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Target-Date Funds: Find a More Secure Path to Retirement

target-date fundsAsset allocation determines the blend of investments in each portfolio; the process seeks to maximize value based on one’s time horizon and tolerance for risk. A target-date fund offers specific asset allocations and investment selections for specific objectives. It automatically resets the asset mix of equities and fixed income assets in its portfolio according to a time frame specified by an investor.

Target-date funds are grounded in economic theory and are aimed to serve individuals who are otherwise unable to seek better customized solutions. The funds are simple solution to invest with a hands-off approach. Target-date funds are particularly popular among retirement planners, since the funds provide an appropriate balance between two competing desires: investors wish to maximize their wealth at retirement but they also wish to reduce volatility for their absolute wealth accumulation.

Target-date funds are also appropriate vehicles for sophisticated investors and active managers who can better time the market. The funds are free to move from higher-risk assets toward more conservative ones as they approach investors’ respective retirement date.

For example, a worker hoping to retire in 2020 would invest in a target-date 2020 fund, while a worker hoping to retire in 2040 would invest in a target-date 2040 fund. The 2040 fund has a longer time horizon, so it would more likely be weighted heavily toward equities.

During the financial crisis of 2008, one target-date 2010 fund lost more than 40% of its value; however, this category has enjoyed rapid growth in recent years. In 2013, a Morningstar report said that the equity allocations for 2015 target-date funds are between 8% and 58%.

A Useful Measurement: The Funded Ratio

Investors can add value to their portfolios by customizing asset mix accounting for the funded ratio. A funded ratio places the unfunded liabilities in the context of the assets of the retirement system. The ratio is expressed as a percentage of a system’s liabilities, and it measures the value of one’s investment portfolio against the present value of one’s projected future liabilities to calculate spending needs.

A funded ratio is calculated by dividing net assets by the actuarial accrued liabilities. A ratio of 1 means that a person has just enough assets to meet their liabilities, while overfunded and underfunded individuals have ratios above or below 1, respectively.

Mathematically, one can show that the optimal allocation to volatile assets like equity classes follow a U-shaped curve with a minimum equity allocation when the funded ratio is 1 and allocations becoming more aggressive as one moves further away from 1. However, there is no generally agreed-upon best practice when one is underfunded about whether to take risk or to lock-in what remains with secure assets. Historically, the funded ratio indicates the level of active participation by an investor, and a higher ratio can improve investment outcomes.

Final Thoughts

The bottom line is that no investment vehicle is perfect. In the case of target-date funds, it is essential to acknowledge that each of the funds comes with its own fee structure, risk profile, and asset mix. Investors should carefully check the holdings and fees, as some funds may have high fees. Beyond that, performing measurement or comparison against any index is virtually impossible.

Basu and Drew (2009) indicate that target-date funds are counterproductive to the goals of typical retirement savers. Most portfolio growth for individual investors will occur late in their careers when they can enjoy capital gains from larger portfolio balances, however, target-date funds may have already switched to a more conservatives asset allocation by then. That said, target-date funds might miss out on the biggest opportunity to enjoy outsized capital gains, since they reduce equity exposure probably at the wrong time.

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