While loathed by some in the financial planning community, target-date funds (TDFs) are a godsend for many investors. Their simplicity and structure allow investors to own a basket of asset classes that automatically rebalance to a more conservative mix as an investor approaches retirement. With low costs and one-ticker ease, they’ve made saving for retirement an easy exercise for many investors.
And now, they look to make another part of the retirement puzzle easy as well.
Turning a pool of assets and cash into a paycheck remains a difficult proposition for many investors and financial advisors. But with innovation from BlackRock, this may finally be a simple act. Annuities in TDFs are now here.
Target-Date Funds Bloom
Whether you call them lifecycle funds, age-based funds, or something else, there is no denying the creation of the target-date fund (TDF) has changed retirement savings for many investors and advisors. Created in the late 1990s, pension reforms in 2006 made them an easy default option for 401(k)s and other retirement plans. Since then, their use among investors has grown over 10×.
By the end of 2023, more than $3.4 trillion worth of investors’ retirement savings sat in target-date mutual funds, collective investment trusts (CITs), and other fund structures. That’s a lot of coin, and it underscores the simplicity of TDFs and why they make a great default option for many investors.
TDFs provide instant asset allocation of stocks, bonds and other asset classes. The key is that their mix shifts and follows a glidepath toward the retirement age of the investor. This means that early on, the fund will have a more aggressive stance — overweighting equities — and get more conservative, holding more bonds and inflation-linked assets, when they hit retirement age.
This automatic rebalancing and re-risking are key to the TDF’s strategy and ability to provide growth appropriate for age and timeline.
The Income Issue
Where TDFs win on the accumulation side of the equation, the income side of the formula falls flat. After an investor retires, it’s still up to them to turn that pool of money into a steady paycheck. And while a more conservative mix can help, it’s up to the investor or their advisor to figure this out.
The issue involves two key risks: sequence of returns risk and longevity risk.
Longevity risk is the risk that you will outlive your financial resources. Thanks to modern medicine and changes in lifestyles, a retirement portfolio needs to last not only throughout retirement but potentially longer than a person’s working life. The sequence of withdrawal risk has to do with the timing of withdrawals from a retirement portfolio. The initial years of retirement are particularly critical for preserving a lasting nest egg; beginning withdrawals during a market downturn could rapidly deplete your funds.
Both of these issues can undermine even the best income plans, impacting retirement readiness for portfolios.
Annuities have been tapped by many in the planning community as a way to overcome these issues. However, purchasing annuities comes with its own set of pitfalls. Investors and financial advisors must ensure that these products align with their income plans.
Against this backdrop, asset manager BlackRock has introduced a new solution that combines the ease of asset accumulation with the potential for income generation. The firm has launched a new version of its TDFs called LifePath Paycheck. Here, a portion of the fund’s assets are invested in annuities with the option of purchasing lifetime income at retirement.
Starting at age 55, a portion of the TDF’s glidepath is allocated toward annuity contracts. By age 65, roughly 30% of the portfolio will be earmarked for retirement annuities. Between ages 59½ and 72, investors can use the earmarked funds to purchase an annuity from selected insurers, currently Brighthouse and Equitable. The remaining 70% of the TDF’s assets will be invested in stocks and bonds according to a standard glidepath for that age. If investors choose not to purchase an annuity, the 30% allocation functions like a traditional bond allocation within a target-date fund.
This chart illustrates how the new LifePath Paycheck funds glidepath works.
Source: BlackRock
Not to be outdone, both TIAA and Capital Group have announced products offering annuities as part of their target-date series.
The goal is to take away the guesswork in selecting an annuity for a portfolio and instead embed it at the onset. Investors can easily plan for future income without having to lift a finger.
Still Some Pitfalls
But not all analysts are thrilled that annuities are now making their way into TDFs. And in fact, there could be some major downsides.
According to a new report by Morningstar, TDFs with annuities aren’t a panacea for generating income either. Part of the pitfall comes with construction. Just like regular target-date funds, these annuity funds come in different flavors and use varying styles of annuities to get the job done. 1
For example, TIAA’s suite of products buys annuities during the accumulation phase. This allows investors to lock in income ahead of time. However, if interest rates are low during this time, investors may actually lose out on potentially higher income streams. Moreover, this approach reduces the balance of a portfolio that could be invested elsewhere for higher returns. Conversely, those who choose deferred annuities, which allow investors to purchase income at a later date, might receive lower income thanks to market volatility. Those investors who use fixed annuities may not generate enough returns.
Supersavers may also be at a disadvantage and may not need all the income the TDF generates. This could “lock” them into the income and higher taxes they generate. There may be a sweet spot of savers and 401(k) balances for these new target-date products. And since they are new, we don’t know what that sweet spot is just yet.
Still a Good Deal
In the end, we have a long way to go with regard to cracking the retirement income solution. TDFs with annuities have the ability to help investors in the so-called sweet spot generate needed income in retirement. However, like all investments, investors need to check under the hood and kick the tires. For some, it may be better to explore using your TDF to buy an annuity or two after accumulation. Investors can then choose their income plan.
Annuities remain a great way to generate income in retirement. The new launches of target-date funds with embedded annuities look to remove a major hurdle from adoption. But like anything in life, there are trade-offs. Investors need to do their research before enrolling these funds in their 401(k) or IRA.
