Target-date providers use different methods to tackle inflation

Target-date series follow a fairly traditional format of building up equities when investors are young, then mitigating risk over time via more fixed-income investments. However, for those years between the biggest allocation to equities and the biggest allocation to fixed income, there's a world of difference in how target-date providers address inflation and risk.

Short-term Treasury inflation-protected securities is the inflation-protection choice for the glidepath of Vanguard Group's target retirement funds. The company's short-term TIPS fund, with maturities of less than five years, are introduced five years before the retirement date of a given fund. The amount increases monthly until it reaches 17% of the total portfolio — and 24% of the fixed income component — seven years past the retirement date and beyond.

Vanguard's target-date fund developers chose the firm's short-term TIPS fund because other possible inflation-protection assets — including longer-duration TIPS — were too volatile by comparison, said James Martielli, head of investment solutions in Vanguard's institutional investor group, based in Malvern, Pa.

"Short-term TIPS have relatively low volatility and a pretty high correlation to unexpected inflation," said Mr. Martielli, adding that Vanguard replaced its longer-term TIPS fund in 2013 with the short-term version. "We concluded that short-term TIPS offered better protection against unexpected inflation." The longer-term TIPS fund has maturities of one to 30 years.

Vanguard's research showed that other asset categories have had a strong correlation to unexpected inflation, but the volatility of commodities, precious metals and real estate investment trusts far exceeded that of short-term TIPS. Mr. Martielli noted that REITs are part of the target-date fund's equity component.

The target-date series' heavy emphasis on equities during the early years when younger workers are building their retirement savings provides inflation protection over the long term, he said. As participants grow older, they look to reduce risk, and fixed income starts to play a bigger role in the series starting at age 40.

"When we construct a target-date fund, we take a very long-term view," Mr. Martielli explained. "We are not looking to tactically allocate from one month to the next or from one quarter to the next."

The company's strategic asset allocation committee meets regularly to review the methodologies of all Vanguard investment products. "We constantly evaluate and re-evaluate our target-date funds, but we do not constantly change," he said.

When Putnam Investments built its Retirement Advantage Trust target-date series, the collective investment trust-based product contained seven broad benchmark categories ranging from U.S. large-cap equity to money market funds.

These allocations change as the glidepath changes, but Putnam also allows for tactical allocations. In January, for example, Putnam officials added commodities to the target-date series. As of June 30, the allocation ranged from 1% for the 2065 fund to 3% for the 2025 fund.

"This allocation is part of our dynamic allocation process that allows for investments in commodities at opportune times, without the long-term drag of inferior risk-adjusted returns," said Brett Goldstein, Boston-based co-CIO of global asset allocation. "Year-to-date, we are overweight on commodities," he said.

Mr. Goldstein said Putnam chose this approach rather than create a target-date series with what he called "static" allocations — specific long-term allocations to assets such as commodities and TIPS.

"We don't include them on a structural basis," preferring, based on internal research, to make adjustments "on an as-needed basis," he said.

Putnam's research showed that commodities were a poor long-term inflation-hedge choice.

Putnam compared the Sharpe ratio of commodities, bonds and equities between May 1991 and May 2021. The equities score was 0.56, the bond score was 0.61 and the commodities score was -0.11 for this measurement of risk-adjusted returns in which a higher score means a better risk-adjusted return.

As for TIPS, Putnam's research showed a high correlation with U.S. Treasuries. Given this correlation, "it is not clear that TIPS warrant a strategic allocation in a glidepath portfolio," Mr. Goldstein and Seamus Young, senior investment director, wrote in a July 19 Putnam blog post.

"Today, the real yield on a Treasury inflation-indexed security is just shy of -1.00%," they wrote. "This means that investors who purchase TIPS today at negative real yields and hold them to maturity are guaranteed to lose purchasing power."

Putnam's conclusion is that the best inflation hedge is a fully invested portfolio emphasizing active management, Mr. Goldstein said.

T. Rowe Price Group Inc.'s target-date construction offers a structural inflation-protection component as well as a tactical overlay that allows for adjustments.

The T. Rowe Price target-date fund glidepath starts with a heavy dose of U.S. and international equities with some U.S. investment-grade bonds and high-yield bonds 25 years before the date of a fund that is closest to a person's retirement age, typically at 65. Over time, the fixed-income components increase.

T. Rowe Price addresses inflation two ways — real assets through publicly traded companies and inflation-focused bonds.

The target-date series' equity component always contains a 5% allocation of real assets-focused companies regardless of how much total equity is allocated to the glidepath. These investments — covering such areas as commodities, natural resources, energy and real estate — are "designed to improve the long-term risk-return profile of the portfolio by dampening sensitivity to material changes in the prevailing inflation regime," said Andrew Jacobs van Merlen, the Baltimore-based co-portfolio manager of target-date strategies.

The other strategy is inflation-focused bonds, which T. Rowe Price describes as primarily TIPS.

For one target-date series, the inflation-focused bonds start with a 1% allocation nine years from the retirement date. The amount rises to 20% of the total allocation 25 years beyond the retirement date. For another target-date series, the inflation-sensitive bonds start at a 1% allocation 19 years before the retirement date and reach a 20% allocation at the retirement date.

"We are planning over a life cycle, so we need enough growth assets to mitigate inflation over time," Mr. Jacobs van Merlen said. "Equities are a pretty decent hedge against inflation over the long term."

However, as participants approach retirement, TIPS indexed to inflation provides greater protection and risk mitigation, he said.

Mr. Jacobs van Merlen said the tactical overlay allows target-date fund managers to make adjustments to asset categories. For example, the target-date series was overweighted in TIPS in February but began reducing its exposure in July even though it is still overweight.

"This is not market timing," said Mr. Jacobs van Merlen, noting that an investment committee usually meets every month to assess economic trends. "We look at the risk," he said.

Tactical allocations are done incrementally. These allocations "have a typical investment horizon of six to 18 months," he said.

'We are planning over a life cycle, so we need enough growth assets to mitigate inflation over time.'

T. Rowe Price's Andrew Jacobs van Merlen