Since the U.S. Pension Protection Act of 2006, target-date funds (TDFs) have surged in popularity as retirement investment strategies, largely because they are simple to administer, qualify as default investment alternatives for automatic enrollment in retirement plans, and are perceived to lower risk at retirement by gradually decreasing allocation to high-risk assets. Market share of the 401(k) industry in TDFs has grown from 5 to 13 percent from 2006-2011, and the percentage of 401(k) participants holding TDFs has grown from 19 to 39 percent. Total assets in TDF mutual funds have grown from 71 billion at the end of 2005 to 481 billion in total net assets at the end of 2012 (Investment Company Institute, 2013).
This current confidence in TDFs may be misplaced. We show that every glide path can be matched to many others with the same risk characteristics at a target date, including an unchanging portfolio and even paths increasing in equity exposure over time. Furthermore, although specific glide paths can be selected to maximize either expected or median wealth, the “best” glide path for a given risk level at retirement is sensitive to both mean-variance and contribution-pattern assumptions and does not meaningfully increase the retirement wealth over nearby alternatives. Across a broad set of assumptions, while the optimal strategy is sometimes a gently decreasing glide path, the particular glide path is unlikely to be identifiable under realistic uncertainty about the inputs, and the benefits of this mathematical optimality are dubious in practical terms compared with other nearly optimal glide paths. In particular, a fixed portfolio over the investment period provides a transparent indication of its true risk characteristics, while being the best strategy for lump-sum investment and often nearly optimal for other investment plans. For the purposes of the simulation experiment presented here, we consider the fixed portfolio as truly fixed and unchanging through the duration of the glide path, but in practice, this type of investment could be adjusted to match changing risk appetites or markets, whereas a glide path needs to be followed through to attain its targeted risk level. The ability to cross-sectionally match a risk target is important, especially since market conditions through the entire investment horizon are unlikely to match those at the time when saving starts.
While each TDF has its own details as to how the portfolio is adjusted as retirement approaches, they all rely on a planned shift in holdings over time. This plan is generally set into motion at the onset of saving and acts as a “cruise control” or “autopilot,” with relatively few interventions. There is no theory or even consensus among providers as to the optimal glide path, but invariably these funds are built on the assumption that riskier assets should have greater exposures at first, and as the target date nears, allocations should be shifted toward lower-risk securities. The perception is that the glide path will create a more favorable probability distribution for retirement wealth. The process of trading toward increasingly low-risk model portfolios is often referred to in the industry as “de-risking” the portfolio. However, there is wide disagreement over what constitutes proper life-cycle risk aversion, and indeed, some advocate for less risk in early investment years.1