Glide Path Within a Glide Path: How Fixed Income and Equity Can Work Together to Help Improve Retirement Outcomes
All target date series feature glide paths that reduce equities and simultaneously increase fixed income over time. American Funds Target Date Retirement Series® is distinguished by also featuring shifts in the nature of both the equity and the fixed-income exposure.
There is a perception in the marketplace that target date funds treat equities and fixed income similarly, and that the chief question is how much exposure to each asset class exists near and after retirement. In other words, how should the market risk that comes with equity exposure be balanced with the longevity risk — the potential to outlive your money — that comes with reducing it?
An important question is often neglected in these discussions: namely, what type of equity and fixed-income exposure should an investor have? The answer is important because not all equity is created equal, and not all bonds are created equal either. Dividend-paying equities have historically tended to be less volatile than those that don’t pay a dividend, while different kinds of fixed-income holdings can be used within a portfolio to achieve different objectives.
Allocations Adjust as Investor Objectives Change
As target date investors’ needs evolve during their lives, appreciation, income and preservation are required in different combinations. This is reflected in evolving asset allocations; and the type of equity and fixed income matters as much as the simple reduction of equity and increase in fixed income in the glide path of a target date fund.
In the accumulation phase, investors require appreciation. The transition to retirement is more complex, requiring a balance of appreciation, income and preservation. The distribution phase demands income and preservation with modest appreciation to address longevity and inflation risks.
The ability to use different types of equities and bonds — not just reducing equities and increasing bonds — to achieve these objectives gives a target date series multiple levers to help participants retire successfully.
The equity exposure shifts over time to reflect investors’ changing objectives — appreciation primarily in the early years, appreciation with downside protection in the transition stage, and preservation in the distribution stage. The focus on dividend-growing and dividend-paying equities is designed not only to help reduce volatility as participants approach retirement, but to pursue the dual needs of income and asset preservation after retirement. The recalibration to dividend-paying stocks also allows for a subtle shift to higher yielding fixed income.
Fixed-income securities also vary in their profiles with regard to yield, expected return and correlation to equities. Corporate bonds and international bonds may provide greater income than U.S. government bonds, but usually with higher correlation to equities.
American Funds Target Date Retirement Series Glide Path
A Dividend Focus Can Enhance Returns
Emphasizing dividend-paying stocks can also produce superior returns compared with an indifference to potential dividends or an emphasis on non-dividend payers. The chart below depicts how dividend-growing and dividend-paying stocks have produced greater returns, with less volatility, than non-dividend payers and the broader global equity universe for more than two decades.
At American Funds, we believe that both dividend-growth and dividend-income strategies should be a core part of an equity allocation, especially as investors enter retirement, for two related reasons that are both well-established: the dependability of the return stream and the potentially lower volatility of the equity allocation.
Dividends Have Been a Powerful Way to Reduce Volatility and Generate Return $100,000 investments (1990–2013)
Fixed Income’s Changing Role Throughout the Series
In our series, fixed-income investments serve four distinct purposes: risk mitigation via their low correlation to equities, income, near-term inflation protection, and capital preservation. Far from retirement, our target date funds hold government bonds to dampen equity volatility. During the transition stage to retirement, the funds add to investments in international bonds, corporate bonds and high-quality mortgage-backed bonds, while reducing investments in U.S. government bonds.
This fixed-income approach can help investors achieve potentially greater income from bonds in the transition phase. With equities contributing more income and lower volatility in the transition stage, the opportunity exists to use a different mix of bonds that has the potential to make a greater contribution to total return by delivering higher income. In other words, achieving greater relative stability in equities by emphasizing dividends allows for a potentially greater return contribution from bonds.
Over long periods of time, corporate bonds and international bonds have the potential to generate higher yields compared with U.S. government bonds. However, these bonds have the potential to be more volatile than U.S. government bonds.
The Primary Objectives of Bond Funds in the Series
Equity and Fixed-Income Allocations Are Complementary
The use of historically less volatile dividend-paying equities near retirement allows for a more diversified bond portfolio in the transition phase and a preservation focus in the distribution phase.
The equity and fixed-income components work together. The chart below depicts the changing bond fund exposure in the transition and distribution phases. The adjustment to historically higher yielding bonds would be less appropriate without the complementary adjustment, not just to lower equity weight, but also to higher yielding and less volatile equities — the equity glide path within the glide path.
This approach helps the American Funds Target Date Retirement Series in its goal of balancing longevity risk and market risk. The nature of equity and fixed-income holdings continues to be adjusted throughout the retirement investing life cycle, reflecting the changing needs of the investor.
Glide Path for Bond Funds Underlying fixed-income funds in American Funds Target Date Retirement Series as of June 30, 2014
Underlying Bond Funds Serve Different Purposes at Different Stages
American Funds Mortgage Fund®
Seeking income and preservation. Invests in high-quality mortgage-related securities, providing diversification in one of the bond market’s largest areas.
American High-Income Trust®
A well-researched approach to high-yield investing. Holds carefully researched, higher yielding, lower rated bonds with the potential for capital appreciation as company and economic fundamentals improve. More correlated with stocks than bonds.
The Bond Fund of America®
Well-diversified, quality-oriented income fund. Our most diversified bond fund invests in nearly every sector of the bond market, with a focus on securities rated A or above.
Capital World Bond Fund®
Bridging global markets. Invests primarily in sovereign and corporate bonds in both developed and developing markets. Provides exposure to currency movements and access to higher yields outside the United States, which can add an extra layer of bond diversification.
Intermediate Bond Fund of America®
Balancing income and preservation. Seeks to reduce credit and interest rate risk by holding high-quality government and corporate bonds in a portfolio with a dollar-weighted average maturity between three and five years.
Short-Term Bond Fund of America®
Quality, income and preservation. With a dollar-weighted average maturity of up to three years, the fund seeks a higher yield than money market funds with less interest rate volatility than longer term bond funds. Its high-quality portfolio includes U.S. government bonds and asset- and mortgage-backed securities.
U.S. Government Securities Fund®
A quality foundation. Holds mostly Treasury and agency securities and seeks to actively manage interest rate risk.
American Funds Inflation Linked Bond Fund℠
Invest with the goal of preserving purchasing power. Seeks to provide inflation protection and income consistent with investments in inflation-linked securities.