In “Target-date funds I”  and “Target-date funds II”  I discussed some of the advantages and disadvantages of target-date funds and some simple methods for doing a low-cost implementation.

In my May 11, 2008 Hot Off the Web blog I referred to a recent article in InvestmentNews entitled “Target date funds criticized over risk”, with the following comments “the debate continues on what is the appropriate level of risk, defined as the non-fixed income portion of a retiree’s portfolio. Some feel that the average of 68% equity in the typical target date fund is inappropriate, especially for retirees. Though target-date funds are a relatively new phenomenon, they have accumulated over $180B.” The article also mentions that there now are about 300 target-date funds and have ratcheted their average equity exposure from about 55% to 68% (without any mention of the median investor’s age). As an aside I added that I suspect that ‘risk’ has more to do with the individual investor’s risk tolerance than age.

So, what is risk? In the Asset Allocation section of this website, ’risk tolerance’ was defined as being a composite of one’s ‘ability to take risk’ (a function of age or investment horizon, future earning power, wealth relative to needs, short-term spending requirements) and one’s ‘willingness to take risk’ (a function of psychological make-up as sometimes determined by questionnaires like Vanguard’s, and experience with risk such as the difference between a lifelong entrepreneur and a public servant with a comfortable pension). The ‘implemented risk’ via asset allocation and portfolio implementation may however be further influenced by the return requirement as determined by objectives of the investor, as higher required returns usually come hand in hand with increased risk.

You can see quite readily that defining risk for an age-group would be less specific than for an individual investor. You will also agree that there could be differences in professional opinion on what is the appropriate level of risk for an individual. Now let’s look at some dissenting voices which either explicitly or implicitly disavow the new target-date fund mantra.

On one end of the scale the highly respected Boston U. finance professor Zvi Bodie (who believes the stocks are risky even in the long-run) suggests that the right portfolio for somebody approaching or in retirement is 90%+ inflation indexed government bonds (to protect the downside of the portfolio) coupled with a small part (5-10%) of the portfolio invested in long-term call options (to preserve some upside participation in the market) on the index you want to participate in. You can read more about it in my Life-Cycle Investing  and Protecting the Downside, while Participating in the Upside  blogs. His related suggestion is that you can increase your income with this approach by allocating a portion of the risk-free portfolio to inflation indexed annuities that are now becoming available. By the way Nassim Taleb in “Black Swan” retirementaction.com/BlackSwan.aspx essentially agrees with this approach, except that he didn’t specify explicitly call options for the risky 10%; he suggests highest-risk/highest-return investment vehicles for the risky 10%.

At the other end of the spectrum is Wharton finance professor Jeremy Siegel who in “Stocks for the Long Run” (full disclosure: I have only read reviews of his book) essentially suggests 100% (i.e. beyond enough risk-free assets to cover ‘immediate’ needs) “that through time the after-inflation returns on a well-diversified portfolio of common stocks have not only exceeded that of fixed income assets but have actually done so with less risk.” (In his more recent book “The future for investors” (which I did read)  he discusses asset allocations for Americans and recommends 40% international equities and low-cost ETF based portfolio implementation.
In-between the two extremes, but still on the side of age-independent asset allocations are economics professor emeritus and Nobel laureate Paul Samuelson and professional investor, author and educator Charles D. Ellis.

Ina recent article in CFA Magazine entitled “Canny portfolios” (available only to CFA Institute members) Paul Samuelson states that “I warn against the popular fable that your father at age 50 definitely needs a different portfolio composition than you do at 30. Allegedly, when you reach 50, faced then with fewer investment periods ahead before retirement, you should transform holding into “safer stuff.” The brokerage industry is infatuated with “Life Cycle Target Funds,” tailored differently for those who will retire in 2020 rather than in 2040.” He goes on to say that both the young and old in developed countries (U.S., E.U. or Japan- and I assume he would include Canada) “could aim for about the same passive diversified-index portfolios”. Over time, as the developing world “level of affluence” increases, there will be a reduction of the U.S. securities (stocks and bonds) component of the portfolio “from 85%, to 75%, etc”. (He also mentions that turnover is “your enemy” because passive investing allows you defer the taxes.)

