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.
What Your Peers Are Reading
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.