Given the negative returns of target date portfolios belonging to people near retirement in 2008, much has been written about prudent levels of equity for those near retirement. However, if equity risk is a smaller portion of target date funds at retirement dates, then does that mean the bond portion now poses a substantial risk should interest rates rise? For an answer, we talked with Jim Lauder, CEO of Global Index Advisors.
Since interest rates remain near historic lows, it makes sense that interest rates will increase at some point. Can you give us your perspective on interest rates?
Interest rates have been at low levels for some time, longer perhaps than many thought possible. The 10-year Treasury yield has been less than 4% for more than four years, and it has essentially been below 2% for more than a year. Interest rates are reflecting the accommodative monetary policies of central banks around the world and global growth that is moderate at best and quite weak in other spots, notably Europe. So, while we do not think a sharp increase in interest rates is imminent, we do agree that interest rates are unlikely to move much lower. So, we are prepared for the next move, which we expect will be for higher interest rates eventually.
Your glide path for target date portfolios near maturity is one of the more conservative in terms of its equity risk exposure. Does that mean it has more bond risk?
Not necessarily. While we currently have more exposure to bond risk, or interest-rate risk, than many of our competitors, it is not necessarily true that we will have higher bond risk exposure going forward, for several reasons. First of all, our strategy is based on the Dow Jones Target Date Index methodology, which employs an asset allocation optimizer rather than a simple allocation among the main asset classes—equities, bonds, and short-term investments.
In our case, the risk target of a portfolio for someone 10 years past their retirement date is conservative. To be precise, the Target Today Index has a risk target equal to 20% of the risk of the all-equity benchmark, with the condition that the actual equity allocation be within a 5% band in either direction of the targeted relative equity risk level (maximum of 25% equity and a minimum 15% equity). While that means that the maximum allowable bond allocation is 80%, based on a minimum 15% equity allocation and minimum 5% cash allocation, the optimizer can allocate as little as 5% to bonds under the right conditions. As interest rates rise and bond prices fall, the optimizer should begin to shift assets away from bonds and into our short-term investment portfolio, thereby shortening the overall duration of the target date portfolio and reducing the negative effect of rising interest rates on portfolio returns. While the optimizer will not eliminate bond risk, it does have the ability to soften the blow.