Target Date Funds Research Articles

Practical Applications of Target-Date Funds, Glidepaths, and Risk Aversion

In <b>Target-Date Funds, Glidepaths, and Risk Aversion</b>, from the Winter 2020 issue of <i><b>The Journal of Wealth Management</b></i>, author <b>Javier Estrada</b> (of <b>IESE Business School</b> in <b>Barcelona, Spain</b>) explores why target-date funds (TDFs) use glidepaths that reallocate assets out of high-growth investments and into capital preservation funds as individuals approach retirement. The simple answer is that people become more risk averse as they get older. But therein lies a problem: People tend to have less to invest when younger and more when older–so shifting money into low-growth investments reduces investors’ earnings potential as they accumulate more principal to invest. This may leave them with less at retirement. Whether this strategy is suitable depends on how much investors’ risk aversion really increases with age. Estrada investigates how much risk aversion would have to increase to match the risk reduction implemented by a popular TDF that starts off with a 90%/10% stock/bond allocation and ends up at 50%/50% at retirement. Using statistical analysis, Estrada determines that risk aversion would have to more than double during the last 25 years of working life to match the glidepath. Financial advisors may wish to take these findings into account in discussions with clients. <b>TOPICS:</b>Equity portfolio management, retirement, wealth management, risk management

Target-date funds and portfolio choice in 401(k) plans

AbstractTarget-date funds in corporate retirement plans grew from $5 billion in 2000 to $734 billion in 2018, partly because federal regulation sanctioned these as default investments in automatic enrollment plans. We show that adopters delegated pension investment decisions to fund managers selected by plan sponsors. Inclusion of these funds in retirement saving menus raised equity shares, boosted bond exposures, curtailed cash/company stock holdings, and reduced idiosyncratic risk. The adoption of low-cost target-date funds may enhance retirement wealth by as much as 50% over a 30-year horizon.

Optimal Target-Date Funds for Observed Savings Rates

We study optimal life-cycle portfolio allocation and its application to target-date fund (TDF) design. We show that optimal TDF allocation must be explicitly linked to a savings rate; for example, a higher savings rate generating higher financial wealth accumulation should necessarily come with a more conservative TDF. Further, we quantify the extent to which accumulated wealth, the investing environment, and participant characteristics affect TDF allocations and compare the resulting optimal allocations against the observed universe of U.S. TDF products. Plan sponsors and asset managers can use these findings to improve TDF selection and design.

Dynamic optimization for multi-goals wealth management

We develop a dynamic programming methodology that seeks to maximize investor outcomes over multiple, potentially competing goals (such as upgrading a home, paying college tuition, or maintaining an income stream in retirement), even when financial resources are limited. Unlike Monte Carlo approaches currently in wide use in the wealth management industry, our approach uses investor preferences to dynamically make the optimal determination for fulfilling or not fulfilling each goal and for selecting the investor’s investment portfolio. This can be computed quickly, even for numerous investor goals spread over different or concurrent time periods, where each goal may be all-or-nothing or may allow for partial fulfillment. The probabilities of attaining each (full or partial) goal under the optimal scenario are also computed, so the investor can ensure the algorithm accurately reflects their preference for the relative importance of each of their goals. This approach vastly outperforms static portfolio strategies and target-date funds, widely used in the wealth management industry.

Practical Applications of Measuring Sequence of Returns Risk

In <b>Measuring Sequence of Returns Risk</b> from the Summer 2020 issue of <b><i>The Journal of Retirement</i></b>, authors <b>Andrew Clare</b> (of <b>Cass Business School</b>), <b>Simon Glover</b> (of <b>ITI Group</b>), <b>James Seaton</b> (of <b>Solent Systematic Investment Strategies</b>), <b>Peter Smith</b> (of the <b>University of York</b>), and <b>Stephen Thomas</b>(of <b>Cass Business School</b>) demonstrate that the timing–not just the amount–of investment returns can be vitally important to investors’ retirement income prospects. Major losses right around one’s retirement date are much more damaging than those that happen long before or after retirement. Popular investment vehicles like target-date funds (TDFs) have not protected against sequence risk, so investors need a different strategy. The authors find that a simple stock/bond asset allocation combined with a trend-following strategy for the stock portion (switching assets between stocks and government bonds, based on current market trends) greatly reduces sequence risk and minimizes the chances that retirees will run out of money or need to withdraw less from savings each year. The authors also offer ways to measure how well different investment strategies protect against sequence risk. <b>TOPICS:</b>Volatility measures, downside-only measures, performance measurement

