To grow long-term wealth, target date funds need an aggressive glide path with meaningful equity exposure to manage longevity risk. However, they also need to be conservative to protect against short-term market volatility. Ron Cohen, head of RIA and DCIO Sales at Wells Fargo Funds, said it's a tough but ultimately achievable dual goal.
"You are starting to see mutual fund companies and target date providers utilizing more sophisticated tools where they can stay invested in equities later on in life, but be able to have risk tools in place to make sure you are protecting those participants," said Cohen.
An income replacement rate of 80% of one's pre-retirement income is a widely recommended retirement planning objective. Nevertheless, the average target date glide path delivers this only 58% of the time, according to Wells Fargo Funds.
The income in a target date fund is usually generated from the fixed income side of the portfolio. If interest rates are indeed heading higher, this will certainly put the bond allocations in target date funds under pressure. Cohen said some providers are starting to use other yield-based vehicles as a substitute for bonds, both for yield and protection against a rise in interest rates.
"You are starting to see sophisticated target date providers use alternatives as a way to hedge their fixed income exposure," said Cohen. "Whether that's REITs or TIPs or an infrastructure product, something to give protection as we start to see what happens with interest rates."
Wells Fargo is launching its Dynamic Target Date Funds on Dec. 1. The strategy includes three components designed to protect the portfolio in times of volatility and seize on investment opportunities when they present themselves.
First, in addition to the typical glide path-oriented asset allocation, fund managers use a proprietary tactical asset allocation model to generate additional alpha in a risk-conscious manner and take advantage of market opportunities.
Second, they employ volatility management tools to help moderate the impact of short-term gyrations on the portfolios, particularly within the equity exposure.
Third, they apply a sophisticated overlay strategy -- Tail Risk Management -- to improve participant outcomes by managing excessive volatility and the risk of adverse events.
"If 2008 happens again, the fund has the ability to hedge the entire portfolio and create a basket of futures that mirrors that portfolio, but hedges it and protects the participant as they get closer to retirement," said Cohen.