Understanding TDF Glide Paths

A target-date fund (TDF)’s glide path represents its changing mix of investments over time, Capital Group explains on its website. As a participant’s target retirement date nears, the fund “glides down” to a more conservative mix of investments.

Understanding how a TDF’s glide path works—how equities and fixed-income-type investments shift as investors age—is necessary for defined contribution (DC) plan sponsors to fulfill their fiduciary duties in fund selection and monitoring plan investments.

Glide paths are designed to be gradual in investment portfolios, says John Doyle, senior retirement strategist at Capital Group/American Funds. Young workers who are just building their retirement savings will have a more aggressive risk level in their portfolios, with higher amounts of equities, but those investments will turn conservative, or shift to fixed-income investments, as they age, Doyle explains. “As the individual ages, their investment glide path matures to match their needs,” he says. “Some TDF glide paths will continue even after an individual retires.”

Randy Welch, managing director and portfolio manager at Principal, notes that investing in a TDF automates the management of investments for plan participants. Participants don’t have to be concerned with when to rebalance, shift and de-risk their portfolios, easing their path to retirement. “It’s a very easy and efficient way to get individuals to the proper asset allocation based on their age and time to retirement,” Welch says. “It handles that for them.”

While most individuals will begin investing between ages 22 to 25, some may start as early as 18 years old, Welch notes. Because these workers are just starting their savings journey, they should have very little invested in capital. Instead, they’ll have a higher exposure to equities to develop growth in their portfolios, because they have decades to accumulate, he says.

“Over time, we will de-risk what we think is appropriate, based on the goals that we are trying to achieve for them, and we gradually reduce at the easy level, from equities to fixed income,” Welch explains. “As a person gets closer to retirement, there is more sensitivity to inflation, so there may be [adjustments for that].”

Welch says the basic principle is to start an investor at 93% equities and 7% fixed income in their portfolios. Over time, equity is gradually reduced and fixed income is increased, but a proper percentage of equities is maintained for portfolio growth, based on the investor’s retirement age, he says.

Below is a basic example of a TDF glide path:

Source: Capital Group / American Funds.

Doyle says he believes there is a common misconception in how a glide path moves over the years. TDF managers don’t just change the percentage of stocks and bonds, they tactically manage them over time. It’s not just a pool of stocks that shrinks to a percentage of the participant’s portfolio over time and a pool of bonds that increases as the individual goes along their timeline, he says. “What you own in your stock portfolio at age 25 is very different than what you own when you’re 55 or 65 years old,” he says. “It’s not just a shift in percentage of stocks in the portfolio, it’s a real change in the types of stocks working in the portfolio.”

The same can be said about bond portfolios. Bonds play a different role at various ages along the glide path, therefore what a 25- or 35-year-old participant owns in bonds is different than what a 55-, 65- or even 75-year-old participant should own in their portfolio, Doyle says.

It’s integral to maintain the appropriate level of equity at each stage in the glide path, to ensure proper risk exposure and high growth, but this can differ depending on what the risk profile looks like for a specific investor, Doyle says. For example, at Capital Group/American Funds, a 65-year-old participant is still treated as a long-term investor with a 30-year time horizon for several assets in their portfolio.

Instead of looking at what percentage of the portfolio should be in stocks versus bonds, Doyle says, it’s important to understand what the investor’s risk profile should look like and how to get there. “I don’t know if there should be a specific answer on what percentage of stocks they should have at a certain age,” he notes. “It’s more about portfolio construction and the risk profile, and so the actual allocation is going to vary within guardrails. There’s no one right answer, it’s more about, ‘What does the risk profile look like for someone at that point in their timeline?’”

Welch expresses a similar view, explaining that appropriate levels of equity depend on the characteristics of an investor. At Principal, investors begin with 91% to 93% of equity exposure in the glide path. By the time they reach retirement age, the percentage of equity exposure down to 44% to 45%. When a retiree hits 15 years past retirement, this will decrease to 23% to 24% of equities.

Equities and fixed income portions of a TDF glide path might include different investment types. For example, some glide paths might use real assets that would be considered equities, but that vary in performance, Doyle notes. Real assets are investment vehicles such as commodities, public infrastructure and TIPS [Treasury inflation-protected securities] that provide a cushion to the portfolio should there be a shock in the markets, Welch says.

On the fixed-income side, high-yield bonds may be used. High yield bonds have a greater expected return but more volatility than government bonds, Welch explains. Those who are invested in high-yield accounts experience higher amounts of volatility because they’re investing in companies that are not investment-grade but that have the ability to earn excess return at additional risks, he adds.

Aside from real assets and high-yield accounts, Welch says Principal offers large-cap, big-cap and small-cap equity exposure within the U.S., and both developed and emerging equities in the non-U.S. markets. The company adds inputs to its models to manage expectations when investors are nervous about the market, like during the market swings of 2020 caused by the COVID-19 crisis.

“We give investors in TDFs exposure to many asset classes to help benefit them no matter where they are in the glide path,” Welch continues. “Most individual investors would not gravitate to or have an allocation to high-yield or emerging markets, so the TDF helps them do that.”