Practical Applications of Glide Path Indexes

In <b><i>Glide Path Indexes</i></b>, from the Spring 2020 edition of <b><i>The Journal of Index Investing</i>, Ronald Surz</b> of <b>GlidePath Wealth Management</b> discusses how investors can protect their savings as they transition into retirement. Glide path indexes, such as target-date funds (TDFs), vary asset allocations depending on an investor’s age, reducing equity exposure as an individual approaches retirement. But most portfolios following industry-standard paths incorporate too much risk at the wrong time: the years bracketing retirement. If investors are allocated too heavily to equities during those years, they face the risk of liquidating stocks at low prices to produce cash flow for their the initial phase of their retirement. These unfortunate investors then have less to draw from to meet future retirement expenses and much less time to repair overall portfolio damage using income from employment or other sources. Surz proposes an alternative glide path that uses rigorous risk management and greater diversification to substantially diminish this hazard. To better protect savings, Surz’s approach dramatically lowers equity and long-term bond exposure in favor of safer assets as an investor nears her retirement date. His glide path strategy then gradually incorporates more equity and bond risk as investors move through retirement, so as to revitalize growth potential and extend the life of the investor’s savings. <b>TOPICS:</b>Wealth management, retirement, mutual fund performance

Importance of Costs in Target Date Fund Selection Using Three Morningstar Ratings

Although target date mutual funds (TDFs) have only been around since the mid-1990s, they are now common vehicles for retirement investing. Sixty percent of US companies now automatically funnel employees’ non-directed retirement funds into TDFs, which account for nearly one-quarter of all savings US workers have in 401(k)s. Helping investors pick among TDFs, Morningstar rates past risk-adjusted performance using a star system and provides forward-looking evaluations of more than 2,500 TDFs using either Analyst Ratings or a newly implemented machine-learning-based Quantitative Ratings. Morningstar assigns Analyst Ratings to a smaller subset of TDFs that tend to have been in existence the longest and have the largest size. We find that TDFs with lower fees have significantly higher star ratings than their higher expense counterparts. No-load TDFs have significantly higher star ratings than their load-charging counterparts. In assessing future fund prospects, TDFs with low expense ratios are favored by both analysts and artificial intelligence. TDFs without load charges have significantly better Quantitative Ratings than their load charging counterparts. TDFs with Quantitative Ratings tend to be smaller, younger, and have poorer prior performance than TDFs with Analyst Ratings. <b>TOPICS:</b>Long-term/retirement investing, mutual funds/passive investing/indexing, information providers/credit ratings <b>Key Findings</b> ▪ Target date funds (TDFs) with low expenses and without load charges have significantly higher Morningstar star ratings of past risk-adjusted performance. These same low-cost funds have higher Morningstar Analyst ratings and Quantitative ratings, which estimate future fund prospects of performance. ▪ Regression results suggest Morningstar’s two forward-looking fund ratings are not perfect substitutes. Analyst ratings weight fund expense and fund age more heavily (both negatively) while the computer-generated Quantitative ratings are more positively influenced by past fund performance. ▪ Morningstar’s star ratings, Analyst ratings, and Quantitative ratings all suggest that retirement investing will result in a larger nest egg when attention is restricted to no-load, low-expense TDFs. Additionally, the ratings suggest investors should favor larger but relatively younger funds.

