Blind faith: Do target date funds miss the mark by relying on age-based allocation?
Target date funds have ridden a wave of success in asset growth and popularity among defined contribution plans. This may be due to perception rather than proven performance—a perception of risk protection provided by the glide path approach that reduces investment risk as participants gets closer to retirement. But this expected risk protection failed during recent financial market swings, as most funds were “blind” to market conditions and participants suffered large losses as a result. An important lesson over the past two decades has been that target date funds (and balanced funds) are subject to significant drawdown risk that hurts participants’ chances of successful retirement outcomes.
This paper asks two essential questions:
- Should asset allocation strategies be based solely on the age of the participant (time to retirement), or should they be adjusted continually, to take advantage of market opportunities and protect from market threats?
- If asset allocation is adjusted according to market conditions, how much “investment skill” does a manager need in order to provide better performance for the strategy and better retirement outcomes for participants?
We approach these two essential questions by first describing the types of asset allocation strategies examined and defining our participant assumptions. From these assumptions, we compare performance of a glide path strategy (which changes asset allocation based on the time to retirement) with that of a static balanced strategy (which maintains the same allocation). Next, we describe a dynamic strategy, such as risk-controlled growth, which adjusts asset allocation based on market opportunities. We then calculate the performance of this dynamic strategy versus a balanced strategy, by varying the manager’s level of investment skill. Finally, we look at the potential improvement in retirement outcomes for each option. In the end, we seek to identify which strategies are most likely to yield better retirement outcomes for participants—glide path or balanced, dynamic or static.
We find that asset allocation strategies based on age alone have relatively little impact on retirement outcomes, despite public opinion to the contrary. Asset allocation based on market conditions can potentially have much larger effects on retirement outcomes, even if the manager chosen has only a moderate degree of investment skill.
The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.