How target date funds help to beat volatility

One of the fundamental principles of investing is that you should be adequately rewarded for the risk you take when putting your cash to work. The risk that investing in the stock market carries is huge, but the potential rewards generated from owning a diversified portfolio of shares could prove to be just as high.

Equities outperform other asset classes over the longer-term, according to research carried out by Barclays on the returns generated by shares, bonds and cash.

The Barclays Equity Gilt Study discovered that:

• If you invested £100 in the stock market back in 1945 without reinvesting the income then the value of your shares would be worth £9,148 today.
• If you invested £100 in Gilts back in 1945 without reinvesting the income then the value of your investment would be £65.

The potential capital gains achieved though investing in these asset classes greatly increases if you reinvested the income they have generated in the past 70 years:

• The value of your £100 shares would be worth £179,695 today following dividend reinvestment
• The value of the £100 invested in Gilts reaches £7,773 following coupon payment reinvestment

Real investment returns by asset class (% pa)

Source: Barclays Research

Rise and fall

So investing in shares offers the potential for long-term capital growth and could mean a comfortable retirement for those choosing to invest most or all of their pension fund in the stock market.

The downside with shares is that prices don’t just rise. They have a tendency to fall too. The risk is that if you buy shares in the expectation that their value will increase but their price falls then it could hit the size of your pension pot, leaving you with less than expected when your retirement date arrives.

Recent events provide a harsh reminder of how volatile the stock market can be and the risks that investors are taking in owning shares. Fears of a slowdown in China, the world’s second largest economy, have forced not just the London Stock Exchange, but markets around the world lower as investors move their cash out of equities and into perceived safer assets, such as bonds or cash.

The effect that the raft of disappointing economic data in China is having on London’s blue chip index has moved the story from the business sections of the national press onto the front pages due to:

•      The FTSE 100 losing 14.7% of its value since 27 April 2015

•      The FTSE 100 plunging 4.7% on Monday 24 August, wiping £74 billion off the value of its constituents’ shares in just one day.

China crisis hits the FTSE

Source: Thomson Reuters Datastream

Volatile times

Volatility in the stock market goes with the territory, but such turbulence is often a short-term occurrence. If your timing is wrong when you need to take your money out then you could have less cash than if you had sold your shares a month or two earlier.

This could be a problem when it comes to retirement planning. When the time comes for you to leave work and cash-in your pension you could be left with a smaller fund than you had hoped for to fund your twilight years, reducing the quality of your lifestyle in retirement.

If you have a pension managed by a fund manager then there is a good chance that some or all of your money is tied-up in the FTSE 100. So how worried you should be by the huge losses racked up by the stock market since April depends on your age or how close you are to retirement because the likelihood is that the size of your pension fund has shrunk.

So those approaching retirement should be much more concerned than say someone in their 30s. It could mean that someone in their 60s they have to postpone their retirement or settle for a smaller pension.

The recent volatility shows how important it is for people to have a plan if they are investing for a specific event or date. A plan that helps them to benefit from the potential gains that the stock market can offer, while reducing the risk of huge losses the closer to retirement you get.

Target date plan

One option available to help savers achieve this is to look at investing in a target date fund.  

Also known as lifecycle or age-based funds, a target date funds automatically alter the weightings of stocks, bonds and other assets in its portfolio according to a set time frame.

The idea is that it gradually reduces volatility as the target maturity date of the fund approaches, which is on or around an investors’ retirement age. So, they are funds that manage risk to reflect a saver’s remaining investment time horizon.

This is the investing equivalent of flying a plane on autopilot. It is a low maintenance retirement plan where assets are bought, sold and managed for you to reduce risk in the portfolio the closer the fund gets to your planned retirement date.

As a saver your only input is deciding how much to invest and the year you want to start withdrawing your cash. So you put your money in, decide when you want to take it and any gains it has made back and then forget about it until your retirement arrives.

Here are how these funds look depending on how close to maturity they are:

• If an investor is decades away from retiring they can expect equities to feature heavily in their target date fund.

Decades of growth potential

Source: Architas BirthStar

• But the closer the fund gets to your retirement date the more conservative it becomes, the lower the risk it carries, such as buying more bonds than equities. The strategy changes from growth to protection.

Retirement ahoy

Source: Architas BirthStar

Target date funds are proving to be a popular way to prepare for retirement. In the US more than $700 billion was invested in target date funds at the end of 2014.

In the UK, they are used for workplace pension investing, such as National Employment Savings Trust (NEST) - the government-established workplace pension scheme.    

Target date funds are managed by a professional, who alters the risk/return balance as applicable. Decisions are made based on the time horizon of a saver’s goal and changing market conditions, but be aware:

This does not mean that returns are guaranteed. You still run the risk of collecting less than hoped on your retirement date or, worse still, losing all your money.

As with all investments that you make you need to DO YOUR HOMEWORK. Look at the funds on offer and the track record of its investment manager. Also look at costs:

• Is there an entry fee?
• Are there regular management or performance charges?
• Is there a charge for cashing in your investment early?

There is no guarantee that a target date fund will deliver an adequate pension pot on retirement, but for those who see the investment world as too complex or do not have the time to react to the latest market trends investing in such a product could see your savings benefit from the growth the stock market offers, while providing a margin of safety against volatility hitting the FTSE 100.

Providers of target date funds include Vanguard, Fidelity and Architas BirthStar.

Mark Dunne

AJ Bell Head of Research