Improving on Defaults: Helping Pension Participants Manage Financial Market Risk in Target Date Funds

The central issue of this paper is analysis and resulting proposals to help unsophisticated pension participants achieve pension portfolios that match their level of risk aversion when there is a large amount of unexplained heterogeneity in risk aversion. Target date funds are commonly used as the default investment in defined contribution plans in the U.S., UK and other countries. These funds recognize that individuals usually should hold less risky investment portfolios as their expected retirement date approaches because their ability to bear financial market risk declines as the time horizon decreases. However, these funds do not account for differences in risk aversion among people with the same target date. Empirical studies find large amounts of unexplained heterogeneity in risk aversion. Target date funds cannot deal with this issue simply by sorting people into demographic groupings, other than age, that are known to affect risk aversion, such as gender. Financial education can help people do a better job of managing financial market risk in their pension portfolios, but we argue that it is unreasonable to expect millions of pension participants to attain advanced levels of financial literacy. This paper considers three innovations in target date funds that can help individual pension participants do a better job of managing financial market risk. The analysis can be applied to other situations where defaults are used for investing pension participants’ portfolios. The paper suggests new lines of research relating to individual differences in risk aversion.

Multistage allocation problem for Mexican pension funds.

The problem of multistage allocation is solved using the Target Date Fund (TDF) strategy subject to a set of restrictions which model the latest regulatory framework of the Mexican pension system. The investment trajectory or glide-path for a representative set of 14 assets of heterogeneous characteristics is studied during a 161 quarters long horizon. The expected returns are estimated by the GARCH(1,1), EGARCH(1,1), GJR-GARCH(1,1) models, and a stationary block bootstrap model is used as a benchmark for comparison. A fixed historical covariance matrix and a multi-period estimation of DCC-GARCH(1,1) are also considered as inputs of the objective function. Forecasts are evaluated through their asymmetric dependencies as quantified by the transfer entropy measure. In general, we find very similar glide-paths so that the overall structure of the investment is maintained and does not rely on the particular forecasting model. However, the GARCH(1,1) under a fixed historical covariance matrix exhibits the highest Sharpe ratio and in this sense represents the best trade-off between wealth and risk. As expected, the initial stages of the obtained glide-paths are initially dominated by risky assets and gradually transition into bonds towards the end oof the trajectory. Overall, the methodology proposed here is computationally efficient and displays the desired properties of a TDF strategy in realistic settings.

An Examination of Target Date Fund Glidepath Construction

The paper examines Target Date Fund glidepath construction as well as asset allocation strategies. We consider characteristics, features, and assumptions in solving the multi-period portfolio selection problem. This paper discusses the theoretical underpinnings of deterministic, adaptive, and stochastic models as well as some interesting alternative strategies. Furthermore, we also propose research topics for future consideration that the author believes may improve upon the existent model frameworks.

An Analysis of the Performance of Target Date Funds

This article presents a thorough evaluation of target date funds (TDFs) for the period 2010–2020. TDFs have grown enormously in assets, reaching $1.4 trillion at the end of 2019, and account for approximately 24% of all assets in 401(k) accounts. We report on the results of a style analysis evaluation of TDFs that determines their effective asset allocation. It examines both the constant in the style analysis regressions and resulting Sharpe ratios, which reflect the over- or under-performance of the funds relative to a passive benchmark with the same asset allocation. Lower cost TDFs tend to match the benchmark returns, while higher cost TDFs deviate from them considerably. We examine how TDFs performed in the stock market crash between February 19 and March 23, 2020, during which five-week period broad market averages fell by about one-third. We find that the value of long-dated TDFs (those with a target date of 2045 and beyond) fell by between 30% and 35%, while the 2025 funds, designed for people roughly 60 years old, lost between 20% and 25% of their value. We find that past performance only weakly influences future expected performance. As with equity funds in general in this period, TDFs with actively managed ingredient funds, on average, trailed the performance of their cheaper passively managed counterparts. <b>TOPICS:</b>Pension funds, portfolio theory, risk management, performance measurement <b>Key Findings</b> ▪ Even near term target date funds (TDFs) have considerable equity exposure. For instance, 2025 TDFs lost between 20 and 25% of their value in the five weeks between February 19 and March 23, 2020. Many longer horizon TDFs did no better than pure equity funds in this period. ▪ 75% of actively managed TDFs failed to do as well as the best fitting set of reference ETFs. ▪ Past performance is only a weak predictor of future performance for TDFs. An extra 1% per year return in 2010–14 period only increases the expected return in 2015–19 by 9 basis points per year.

