Over the past decade, target-date funds have become a half-trillion-dollar industry by seeming to answer several of a typical investor’s prayers all at once. They’re designed for people who understand their limitations: They can’t time market swings, don’t want to be bothered about rebalancing their portfolios each year, and don’t want to spend time pondering asset allocations. Target-date funds, also known as life-cycle funds, essentially ask investors one question—what year do you hope to retire?—and take it from there. The funds shift their assets over time, moving from riskier equities to more stable bonds as the specified date approaches. Investors who like the idea of a predetermined path to retirement have helped swell the assets in target-date funds to $508 billion as of March 31, up from $378 billion at yearend 2011, according to Morningstar (MORN) figures.
Target-date funds were designed for normal times, though lately the markets have been anything but normal. For an unprecedented five years, the Federal Reserve has been holding short-term interest rates near zero to help stimulate the economy. When the central bank takes its finger off the scale, rates have only one direction to go: up.
That means bond prices will fall. (Bond prices and yields move in opposite directions.) Investors and money managers are thinking about how to prepare for the inevitable upheaval. Those planning to retire after, say, 2030 may be able to safely look past this shift, because their funds are overwhelmingly in equities. Those who are on the cusp of retirement—and have 70 percent or more of their funds in the asset class that’s likely to lose value—have more to be anxious about. And avoiding anxiety was the whole reason for picking a target-date fund in the first place.
The largest target-date fund manager, Fidelity, announced in September that it was increasing its allocation to stocks by as much as 15 percentage points for investors younger than 67. “It’s an evolving issue in the industry,” says Josh Charlson, a senior mutual fund analyst at Morningstar in Chicago. “A lot of asset managers are still kind of feeling their way through it and trying to come up with some solutions. They don’t want to do anything too radical and end up taking on other types of risks without thinking it through, but you will see some shifts over the next few years.”
Charlson, who writes an annual report on the target-date fund industry, says some managers are shifting to bonds with shorter durations (duration is a measure of a bond’s sensitivity to interest rate changes), as well as shifting to corporate from government bonds. The thinking: If the Fed allows rates to rise, it will be because the economy is sturdier, and that means fewer companies may go bust. When corporate bonds are viewed as less likely to default, their prices tend to rise.
In interviews, several advisers gave the same counsel to individual investors: Don’t try to time the rise in interest rates. It’s as difficult as predicting when the stock market will swoon. “The other thing people should think about is that rates don’t all go up at the same time,” says Catherine Gordon, a principal in Vanguard’s Investment Strategy Group. The bond market “is not a monolithic, synchronized entity.” Nobody knows which of the many flavors of bonds—corporate, government, emerging-market, junk—will outperform the others.
Even if bonds look like sure losers now, they still provide a crucial diversification against stocks, which tend to be more volatile. A 10 percent loss in fixed income looks good, even if it’s on the eve of retirement, compared with a 20 percent drop in equities.
Ultimately, investors should welcome higher rates, Gordon says. In a blog post for Vanguard, titled “Waiter, There Are Bonds in My Target Retirement Fund!,” she writes: “ ‘Bond math’ means rising interest rates that lead to increasing bond yields are not necessarily a negative development for long-term investors. This is because, over time, higher rates translate to higher dividends on the funds, which will help offset any capital losses incurred as rates rose.”
This isn’t the first time investors have fretted about the autopilot nature of target-date funds. “There’s always a subject du jour,” says Chip Castille, a managing director at BlackRock (BLK), who was a researcher on the team that developed the first target-date fund in 1993. “In 2008 we were having the discussion around equities.” That year the Vanguard Target Retirement 2010 Fund lost 23.6 percent—better than the Standard & Poor’s 500-stock index loss of 38.5 percent, but brutal for those only two years away from retirement. The fund has since rebounded 60.1 percent, with dividends reinvested. “When the dust settled,” Castille says, “it was very clear that people who were in target-date funds and remained in them did better than people who were not in target-date funds.”