Academic journal article Financial Services Review

Shortfall Risk of Target-Date Funds during Retirement

Academic journal article Financial Services Review

Shortfall Risk of Target-Date Funds during Retirement

Article excerpt

Abstract

Target-date mutual funds are likely to increase in popularity because they are now one of the three approved default options for many retirement plans. In the retirement years, target-date funds become increasingly conservative with higher bond concentrations. Using a bootstrap simulation and rolling period analysis, three target-date fund classifications are shown to have higher probabilities of running out of money and lower balance remaining when compared to fixed allocation portfolios. A fixed 50/50 stock/bond portfolio unambiguously out-performs the target-date funds, regardless of methodology employed. In light of this evidence, diese funds should revisit their asset allocation strategy. © 2008 Academy of Financial Services. All rights reserved.

Jel classification: D14; G11; J26

Keywords: Retirement; Asset allocation; Bootstrap; Target-date funds; Lifecycle funds; Mutual funds

1. Introduction

Target-date mutual funds change portfolio asset allocation on a prestated schedule based on an investor's current age. Each investor can contribute to a target-date fund that matches their anticipated retirement year and the mutual fund does the rest ... the mutual fund industry's version of "cruise control asset management." Israelsen (2008) estimates that at the end of 2007, 229 distinct target-date funds with $177.7 billion in assets were under management. The popularity of such funds is expected to increase because Department of Labor rules have recently designated them as one of the three Qualified Default Investment Options (QDIAs). The focus of this investigation is on a subset of such funds, specifically the 131 funds1 categorized with target retirement dates in the 2000 to 2014 range. The empirical question of immediate interest is: "How effective are such asset allocation schemes in comparison to a self-managed constant allocation?"

In a recent article, Spitzer and Singh (2007) cast some doubt on the wisdom of changing asset allocation during retirement to greater and greater concentrations of bonds, the strategy that is generally pursued by so-called "life-cycle" or target-date funds. This paper shows that the reservations expressed by Spitzer and Singh were warranted. Target-date funds tend to reallocate funds to higher and higher concentrations of bonds in retirement when withdrawals (not contributions) are being made. The rebalancing strategy results in a higher probability of running out of money and a smaller balance remaining at the end of 30 years than portfolios that maintain 50% or more in stock.

2. Target-date funds: A synopsis

2.1. Literature review

Because of the relatively recent introduction of target-date mutual funds, the amount of research on various aspects of these funds is limited. Vicera (2007) examines lifecycle funds in the context of portfolio theory. One of his many conclusions is that when the default choices (in a QDIA) for a defined contribution plan are between a target fund and a money market fund, the target-date fund is preferable.

Bodie and Treussard (2007) suggest integration of human capital risk in the optimization process. One of their conclusions is: ". . . People who are very risk averse and who have a high exposure to market risk through their labor income would experience a substantial gain in welfare from being offered a safe target-date fund rather than a risky one" (p. 47). Bodie and Trussard suggest that the transition from equities to debt in the target-date funds be less linear and more "humped."

Mitchell, Mottola, Utkus and Yamaguchi (2007) study portfolio compositions before and after the existence of target-date funds. When target-date funds are available, the number of "all equity" or "all cash" portfolios in pension plans decreases. Target-date funds are found to change stock/bond allocations by age group, in part probably because of the additional asset allocation opportunities provided in the target-date funds. …

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