Target-Date Funds: A Regime-Based Approach

Abstract

Target-date funds automatically shift the asset mix at regular intervals toward safer assets as the fund’s target date, which may be several decades away, draws near. A target-date fund is designed to reduce exposure to loss as the investor moves closer to retirement and has fewer years to offset potential losses. The implicit assumption of a target-date fund is that exposure to loss from risky assets increases as time decreases; hence the shift to safer assets as the investment horizon shrinks. However, another implicit assumption of target-date funds is that the standard deviation of assets is relatively stationary. The typical approach for determining the glide path assumes implicitly that the asset’s annualized standard deviation will not change much during any subperiod within the longer horizon. This second assumption is contrary to experience. Subperiod volatility is highly nonstationary, although it is not entirely unpredictable. Investors would be better served by the strategy this author describes, of not only managing the effect of time on exposure to loss but also accounting for the nonstationarity of risk.