Practical Applications of Glide Path Indexes

In <b><i>Glide Path Indexes</i></b>, from the Spring 2020 edition of <b><i>The Journal of Index Investing</i>, Ronald Surz</b> of <b>GlidePath Wealth Management</b> discusses how investors can protect their savings as they transition into retirement. Glide path indexes, such as target-date funds (TDFs), vary asset allocations depending on an investor’s age, reducing equity exposure as an individual approaches retirement. But most portfolios following industry-standard paths incorporate too much risk at the wrong time: the years bracketing retirement. If investors are allocated too heavily to equities during those years, they face the risk of liquidating stocks at low prices to produce cash flow for their the initial phase of their retirement. These unfortunate investors then have less to draw from to meet future retirement expenses and much less time to repair overall portfolio damage using income from employment or other sources. Surz proposes an alternative glide path that uses rigorous risk management and greater diversification to substantially diminish this hazard. To better protect savings, Surz’s approach dramatically lowers equity and long-term bond exposure in favor of safer assets as an investor nears her retirement date. His glide path strategy then gradually incorporates more equity and bond risk as investors move through retirement, so as to revitalize growth potential and extend the life of the investor’s savings. <b>TOPICS:</b>Wealth management, retirement, mutual fund performance

Portfolio Management for Insurers and Pension Funds and COVID-19: Targeting Volatility for Equity, Balanced and Target-Date Funds with Leverage Constraints

Insurers and pension funds face the challenges of historically low interest rates and volatility in equity markets, that have been accentuated due to the COVID-19 pandemic. Recent advances in equity portfolio management with a target volatility have been shown to deliver improved on average risk adjusted return, after transaction costs. This paper studies these targeted volatility portfolios in applications to equity, balanced and target-date funds with varying constraints on leverage. Conservative leverage constraints are particularly relevant to pension funds and insurance companies, with more aggressive leverage levels appropriate for alternative investments. We show substantial improvements in fund performance for differing leverage levels and that the return per unit of risk is not significantly impacted by the leverage constraint. Of most interest to insurers and pensions funds, we show that the highest return per unit of risk is in targeted volatility balanced portfolios with equity and bond allocations. Furthermore, we demonstrate the outperformance of targeted volatility portfolios during major stock market crashes, including the crash from the COVID-19 pandemic.

Practical Applications of Measuring Sequence of Returns Risk

In <b>Measuring Sequence of Returns Risk</b> from the Summer 2020 issue of <b><i>The Journal of Retirement</i></b>, authors <b>Andrew Clare</b> (of <b>Cass Business School</b>), <b>Simon Glover</b> (of <b>ITI Group</b>), <b>James Seaton</b> (of <b>Solent Systematic Investment Strategies</b>), <b>Peter Smith</b> (of the <b>University of York</b>), and <b>Stephen Thomas</b>(of <b>Cass Business School</b>) demonstrate that the timing–not just the amount–of investment returns can be vitally important to investors’ retirement income prospects. Major losses right around one’s retirement date are much more damaging than those that happen long before or after retirement. Popular investment vehicles like target-date funds (TDFs) have not protected against sequence risk, so investors need a different strategy. The authors find that a simple stock/bond asset allocation combined with a trend-following strategy for the stock portion (switching assets between stocks and government bonds, based on current market trends) greatly reduces sequence risk and minimizes the chances that retirees will run out of money or need to withdraw less from savings each year. The authors also offer ways to measure how well different investment strategies protect against sequence risk. <b>TOPICS:</b>Volatility measures, downside-only measures, performance measurement

