Missing the Target?

Reprinted from Financial Planning Magazine, September 2007
By Craig L. Israelsen and Joe Nagengast

target-date fund is essentially a mutual fund that follows a dynamic asset allocation model over time, ultimately reaching a predetermined, retirement-based equity/fixed income allocation that closely coincides with the retirement year of the investor. This dynamic asset allocation path through time is anecdotally referred to as the "glidepath." The classic glidepath for a prototypical target-date fund can best be described as transitioning from an equity-heavy portfolio to a primarily fixed income portfolio as the fund moves closer to its stated target date.

Beyond this general commonality, the glidepaths of various target-date funds vary in material ways. The differences may include risk exposure, asset-weighting protocols, number and types of asset classes employed, use of active funds vs. passive funds, and the employment or avoidance of tactical portfolio management.

The objective of this paper is to assess the state of the art of the glidepath among target-date funds. But first, a few thoughts about the funds themselves. We have a very straightforward perspective: If the notion of a dynamic asset allocation model over an investor's lifetime makes sense, then the concept of a target-date fund makes sense. Nevertheless, we acknowledge and accept that there are legitimate challenges to the basic underlying assumptions of target-date funds.

One of the challenges is that, for many investors, heavy equity exposure produces unacceptable levels of portfolio volatility, even in the long run. Another challenge is that target-date funds fail to account for the life-cycle interplay of financial capital and human capital and thus misunderstand the risk capacity of many investors. Additionally, target-date funds seem to be firmly stuck in the dominant theoretical framework of the past 30 or 40 years, which is myopically focused on asset accumulation and largely blind to the very different demands of asset distribution. Lastly, target-date funds (and most other domestic asset managers) fail to fully acknowledge the global nature of our economy, usually deploying no more than about 30% of their equity allocation to foreign holdings when the non-U.S. economy accounts for roughly 60% of the global market capitalization according to Ibbotson/Morningstar.

These are all legitimate issues for concern and will need to be addressed-perhaps in future articles. We also recognize that, for a defined contribution plan, almost any target-date fund makes a far better default option than cash. Certainly few would argue with the proposition that a target-date fund is a better option than leaving participants to fend for their portfolios themselves, equipped with no more than a handful of pamphlets and a few 401(k) investment education sessions.

To those who find fault with the relative simplicity of target-date funds we respond with these questions: Is investing supposed to be complex? Do we really think everyone should need a degree in finance to have a chance at retiring with a modicum of financial security?

For most individuals, investing should not be complex, we believe. In fact, investing should be boring, with the primary ingredients being time and money rather than complexity and excitement.

Mapping a Trajectory

We often speak of a glidepath as if there were only one. In fact, there are several glidepaths, or dynamic asset allocation paths through time. The primary glidepath generally refers to the equity allocation in a target-date fund, which can be subdivided into at least two separate components: US and non-US. As shown in "The Target-date Glidepath" POSITION TK the US equity glidepath in the typical target-date fund is represented by the blue line and the typical non-US equity glidepath by the pink line. The average total equity allocation (i.e., current location on the glidepath) for current funds through 2050 funds is shown in "Tilted Toward Equities" POSITION TK. As of June, 2007 the average total equity allocation (combining US and non-US) was just over 90% in the most distant target dates (2045 and 2050 funds). Among funds that have already reached their target date (2000, 2005), or what we call current funds, the average equity allocation in June 2007 was just under 38%. Our data source was Morningstar.

A second glidepath exists for the bond allocation of the target-date portfolio. As shown in "The Target-Date Glidepath", the glidepath of bonds ascends, rather than descends. (Hence, the term glidepath is a bit odd: a glidepath implies a descent. So much for the aviation metaphor.) In general, the bond glidepath represents a mirror image of the equity glidepath. Funds with distant target dates (2035 and beyond) have an average bond allocation of less than 10%. If the cash allocation is added in, distant target-date funds (2035 through 2050) still have less than 13% of their portfolio in fixed income.

To put this into perspective, the average target-date fund allocation suggests that a person who is currently 37 years old should have a retirement portfolio consisting of nearly 90% equities. A 57-year old should have a 60% equity allocation in his/her retirement portfolio, while a 62-year old should still be nearly 50% in equities. Finally, a person currently in retirement who uses the average allocation of "current" target-date funds as the guideline should have about 38% of his or her portfolio in equities.

Here's our take: the equity allocation in distant funds (2030 and beyond) is not one we wish to argue against at this point. If one accepts the presence of an equity premium, a retirement portfolio should be based primarily in equities during the early years of the accumulation phase. Beyond that, however, differences of opinion will abound regarding how the portfolio should be allocated between equities and fixed income, especially when the investor nears the target date (which in theory is the beginning of the fund's distribution phase). Our intent here is to specifically assess the equity allocation among what we refer to as "current" and "near-term" target date funds (current funds have reached their target date and near-term funds are within 10 years of doing so).

