank of America accounted for nearly 15% of the conglomerate's vast equity portfolio. Until very recently, Wells Fargo was also a prominent Read More
One of the defining distinctions for retirement income planning, as opposed to traditional wealth management, is that the focus shifts to best meeting an ongoing spending objective in retirement. Traditional target-date funds (TDFs) aren’t designed to meet a spending objective; their focus is on growing nominal account balances while also managing account balance volatility. However, a stable account balance does not necessarily translate to stable income. Dimensional Fund Advisors’ (DFA) new target-date retirement income funds bridge this divide by providing a target-date fund that uses a more complete risk management framework that manages volatility of expected affordable retirement spending.
In 2012, I wrote here about Dimensional’s Managed DC® pension. At that time, greater effort was made by DFA to encourage the purchase of an inflation-adjusted income annuity at the retirement date. Its focus has always been on the income side and a more complete risk management framework. Since that time, however, DFA’s approach has evolved to include a mutual fund offering in their new target-date retirement income funds.
Advisors serving retirees should pay attention to these developments.
Retirement goals: Manage wealth or 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. The 4% rule indicates that an inflation-adjusted income equal to 4% of the retirement-date wealth level will be sustainable from a portfolio of stocks and bonds. Its success is justified because it worked historically or can be expected to work on average, rather than because any effort is made to link how current interest rates or capital market expectations relate to a sustainable spending rate.
Target-date funds focus on controlling portfolio volatility as the target (retirement) date 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 due to 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. Because target-date funds, by design, must be generalized to provide a reasonably close approximation to the typical investor needs, DFA views the spending objective for the target-date income fund to provide support for 25 years of inflation-adjusted spending commencing at the target date. This could reflect ages 65 to 90, for instance. Twenty-five years extends beyond the life expectancy for 65 year olds, but there is still risk of outliving this time frame. However, lengthening time frames require spending less to extend assets out for longer, and DFA views 25 years as a reasonable compromise between supporting longevity and supporting higher income for the typical investor.
The next step is to recognize which variables create the largest impact on the amount of wealth needed to support 25 years of inflation-adjusted spending. General market volatility may be important for those seeking a higher income through the inclusion of growth assets with a risk premium, but it is important to assess the importance of interest rates and inflation. This is why traditional target-date funds fail to support a retirement spending objective. They rarely make sufficient effort to coordinate the investments 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 are specifically designed to have a duration that matches the duration of the 25-year spending objective. For a portfolio of Treasury bills, nominal wealth remains fairly stable, with growth reflected by what is offered with short-term interest rates as they fluctuate over time. However, when framed from the perspective of the amount of real retirement spending a portfolio of Treasury bills can sustain has lots of volatility. Rising inflation and decreasing real interest rates will decrease the amount of real spending that the portfolio can support over 25 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 wealth stable, the real spending these investments can support is actually quite volatile.