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New Study Highlights Target Date Fund Flaws

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What You Need to Know

  • Target date funds have the same asset allocation for all investors regardless of their individual circumstances.
  • A new research paper shows that the allocation to equities in most target date funds is too low from many retirees.
  • Target date funds and similar funds could be improved by taking a number of external factors into account in their asset allocation.

Are target date funds a good choice for retirement savers? This has been an ongoing discussion over the years. TDFs are a staple default option in employer-sponsored retirement plans such as 401(k)s and 403(b)s.

While these funds provide a basic level of investment management for millions of workers, a new working paper shows how they produce suboptimal results for investors and suggests ways to improve them.

Target date funds have increased in popularity since the Pension Protection Act of 2006 (PPA) introduced the QDIA (qualified default investment alternative) as a safe harbor default option for 401(k) plans. TDFs are among the most common QDIAs used in many plans.

The target date fund corresponding to a participant’s normal retirement age would qualify as a QDIA for participants who don’t make an investment election on their own. 

One Size May Not Fit All

On the positive side, target date funds represent a managed option for participants who are not comfortable managing their investments on their own.

Target date funds are a one-size-fits-all investment, however. For example, a TDF with a target date of 2035 is geared to someone who will retire at or near 2035. If we assume that someone investing in the 2035 fund today is about 51, the fund assumes that the investment needs of all 51-year-olds are the same. I think all financial advisors know that nothing could be further from the truth. 

The Glide Path

Over time, the allocation to equities in target date funds decreases as we get closer to the target date of the fund. At some point, this allocation to equities levels off into a glide path that remains as a static allocation past that age. The glide path differs among target date fund families. Of the “big three,” T. Rowe Price has traditionally started their glide path at a later age than Vanguard and Fidelity. 

The glidepath allocation, and in fact the allocation of most TDFs around 15 years prior to retirement (approximating age 50), is not optimal for most retirees and pre-retirees, according to a recent academic research paper. 

NBER Research Paper

The working paper, titled Simple Allocation Rules and Optimal Portfolio Choice Over the Lifecycle, was recently published by the National Bureau of Economic Research. 

The authors of this research paper were Victor Duarte and Julia Fonseca of the University of Illinois; Aaron Goodman of MIT; and Jordan A. Parker of MIT and the NBER.

The authors of the research paper developed a machine-learning algorithm to solve for the optimal portfolio choices using a detailed and quantitatively accurate life cycle model that combines many features that have only been modeled separately in other research projects. In addition to age, their model included 22 variables, some of which apply only to retirement savers in their working years and some that apply only in retirement. 

Some conclusions of the study include: 

Optimal Equity Allocation

Their model suggests that on average, the allocation to equities should follow a hump-shaped pattern for a household over their working life. This allocation peaks around age 45 at an equity allocation of 80%. It then declines to about 60% at and during their retirement years

The authors note that through age 50, the optimal allocation to equities based on their research is similar to the allocation to equities in most target date funds. 

More on this topic

Their research showed that average optimal allocation to stocks starts at 90% when a person begins working, declining to around 80% around age 50. They found that a typical TDF mimics this allocation with a 90% allocation until age 40. The allocation then decreases gradually to 75% at age 50.

At this point, the equity allocations diverge. The equity allocation in most target date funds declines to about 50% at retirement and then continues to decline to around 30%-40% once the glide path flattens out. According to the findings of the research, this allocation is too low for most retirees. 

Substantial Variations

The researchers found that mutual funds, like target date funds where the asset allocation is a function of age, are inappropriate for many investors. This is especially true as investors age to where they have typically accumulated the most wealth for retirement. 

Their model indicates that the 90th percentile of their optimal cross-household allocation to equities approaches 100% for retirement accounts at all ages in their study. The 10th percentile declines over time from about 30% allocated to equities at age 25 to less than 20% in retirement. 

There are a number of possible reasons for these discrepancies in the optimal allocation to equities for different households. These could include differences in risk tolerance, plus higher non-portfolio retirement income streams such as a pension, annuities or other sources for those with lower equity allocations. 

Target date funds do not take into account that two investors of similar age may have radically different retirement situations calling for distinctly different portfolio allocations. 

Purchasing Power Declines

A third conclusion of their research quantifies the loss in purchasing power from going with a target date fund as opposed to the optimal investing behavior identified by the researchers in the study. 

The researchers found that on average, investing in an age-based portfolio such as a target date fund resulted in an annual loss that was the equivalent of 1.7% of consumption or purchasing power if the investor reoptimized their other behaviors each year. The loss rose to 2.8% of consumption each year if the household did not reoptimize their other behaviors. 

Improving Target Date Portfolios 

Their research found that the advice inherent in mutual funds such as target date funds could be improved by taking a number of variables into account. These could include: 

  • Differences in the wealth levels of investors.
  • The state of the business cycle.
  • Dividend-to-price ratios. 

They found that taking these variables and others into account and tailoring the fund allocations accordingly could add value to investors across the wealth and income spectrum. 

Implications for Advisors

These findings and those of other studies that came to similar conclusions have several implications for financial advisors. 

If you advise the sponsor of a 401(k) or similar defined contribution plan, you will want to consider whether a target date fund family is the best answer for offering a managed account solution for the plan participants. Do they offer the opportunity for the best participant outcomes? This is a key question with the emphasis on retirement readiness on the part of many retirement plan sponsors.                                            

If your clients have money in a 401(k), 403(b) or other workplace defined contribution plan, you will likely want to help them construct their own portfolio from among the various investment options in the plan versus having them default to a target date fund option. 

The research points out that all investors are different and that one-size-fits-all investments such as target date funds may not be a good fit for all investors at all stages of life.


Roger Wohlner is a financial writer with over 20 years of industry experience as a financial advisor.