Research Affiliates: Are Our TDFs Massively Underweight Inflation-Fighting Assets?

July 31, 2018

Key Points:

  • An industrywide underallocation to inflation-fighting assets in TDFs leaves investors vulnerable to macroeconomic and market risks, including high-surprise-inflation conditions, bear markets, and volatile markets.
  • We urge investors to proactively put inflation-fighting assets in place when the need does not seem self-evident—not after the markets have already inflicted damage and the need for protection is obvious.
  • A diversified exposure across multiple inflation-fighting asset classes via a contrarian multi-asset approach can serve as powerful insurance for retirement portfolios.

We both recently moved and bought homeowners’ insurance, once again. Like most Americans,1 for our most valuable assets—our homes typically being the most valuable asset—we willingly pay for protection against a variety of natural disasters such as earthquakes, hurricanes, tornados, and floods.2 Even though the possibility that any of these individual risks materializes is remote, we don’t bat an eye when it comes to buying insurance coverage. As long as risks specific to our geographic location are fully covered by our yearly premium, we “sleep easy.”

Protecting our retirement assets should be no different. Inflationary waves, market downturns, and jolts in volatility are all legitimate threats that can shrink our retirement nest eggs, compromising the spending power of our eventual withdrawals. Unfortunately, traditional retirement portfolios offer minimal protection against these risks, even though the cost of insuring against them is cheap and the likelihood of their materializing is rising.

In this article, we delve into 1) why an industry-wide underallocation to real, or inflation-fighting, assets in target-date funds (TDFs) leaves investors vulnerable to macroeconomic and market risks that can undermine their financial security in retirement; 2) how adding real assets to retirement portfolios may lead to improved outcomes; and 3) the potential challenges investors face in gaining the protection they desire for their retirement portfolios.

Composition Of TDFs
Introduced in 1994, TDFs have been touted as a “one-stop” investment vehicle for retirement savings. They are intended to be a well-diversified, dynamic, multi-asset portfolio set-it-and-forget-it option that de-risks over time by increasing exposure to bonds at the expense of equities.3 Given that they automatically address asset allocation, rebalancing, and portfolio construction considerations relevant to specific age cohorts, TDFs have—not surprisingly—grown rapidly, especially over the last decade. Having assumed the role of default option for the majority of corporate sponsors of defined contribution plans, TDFs have accumulated over $1 trillion in assets as of year-end 2017 (Holt, 2018).

Are TDFs really the one-stop solution they claim to be, providing adequate diversification to protect our retirement assets over a variety of market and inflationary regimes? Or are we “sleeping easy” just before our basement, which is not covered by our insurance policy, is flooded?

Let’s look under the hood of the 10 most dominant providers of mutual fund TDFs, which had combined assets of just over $820 billion of the total $880 billion, an all-time high, across all vintages as of December 31, 2016 (Holt, 2017).4 All of these portfolios hold considerable positions in US stocks and bonds. For instance, on an average asset-weighted basis, the 2030 TDF vintage across the 10 largest providers allocates 63% to US assets. Further, we conservatively estimate that over three-fourths of the exposure within the Global Stocks and Bonds category is actually developed-market stocks and bonds,5 which raises the total allocation to mainstream stocks and bonds to over 80%.6


For a larger view, please click on the image above.


But what about real assets? The average TDF exposure to real assets, those assets typically considered to offer direct protection against rising inflation, was only 4.5% at year-end 2016. These “traditional inflation fighters” include 1) Treasury Inflation Protected Securities (TIPS), whose prices adjust annually with the CPI inflation rate and are guaranteed by the US Treasury; 2) commodity futures, whose prices change to reflect changes in the cost of the respective underlying raw material; and 3) real estate investment trusts (REITs), whose prices change in line with changes in the rents earned by the real estate property the REIT owns.7

Asset classes other than real assets also provide inflation protection, even if they are not commonly viewed as inflation fighters. We at Research Affiliates refer to these asset classes as “stealth inflation fighters,” a category that includes high-yield bonds and bank loans, along with allocations away from the US dollar into emerging markets (EM) currencies, bonds, and equities. (After all, what is inflation, if it’s not US dollar debasement?) These asset classes have demonstrated positive correlation with US inflation, with many offering inflation protection superior to that provided by TIPS.8 Across the 2030 TDF vintages offered by the 10 largest providers, these stealth inflation-fighters had an average allocation of 6.4% as of December 31, 2016. Adding this to the 4.5% allocation to real assets, the total allocation to inflation-fighting assets was only a modest 10.9%.

For investors getting closer to retirement, the average exposure to inflation-fighting assets only falls from these low allocations as they age. Consider (as of July 2018) the most popular target retirement fund built for investors who are retiring five years hence. These soon-to-be retirees have barely 4.0% in traditional inflation-fighting markets, and their exposure to high-yield bonds, EM bonds, and EM currencies is zilch. Their sole allocation to stealth inflation fighters is 3.5% to EM equities, which puts combined inflation-fighting exposure at a measly 7.5%. We believe investors should, instead, be increasing portfolio diversification and raising inflation protection as retirement gets closer.

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