There was a major development in 2006 that transformed the way Americans invest for retirement. It solved one problem, but created another that will cause additional suffering for people retiring in this economy.
The mid-2000s marked the beginning of the nudge revolution, where policymakers thought they could trick people into more desirable behavior. The idea seemed particularly promising when it came to saving for retirement, where research has shown that automatically enrolling people in retirement accounts would increase savings and lead to better investment decisions.
So in 2006, the new Pension Protection Act allowed employers to enroll their workers by default in a 401(k) or similar retirement plan. Most plans put people into target date funds, or TDFs, which were based on the principle that as you get older you should adjust your portfolio to reduce risk. Thus, TDFs invest young people in equities and gradually move them into bonds as they approach retirement.
More than 15 years later, we have proof that it works well. A group of economists studied the portfolios of plan participants from 2006 to 2018. On at least one level, the boost was a success. Economists found that switching workers by default to TDFs increased stock ownership and participation in pension plans.
But TDFs have a major weakness, and their adoption has also introduced a new risk for retirees that is only just beginning to be felt in today’s high inflation environment.
Target date funds are still very popular: $3.27 trillion in assets were invested in them at the end of 2021. Before 2006, if you joined a plan and did not choose the funds yourself, your savings were invested in a money market account. equivalent to money, which many people have never changed.
TDFs are more aggressive. If you are more than 25 years from retirement, TDFs will invest you almost entirely in the stock market. This strategy has increased the wealth of many Americans because the last 15 years have been very good for the stock market. The study also found that Americans tend to adopt bonds as they age, as TDFs are designed to do. This was not the case before 2006, when portfolio allocations did not change much with age.
TDFs are a good strategy while you are in the savings phase of your life. But they have a crucial weakness that stems from what financial economists call the time diversification fallacy, or the misconception that the longer you invest in markets, the less risky they are. The logic follows that if you are closer to retirement, stocks are riskier because you have fewer years to reap gains or recoup losses. Therefore, you need to reduce your market exposure.
If you read the prospectus of the most popular TDFs, the funds claim that their objective is to provide retirement income, but that is not how the funds are invested. The funds move savers into shorter-term bonds – the duration is usually about five years around retirement age and it shortens further during retirement. This is a reasonable strategy if the goal is to avoid losing money in the markets. But that’s not a useful strategy when it comes to spending your retirement money.
I agree that it makes sense to invest more in bonds as you get older. There is, however, a subtle but important distinction when it comes to the type of bonds – and TDFs are invested in the wrong type. The theory behind lifecycle investing isn’t that you need to reduce risk as you get older, it’s about assessing the potential for future earnings. When you’re young, most of your wealth resides in your future earnings, which is similar to bonds because paychecks provide income in fixed, regular installments. So when you’re 25, you’re essentially overexposed to bonds and need more stocks. As you approach retirement, your future income represents a smaller share of your wealth and you need to buy more bonds to compensate.
But your goal as you age isn’t just capital preservation, it’s replacement of lost income. When you reach retirement, you will probably have to fund about 15 to 20 years of expenses between you and your spouse. But if you invest in short-term bonds and equities – TDFs have increased exposure to equities for all ages over the past 10 years – you will face a lot of risk because the bonds chosen by TDFs do not don’t offer much inflation protection (inflation-protected bonds only make up a tiny fraction of the bond portfolio). If inflation continues to rise and interest rates rise (lowering the value of your bond investments), you will fall further behind.
A better strategy would be to invest the fixed-income portion of your portfolio in long-term inflation-protected bonds, the duration of which matches your future spending needs. And, unless you’ve got plenty of money saved up, chances are you’ll still need some exposure to equities throughout your retirement to help hedge inflation and hopefully the, create more growth. This provides better protection against inflation and rate fluctuations. The consequences of TDFs exposing a generation of Americans to duration mismatch are only just beginning to be felt.
Americans are retiring in an environment of high inflation, with unclear guidance on how to spend their nest egg while stuck in an investment strategy that is not helping them preserve their income. Their expenses will fluctuate from year to year as the stock market and interest rates rise and fall, and they may experience a decline in their standard of living as they age.
The nudge revolution has come to an end. One of its biggest wins is increasing participation in retirement savings plans, which has resulted in a significant and positive increase in share ownership. But the problems on the fixed income side show that boosts are not a panacea; they should also provide the correct defaults.
Allison Schrager is a Bloomberg Opinion columnist covering the economy. A senior fellow at the Manhattan Institute, she is the author of “An Economist Walks Into a Brothel: And Other Unexpected Places to Understand Risk”.