Rethinking target date funds
Retirement | Global
Is the conceptual design behind Target Date Funds sufficiently robust to warrant the claim of being “the” ideal solution for defined contribution retirement plans?
In the United States, Target Date Funds are becoming highly popular as a Qualified Default Investment Alternative (QDIA) for 401(k) and other defined contribution plans. TDFs claim that they can provide a “safer” alternative to traditional strategic asset allocation portfolios (e.g. the 60/40 equities/bonds portfolio) by providing a mostly automatic investment policy that combines broad diversification with a “glide path” dynamic allocation based on the participant’s age and expected retirement date.
The “glide path” is the distinguishing feature of TDFs, and although there are several variants, the general idea is to gradually reduce exposure to risky investments such as equities as the retirement date approaches, and to redirect funds to more conservative assets. The intuitive appeal is that a participant nearing retirement age would have most of the moneys invested in safer assets such as bonds or cash, which would provide better protection in the event of a severe market downturn near the retirement anniversary. Conversely, a younger participant could afford to hold a larger fraction of equities based on the alleged notion that equities can recover their value after a market downturn given a sufficiently long time horizon.
However, questions can be raised about the common claims made by TDF marketers that the “glide path” can provide a “safer” or a “more certain” outcome to investing for retirement. Surprisingly, in-depth rigorous research in support of these claims is conspicuously missing. A recent study by the Government Accountability Office (GAO)documents that TDFs have exhibited a wide range in performance during the 2008 market downturn, including some significantly negative returns for funds targeting 2010. The study has raised the concern that TDFs may be much riskier than expected.
We note that the TDF strategy appears, of course, to have the lowest amount of risk. But any reduction of risk comes predictably at the expense of the lowest expected median return among the three investment alternatives. From a practical standpoint, it ends up defeating the TDF proposition to some extent because any advantage due to the reduction of risk is negated by the corresponding expectations of a lower return. This detail is not often emphasized in TDF marketing literature.
We need a complete and consistent framework to vet the risk and return proposition of TDFs. In particular, financial operators and the Department of Labor should re-examine the existing TDF solutions and encourage more accurate disclosure of the expected risks and returns of each product in a manner consistent with (a) rigorous analysis based on commonly accepted financial theory and (b) realistic empirical market evidence.
For a full analysis of the target date fund model, download our complimentary white paper, “Re-thinking Target Date Funds: No magic formula.”
