Target-date retirement funds are the money management industry’s answer to one-stop shopping.
The name is self-explanatory: target-date funds focus on a future retirement date. Based on a pre-set time horizon, the funds tend to be more aggressive early on, and become more conservative as the target retirement date approaches. The change in asset allocation over time is called the fund’s “glide path”.
In theory, target-date funds are a simple solution to retirement planning. In reality, they aren’t all they are made out to be.
Because target-date funds are set on a pre-determined road map, they don’t respond appropriately to changes in the economic environment. Target-date funds vary dramatically in their glide paths, so two funds with the same retirement date may have very different levels of risk. And because target-date funds are designed to fit everyone, they end up fitting no one…a one-size-fits-all fund can’t accommodate an individual investor’s unique needs.
A recent paper from Research Affiliates, “The Glidepath Illusion”, takes target-date funds and turns them on their head – literally.
Research Affiliates poured over 141 years of stock and bond market data going back to 1871. They ran a simulation that assumed an investor put away $1,000 a year (adjusted for inflation) in a fund that started out with an allocation of 80% stocks and 20% bonds. Over the course of 41 years, the fund shifted to a more conservative mix of 80% bonds and 20% stocks. The resulting portfolio would have been around $124,460.
Then they took the traditional glide path and turned it upside down. They assumed that an investor started out with a conservative allocation of 80% bonds and 20% stocks, and ended up with a riskier mix of 20% bonds and 80% stocks at retirement. That investor would have ended up with a portfolio of $152,060.
In other words, the traditional glide path didn’t serve investors as well as a counterintuitive glide path.
Target-date funds are supposed to be a simple, set-it-and-forget-it approach to retirement. For that reason, they are the default option for many 401k plans. But, as “The Glidepath Illusion” concluded, “the basic premise upon which these billions are invested is flawed”.