Dimensional Fund Advisors (DFA) has published a detailed new analysis focused on the performance of different investment and spending strategies in retirement, including a thorough examination of potential target-date fund (TDF) glide paths and their impact on retirement outcomes.
As summarized in an abstract prepared by the firm, investment strategies considered in the analysis include “wealth-focused” glide paths, which combine equities with short-term, high-quality fixed income investments, and “income-focused” glide paths, which combine a moderate equity allocation at retirement and an inflation-protected bond portfolio that uses liability-driven investing (LDI) principles. The spending rules considered include fixed spending similar to the 4% rule (a general rule used to determine how much a retiree should withdraw from a retirement account each year), flexible/variable spending, as well as nominal and real annuitization.
At a high level, the paper finds that, for all spending strategies, an income-focused asset allocation delivers similar retirement income to the wealth-focused allocations. However, the income-focused approach is shown to offer better protection against market downturns, interest rate risk and inflation risk.
“Average assets at age 65 are virtually equal for the wealth-focused allocation with a high equity landing point and the income-focused allocation,” the paper explains. “Notably, the moderate equity landing point of the income-focused glide path reduces the dispersion of outcomes significantly without reducing the average.”
For those using a fixed spending approach, the paper shows, the income-focused allocation has the lowest failure rate. In basic terms, the strategy generates similar lifetime income to the high-equity wealth-focused allocation, along with higher income than the moderate-equity wealth-focused allocation. In sum, the income-focused strategy also offers better downside protection, as measured by the 10th percentile of average income.
For those desiring flexible spending, the income-focused allocation outperforms the moderate-equity wealth-focused allocation on all measures, according to the paper, despite having similar equity exposure.
The paper goes on to show how a TDF glide path with an LDI philosophy can deliver an attractive trade-off between income growth and income risk management. Along these lines, the results suggest that high equity exposure in retirement is an inadequate tool to manage longevity risk.
“A higher exposure to equity leads to higher failure rates under fixed spending, even when longevity is higher than expected; the benefits under flexible spending are also limited,” the analysis warns. “Annuities, which are designed to address longevity risk, are a more appropriate tool. They can also generate higher average income because of mortality pooling, though they require the investor to give up control of her annual spending and assets.”
According to the paper, even moderate increases in inflation and decreases in interest rates can substantially reduce the income generated by the two wealth-focused strategies. The income-focused glide path, on the other hand, is protected against such events by design.
Overall, the study finds that asset allocations in wealth-focused TDFs can leave retirees overly exposed to a number of risk factors—namely market volatility, interest rate movements and inflation increases. Most concerning, these increased risks often seem to come without any additional expected income benefits. The study also tellingly reviews the interaction of asset allocations and spending rules. Notably, fixed spending based on the 4% rule appears to magnify the impact of the three risks above, while more flexible spending can partially diminish their impact.
According to the analysis, unexpectedly volatile target-date funds can have substantial negative impacts on retirees. In fact, they are currently under examination by members of Congress. This is a good thing, the paper suggests, because the sheer magnitude of the risks facing retirees is underappreciated.
“A high allocation to equities does not help manage longevity risk and is no substitute for proper risk management and retirement planning,” the paper concludes.