401(k) Plan Asset Allocation, Account Balances, and Loan Activity in 2018

The bulk of 401(k) assets were invested in stocks. On average, at year-end 2018, 63 percent of 401(k) participants’ assets were invested in equity securities through equity funds, the equity portion of balanced funds, and company stock. Twenty-eight percent of assets were in fixed-income securities such as stable value investments, bond funds, money funds, and the fixed-income portion of balanced funds. More 401(k) plan participants held equities at year-end 2018 than before the financial market crisis (year-end 2007), and most had the majority of their accounts invested in equities. For example, about three-quarters of participants in their twenties had more than 80 percent of their 401(k) plan accounts invested in equities at year-end 2018, up from less than half of participants in their twenties at year-end 2007. Overall, more than 90 percent of 401(k) participants had at least some investment in equities at year-end 2018. More than three-quarters of 401(k) plans, covering more than three-quarters of 401(k) plan participants, included target date funds in their investment lineup at year-end 2018. At year-end 2018, 27 percent of the assets in the EBRI/ICI 401(k) database were invested in target date funds and more than half of 401(k) participants in the database held target date funds. Also known as lifecycle funds, these funds are designed to offer a diversified portfolio that automatically rebalances to be more focused on income over time. In an ongoing collaborative effort, the Employee Benefit Research Institute (EBRI) and the Investment Company Institute (ICI) collect annual data on millions of 401(k) plan participants as a means to examine how these participants manage their 401(k) plan accounts. This report is an update of EBRI and ICI’s ongoing research into 401(k) plan participants’ activity through year-end 2018. The report is divided into four sections: the first describes the EBRI/ICI 401(k) database; the second presents a snapshot of participant account balances at year-end 2018; the third looks at participants’ asset allocations, including analysis of 401(k) participants’ use of target date, or lifecycle, funds; and the fourth focuses on participants’ 401(k) loan activity.

On The Investment Strategies in Occupational Pension Plans

Demographic changes increase the necessity to base the pension system more and more on the second and the third pillar, namely the occupational and private pension plans; this paper deals with Target Date Funds (TDFs), which are a typical investment opportunity for occupational pension planners. TDFs are usually identified with a decreasing fraction of wealth invested in equity (a so-called glide path) as retirement comes closer, i.e., wealth is invested more risky the younger the saver is. We investigate whether this is actually optimal in the presence of non-tradable income risk in a stochastic volatility environment. The retirement planning procedure is formulated as a stochastic optimization problem. We find it is the (random) contributions that induce the optimal path exhibiting a glide path structure, both in the constant and stochastic volatility environment. Moreover, the initial wealth and the initial contribution made to a retirement account strongly influence the fractional amount of wealth to be invested in risky assets. The risk aversion of an individual mainly determines the steepness of the glide path.

Missing the Target? Retirement Expectations and Target Date Funds

Missing the Target? Retirement Expectations and Target Date Funds

Target Date Funds and Portfolio Choice in 401(k) Plans

Target Date Funds and Portfolio Choice in 401(k) Plans

Target Date Funds: Evidence Points to Growing Popularity and Appropriate Use by 401(k) Plan Participants

Target Date Funds: Evidence Points to Growing Popularity and Appropriate Use by 401(k) Plan Participants

Risk Capacity Portfolio Construction

This paper introduces a portfolio construction framework for risk-averse investors that aim to meet or exceed a client’s capital accumulation needs for a future event, such as retirement. Risk Capacity Portfolio Construction (RCPC) presents a risk-optimized alternative to Target Date Funds (TDFs). Risk Capacity Portfolio Construction is an economic sciences innovation that is validated by Skew-Risk Modeling, which was first presented in Targeted Return Portfolio Construction (Sherwood, 2019) and is detailed within this paper in its application to retirement-focused investors. Risk Capacity Portfolio Construction factors skewness and kurtosis into the risk management and asset allocation of an individual’s life cycle and can optimize risk beyond simply accounting for the equity risk premium and human capital. TOPICS:Portfolio theory, wealth management, retirement, risk management, portfolio construction, options, equity portfolio management, tail risks Key Findings ▪ This paper highlights an alternative portfolio construction methodology to Target Date Funds (TDFs) in order to better prepare individuals for retirement, on both a risk-adjusted and absolute basis. ▪ This paper highlights an investor’s ability to incorporate skewness and kurtosis within the asset allocation process of a portfolio that is intended to prepare an individual or group for a future dated event. ▪ This paper highlights how the implied risk probabilities within the options market, referred to herein as Tail Risk Ratios (TRR), can be incorporated in the investment process.