Pension Industry

Are target date funds dinosaurs?
Failure to adapt can lead to extinction.

Authors: 
Peter A. Forsyth, Yuying Li, and Kenneth R. Vetzal
University of Waterloo


Are target date funds dinosaurs? Failure to adapt can lead to extinction.


 

Investors in Target Date Funds are automatically switched from high risk to low risk assets as their retirements approach. Such funds have become very popular, but our analysis brings into question the rationale for them. Based on both a model with parameters fitted to historical returns and on bootstrap resampling, we find that adaptive investment strategies significantly outperform typical Target Date Fund strategies. This suggests that the vast majority of Target Date Funds are serving investors poorly.

 

The pension problem

Conventional defined benefit (DB) plans are becoming a thing of the past. Most organizations do not want to take on the risk of providing a DB plan. More employees are participating in defined contribution (DC) plans, and the trend is likely to continue. In a typical DC plan, the employee contributes a fraction of his/her salary into a tax-advantaged savings account. The employer may also contribute to the DC account. In some cases, the employer manages the DC plan, in the sense that the employee picks from a list of approved investment vehicles, usually bond and stock mutual funds. Upon retirement, the employee has to decide what to do with the accumulated amount in the portfolio. Typical options include buying an annuity or continuing to manage the portfolio to generate a stream of income. There is, of course, no
guarantee of the level of income that will be produced in a DC plan. It would not be unusual for a DC plan member to accumulate for thirty years (possibly with diff erent employers), and then to decumulate for another twenty years. This implies a fifty year investment cycle, making DC plan holders truly long term investors.

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