Charles Ellis in his book “Winning the Loser’s Game” (this book is a must read!) comes down unequivocally against arbitrarily reducing your equity content with age, because “your investing horizon is far longer than your living horizon” (because otherwise you are forced to take age-driven taxable profits, penalizing beneficiaries of your estate -i.e. children, grandchildren and charities- who will almost certainly outlive you). He then suggests his two most important decision rules: “(1) any funds that will stay invested for 10 years or longer should be in stocks and (2) any funds that will be invested for less than two to three years should be in “cash” or money market instruments”. (As if having gone to the same school as Samuelson, Ellis says that “over the long term benign neglect really does pay off”.)

And finally, Schleef and Eisinger in “Hitting or missing the retirement target: comparing contribution and asset allocation schemes of simulated portfolios” “conclude that ‘life-cycle funds’ (also called target-date funds) that reduce equity allocation over time fail to increase the likelihood of reaching a targeted portfolio value compared with fixed asset allocation models” (80:20 or 70:30).

So there you have it! You could call these perspectives the ‘target-date funds are a passing fad’ perspectives. These experts effectively don’t believe in principles underlying target-date funds. Some will challenge Bodie on the appropriateness of a 90% bond portfolio, even if CPI inflation protected, because CPI may not be representative of the real inflation level or for that matter a specific individual’s experienced inflation (my purchase basket is different than yours). Others would consider Siegel’s almost 100% stock allocation for a retiree as absolute heresy. The other views discussed were somewhere between the extremes. Though they wildly disagree as to what is an acceptable level of risk for retirees, and thus the appropriate asset mix in their portfolios, they all agree that age-driven asset allocation doesn’t make sense to them.

Then what is the right answer? Well there may not be a single right answer applicable to everybody. If you think about it a little bit in terms of risk, which I discussed at the start of this article, you would immediately ask yourself what would be the driving force that would reduce the risk tolerance of a retired individual when he reaches age 75, as compared to this retired individual’s risk tolerance at 65? You may conclude (as I suspect right now) that: not much. So you could establish your risk tolerance and the corresponding portfolio (assuming it meets your objectives), and then perhaps stick with that asset mix throughout retirement?

If we use Charles Ellis’s rules: that any assets you won’t need for 10+ years go into equities and assets that you will need in the next 2-3 years go into “cash”, and you assume a 4.0% annual draw from the assets, then your non-stock component to be invested in fixed income securities (assuming 3% inflation and bond returns of inflation+1.5% as suggested by Ellis) will be somewhere between 20 and 37% of the total assets (depending on whether you discount the next ten year withdrawal requirements at the nominal 4.5% or real 1.5% returns on bonds). Assuming 35% as a conservative position, you are looking at a 35% bond/”cash” (10% “cash”, representing the requirements for the next 2-3 years, and 25% bond) allocation and a 65% equity(-like) allocation. So this allocation would be fixed, thus age-independent.

So you might want to factor in risk, then at a ‘lower’, ‘average’ and ‘higher’ risk tolerance level you may use 50-60%, 60-70% and 70-80% equity respectively. The “cash” component would be about 10% (e.g. money market and/or short-term GIC/CDs) in all cases, while the bond component (e.g. intermediate bond ETF or low-cost mutual fund or a set of laddered maturity zero coupon bonds, placed in the tax sheltered portion of the portfolio or using municipals in Americans’ taxable portfolios) would be residual percentage. A very simple implementation of the equity component for a Canadian Investor’s portfolio could be achieved by dividing it in equal parts of U.S. (VTI), Canadian (XIU) and international (EFA); for a U.S. investor 2/3 U.S. (VTI) and 1/3 international (EFA) would be a good start. (Clearly, additional diversification would be achieved in the fixed income portion of the portfolio with the addition foreign and/or high yield bonds, REITs, preferred shares. Similarly additional diversification on the equity-like portion of the portfolio would be obtained with the addition of a low dosage of emerging market stocks, commodities, and perhaps even some hedge funds. Though these would be secondary in importance to getting rolling with the simple implementation first.) This approach also solves some of the disadvantages I discussed in my earlier target-date blogs and will likely be a lower cost implementation.

P.S. Just as I am preparing to post this blog, I came across “New PowerShares are ETFs of ETFs”  who implemented three risk levels in new ETFs PCA, PAO and PTO with 60%, 75% and 90% equity component; the funds include international diversification. I am not mentioning this as a recommendation of the specific ETFs (they have a 0.25% fee on top of the fees associated with the underlying funds), but as an indicator that the current trend toward target-date funds may be starting to shift. By the way, all the issues mentioned with Target-Date Funds  , also apply to these PowerShares funds and similar fixed allocation ETFs.