Academic journal article Financial Services Review

The Evidence on Target-Date Mutual Funds

Academic journal article Financial Services Review

The Evidence on Target-Date Mutual Funds

Article excerpt

1.Introduction

The Department of Labor's safe harbor provision of 2007 has provided a significant boost to the popularity of target date mutual funds (TDFs). These funds are now included as a default investment option in defined contribution plans along with managed accounts and balanced funds. According to Department of Labor, the Qualified Default Investment Alternative (QDIA) provides a plan sponsor "safe harbor relief from fiduciary liability for investment outcomes EBSA (2008)." A consequence of the Pension Protection Act of 2006, employers are increasingly adopting the automatic enrollment option in 401(K) plans, which further supplements the assets under management (AUM) base of TDFs.

Investors held about $1 trillion in target date and lifestyle funds at the end of 2014, compared to a total of $2.75 billion at the end of 1995 (ICI Handbook, 2015). This calculates to a compounded annual growth rate (CAGR) of about 35% over the 10-year period, an impressive flow of investor money to these funds.1

A TDF is managed from its purchase date through an expected retirement year, and in some cases, the fund provides an additional "during retirement" investment option. On the other hand, a lifestyle fund is directed to a broad age group and tailored to its purported risk tolerance. For example, a lifestyle fund focused on younger investors in their 30s will usually have a high equity exposure, while a lifestyle fund aimed at retirees will likely have a heavy emphasis on fixed income securities. Assuming that one's risk tolerance decreases with age, an investor will move from one lifestyle fund to the next one catering to their "lifestyle" as they age, until they are in retirement. In the case of a TDF, this asset allocation is automatically shifted for the investor. A good way to understand the difference between target date and lifestyle funds is to think of lifestyle funds as building blocks of a TDF. So, which of these two fund types should investors prefer? Chang et al. (2014) use a utility maximization framework and use bootstrap simulations to compare welfare benefits of both types of funds. The primary focus of their research is to measure utility derived from fixed and decreasing equity allocation for an individual investor over time. They find that a decreasing equity allocation provides better welfare benefits than a static one. This implies that TDFs are superior investment vehicles from a utility maximization perspective. The authors caution that there is no one-size-fits all TDF, the investor should select such funds based on their risk tolerance. For the purposes of this paper, the term "target date fund" is used to designate a broad class of open-end mutual funds and exchange traded funds (ETFs) that include both target date and lifestyle funds.

The appeal of a target-date mutual fund lies in the convenience it provides to the investor. She does not have to monitor, and periodically alter the asset allocation because of passage of time. In most cases, the fund mandate automatically provides for that. Based on the chosen retirement age, the fund manager allocates the funds to a predetermined allocation schedule; say 85% stocks and 15% fixed income initially when the investor is young. This allocation may eventually reverse to 15% stocks and 85% fixed income closer to the "target date." This change in asset allocation that occurs over many years is commonly referred to as the fund's "glide path."

The Vanguard Target Retirement Fund 2055 (Ticker: VFFVX), is provided as an example. The 2055 in the fund name indicates the anticipated retirement year for the investor. In 2015, this fund is recommended for a 30-year old anticipating retirement at age 70 or a 25-year old anticipating retirement at age 65. Based on the fund's glide path, the initial asset allocation is quite aggressive, with up to 90% in equity securities. According to Vanguard, this becomes "more conservative over time, meaning that the percentage of assets allocated to stocks will decrease while the percentage of assets allocated to bonds and other fixed income investments will increase. …

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