The False Promise Of Target-Date Funds

February 14, 2014

The marketing pitch for glide path funds may implicitly endorse faulty logic that assumes that risk taken earlier in an investor’s life cycle is absent from the retirement wealth distribution. The metaphor for a glide path is an airplane flight—cruising at altitude is like a higher-risk portfolio, and the smooth landing represents a gradual transition to a lower-risk portfolio. However, the airplane metaphor is misleading because it implies a known destination and deterministic outcomes of cockpit controls. Our investigations show that a glide path with decreasing exposure to equities does not offer the claimed protection from risk over other investment schedules, and essentially bets on the timing of the relative performance of assets. Furthermore, the optimal glide path is sensitive to the pattern of contributions.11

The choice that matters most, and has the most impact on the retirement wealth distribution, is the overall risk appetite of the investor. A 60/40 stock/bond ratio is riskier than a 40/60 mix, but the 60/40 portfolio is also rewarded with better expected and median returns in our simulations. The chart for a 60/40 investment is shown in Figure 7. The scale of the wealth distributions now extends to much greater values. The standard deviation of retirement wealth is approximately 2,042, as compared with 953 for the 40/60 portfolio. The increase in risk comes with a substantial reward, as the range of expected retirement-wealth amounts across glide paths is well outside the similar range for the 40/60 investment. However, the lowest quantiles of the 60/40 matched cases do worse than those of the matched 40/60 cases, so there is risk associated with the reward of greater median and expected retirement wealth. The main conclusion from the comparison is that the overall choice of risk level, proxied here by stock/bond ratio, has far more impact on the retirement-wealth outcome than the choice of glide path. It is well known in finance that the ratio of stocks to bonds is the most important determiner of portfolio performance (e.g., Brinson et al. 1986, 1991), and our simulations add further confirming evidence to this hypothesis.

Excerpt From July 2013 Persistence Scorecard

We have provided evidence, through our simulation experiment, that the optimal glide path at a particular risk level is highly dependent on assumptions of both market returns and investment contribution pattern, but there are many glide paths going in both directions that match this optimal one in risk characteristics and nearly match in target-date wealth distributions. Investors are likely better served by choosing a default risk approximating the market with a 60/40 or 50/50 stock/bond ratio, rather than predetermining a glide path that may not be a good fit later in the investment period when either market or personal circumstances change.



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