As a preface to the comments that follow, we observe high equity allocations in many current and near-term funds. We believe this reflects an "outperformance" mentality that permeates an investment community primarily focused on the accumulation phase of investing. We suggest that when target date funds have reached, or are approaching, their stated target date they must transition away from a competitive "outperformance" mentality (which generally equates to higher equity exposure) to a "capital preservation" mentality in anticipation of the distribution phase. Interestingly, we have observed that during the last 12 months many fund families have increased the equity exposure in their target date funds. We wonder whether these changes would be occurring if the US equity market were in a decline. Keeping up with the Joneses is the most accurate analogy here. When one fund family raises the equity ante, others tend to follow so as to not lose in the performance comparison battle.

Too Much Equity-Or Too Little?

As of June, the average equity allocation of 2010 target-date funds was 46%. Recall that in the year 2007, a 2010 target-date fund is analogous to a portfolio held by a 62-year-old. Should a 62-year-old have nearly 50% of his or her portfolio in equities? Given today's longer lives, perhaps some should. But if you look at the age cohort as a whole, we feel the answer is clearly a resounding "No." Yet this is precisely what target-date funds aim to do: estimate the proper allocation for a hypothetical typical person at any given age. Without accepting that premise, there is really no justification for target-date funds, as opposed to, say, balanced funds. We now ask the question differently: Is a nearly 50% equity exposure an appropriate allocation for the largest possible number of 62-year-olds (assuming all individual external differences are averaged away)? For an additional perspective let's examine how other, non-target-date funds design their portfolios. We looked at two groups of balanced funds in the Morningstar database, namely 163 conservative allocation funds and 313 moderate allocation funds. The terms "conservative allocation" and "moderate allocation" are determined by Morningstar, but ultimately refer to the Dow Jones 40% U.S. Portfolio Index and the Dow Jones 60% U.S. Portfolio Index. To continue our consideration of the appropriateness of the allocation for 62-year-olds, we focused only on the 163 distinct conservative allocation funds. We only considered the primary share class of each fund.

Using the average equity allocation of conservative allocation funds as a guideline, a 46% equity allocation for a near-retiree (i.e., a 62-year old investor in the average 2010 fund) may be a bit aggressive. As shown in "Tilted Toward Equities" POSITION TK the average US equity allocation of the largest 25 conservative allocation funds (representing 86% of the total assets invested in all conservative allocation funds) was 32.5%. (Assets in the "Other" Morningstar category were added into the US equity allocation). The average allocation to non-US equities was 6.8%, bringing the average overall equity exposure of conservative allocation funds to 39.3%--which is in line with the average equity allocation of 37.6% among the "current" target-date funds in this study.

Target-date funds that are closing in on the target date (such as 2010 and 2015 funds) have, in general, a considerably greater appetite for equity risk than conservative allocation funds. The average total equity allocation among the 23 distinct 2010 funds in this study was 46% and nearly 60% among eighteen 2015 funds. We suggest that the equity allocation of the average near-term target-date fund is too dependent on equity and therefore potentially too risky for the average investor nearing retirement.

By virtue of the relatively high equity allocation in the average near-term fund, it appears that many target-date funds have an accumulation-mode mentality up until the target date. We suggest that transitioning a target-date fund from accumulation mode to distribution mode-which theoretically begins at the target date-should begin more than three years before the target date inasmuch as the primary goal of a distribution portfolio is to avoid large losses. A 62-year-old with a 46% equity allocation (based on the average 2010 target-date fund equity allocation) suggests that the equity glidepath during the last several years before reaching the target date will be fast and steep-not exactly the ideal way to safely land a plane or prudently position a portfolio. If you don't think that can be a problem, just ask an equity-heavy investor who was planning to retire in 2002.

The Target-Date Glidepath

Source: Morningstar data
Note: Allocations as of June, 2007.

Tilted Toward Equities

The typical target-date fund remains heavily allocated to equities until an investor passes age 60.

Source: Morningstar data
Notes: Asset allocations as of June, 2007.
* Counting only the primary share class
** Implied age assumes a retirement age of 65.
*** Includes assets in Morningstar's "Other" category

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Craig L. Israelsen, Ph.D., is an Associate Professor at Brigham Young University and Principal at Target Date Analytics, LLP (www.TDBench.com).

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Joe Nagengast is president of Turnstone Advisory Group and is a Certified Employee Benefits Specialist. Craig and Joe are part of a team that recently completed the most comprehensive study ever undertaken of target-date funds. For access to the study, please contact Quinn Keeler at qkeeler@plansponsor.com.