Target Date Funds — Do the Risks Outweigh the Benefits? An Economists’ View. Target date funds (TDFs) have become the default investment option of choice for the majority of defined contribution (DC) retirement plans. In fact, 91% of plans have a TDF, according to Callan’s 2018 Defined Contribution Trends survey. That said, are TDFs as “safe” as they are purported to be, and by defaulting participants into this so-called age-based, automatic investments, can plan sponsors truly fulfill their fiduciary obligations?
This is a question the retirement plan industry has asked, particularly with regard to traditional TDFs, and one that Boston University professor and New York Times best-selling author Laurence Kotlikoff posed recently in this article on the crowd-sourced investing website, Seeking Alpha. As befits his background, Kotlikoff approaches the question academically, but the concerns are the same: the asset allocation of TDF portfolios is too risky for younger investors, and too conservative, or “safe,” for older investors.
Here’s why. We know that TDF portfolios are made up of a mix of stocks and bonds. Initially, there is a higher allocation to stocks, then as a retirement plan participant ages and gets closer to their anticipated retirement date, the allocation is gradually adjusted to include a greater weighting of bonds. As Kotlikoff explains, “The target date is usually set at the firm’s typical retirement age, with the employee defaulted into a target-date fund whose duration aligns with the employee’s years to retirement.”
All fine and well. However, as Kotlikoff points out, economic theory does not support TDFs’ age-based thesis. He cites two separate 1969 studies from Nobel Memorial Prize winners Paul Samuelson and Robert Merton, who independently concluded that we should hold the same portfolios as we age. In other words, our investment decisions should be the same when we’re 30 as when we’re 90. Why? Based on Samuelson and Merton’s research, Kotlikoff reasons that the commonly held belief that holding stocks longer makes them safer is a fallacy. In other words, risk is risk, and stocks’ inherent risk does not change the longer they are held.
Therefore, he asks, are TDFs off target? His conclusion: yes and no. In the yes column, accounting for Samuelson-Merton’s findings, Kotlikoff asserts that our wealth includes not just our investments, i.e., the savings accumulated in a retirement plan, but also our future earnings power, along with Social Security. Kotlikoff argues that if our employment earnings and Social Security entail no risk, they are no different from holding bonds. Therefore, he writes, “if the optimal mix of stocks and bonds for Sandra is 50-50 and Sandra’s labor earnings and Social Security benefits constitute half of her total resources, she should invest the rest of her resources – her financial assets – 100 percent in stocks. In so doing, she achieves a 50-50 division of her total resources… As we age and get closer to retirement, the share of our resources represented by future labor earnings declines. On the other hand, the share represented by future Social Security benefits rises. On balance though, these potential bond-equivalent assets fall as a share of resources up through retirement. Consequently, the share of our financial assets invested in stocks should fall. This is what life-cycle funds produce.”
Kotlikoff offers the counter-argument thusly (the short version): TDFs are not a one-size-fits-all investment, and in actuality, when accounting for the Merton-Samuelson model, for a variety of reasons, they are not right for everyone and could be even more off the reservation after retirement. As such, Kotlikoff poses the question, and rightly: are employers fulfilling their fiduciary duty by defaulting workers into “risky investments, be they life-cycle funds or a balanced portfolio?” Under the fiduciary standard, he prescribes “the safest retirement saving vehicle, namely long-term inflation-indexed bonds (e.g., 30-year Treasury Inflation-Protected Securities, or TIPS).”
In Kotlikoff’s view, the widespread use of TDFs as default options in retirement plans is a risky bet, based on economic theory. By contrast, the retirement industry has long looked to TDFs as a simple asset allocation solution designed to help plan participants grow their savings through investment earnings over time, while not taking on too much risk. Viewed through that lens, how can TDFs be wrong?
That said, there has been much discussion in the industry that traditional, off-the-shelf TDFs have, indeed, not delivered on their “promise” of retirement security, primarily due to their one-size-fits-all approach. They deliver asset allocations designed for a general population, which fail to account for individual investors’ unique circumstances, age, risk tolerance, gender, and a host of other, more personal factors. In light of that, growing numbers of plan sponsors are adopting custom TDFs, which employ an asset allocation and glide path (how the asset allocation is adjusted as the fund gets closer to its target retirement year. As their name implies, custom TDFs can be customized based on the specific demographics of an employer’s workforce — an appealing feature. In addition, by adopting a more customized approach, plan sponsors can also demonstrate their fiduciary stewardship by implementing an investment solution that is, by its nature, representative of participants’ best interests. However, the downside is, custom TDFs can also be costly to manage and administer and may require oversight by an in-house or third-party investment manager.
So, are TDFs “off target?” Yes and no, according to the economists. However, theirs is just one viewpoint. Sponsors will likely continue to embrace TDFs, both as an easy-to-use option for participants and as a default investment solution that helps to reduce some of their fiduciary burden. Based on what we know, the benefits of TDFs (especially custom solutions) in retirement plans seem to outweigh the risks, at least for now.
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