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The Evolution of TDFs

Making the case for alternative investments in target date funds.

According to a recent study from the Center for Retirement Initiatives at Georgetown University’s McCourt School of Public Policy, target date fund  investors can benefit from the inclusion of alternative investments in their plans. “The Evolution of Target Date Funds: Using Alternatives to Improve Retirement Plan Outcomes,” developed in conjunction with Willis Towers Watson, reports that the strategic use of alternative assets in a TDF “can improve expected retirement income and mitigate loss in downside scenarios.” 

The Logic

TDFs provide portfolios that typically are broadly diversified across cash, equities and fixed income. That’s a good starting point but Jason Shapiro, senior investment consultant with Willis Towers Watson, maintains TDFs need to increase diversification away from the public equities and fixed income securities that dominate their portfolios. The paper cites the losses incurred with a balanced portfolio (50 percent equities/50 percent bonds) between January 2008 and March 2019 as an example. Even though the portfolio had what most advisors would consider a prudent allocation, the resulting loss of over 18 percent for the period could have disrupted retirement plans significantly for older workers.

Defined benefit (DB) plans use alternatives already. The study points out that: “As of 2016, the largest corporate pension plans in the Fortune 1000 (assets greater than $2.1 billion) held average allocations of 4.2 percent to hedge funds, 3.4 percent to private equity, 3.0 percent to real estate and 3.6 percent to “other” asset classes. … Furthermore, public pensions allocate even more to alternative investments (approximately 25 percent), according to the National Association of State Retirement Administrators.”

Running the Numbers

To examine the potential impact of including alternatives, the study models a hypothetical employee’s account performance over the course of their career. There is no typical American worker, of course, but the model’s assumptions are reasonably broad. The employee participates in a defined contribution plan for 40 years from ages 25 to 65. Savings start at 4 percent of wages initially and increase to 7.5 percent by aged 55 with an employer match of 50 percent on the first 6 percent of savings. Annual wages are assumed to increase at the Consumer Price Index rate plus 2 percent until aged 45, and at the CPI rate after that.

The model portfolio included hedge funds, private equity and real estate. Angela Antonelli, the Center for Retirement Initiatives’ executive director, explains that those asset categories were chosen because they are widely owned and provide the most usable set of returns data over the longest number of years. 

The result of adding those categories is impressive. A TDF diversified with alternatives “increases the amount of annual retirement income that can be generated by converting a participant’s DC balance into a stream of income at retirement by 17 percent or $9,200 for every $100,000 of pre-retirement annual wages in the expected case (50th percentile) or by 11 percent or $2,300 in annual retirement income in a worst-case or downside outcome scenario (5th percentile).”

Retiring participants who left their assets in the diversified TDF also benefited, according to the analysis: “A diversified TDF has a higher probability of maintaining positive retirement assets after 30 years of retirement spending; it also provides higher expected returns and lower downside risk at the time of retirement and 10 years post-retirement, mitigating the negative impacts of a short-term market shock for those participants at or near retirement.”

Practical Challenges

The usual objections to including alternatives focus on liquidity and pricing, benchmarking, fees and governance. Those challenges are manageable, says Shapiro, noting that recordkeepers and custodians are in better position to implement customized TDF strategies that include alternatives.

Nuveen’s target date series, the TIAA-CREF Lifecycle Funds, demonstrates one method for including alternatives in TDFs. According to John Cunniff, the funds’ manager, the portfolios currently  have an allocation of 3.5 percent in direct real estate and he expects to reach the targeted 5 percent level around year-end. The funds work with TH Real Estate, another Nuveen subsidiary and one of the largest global real estate investment managers, for property selection. 

The direct real estate investments are made through a fund owned exclusively by the Lifecycle Funds. That arrangement provides increased control over the assets, which are diversified across property sectors but limited to the United States. The investments started in April 2017 and have been added to the portfolio, Cunniff reports. “In the first quarter (2018), real assets stood out relative to diversified equities or fixed income,” he says. “Our real estate fund outperformed, on a total return basis, all the other funds that we held, from a benchmark perspective. Our long run view on real estate returns is around 5.5 percent—the value for real estate is still there.”

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