Their research showed that average optimal allocation to stocks starts at 90% when a person begins working, declining to around 80% around age 50. They found that a typical TDF mimics this allocation with a 90% allocation until age 40. The allocation then decreases gradually to 75% at age 50.
At this point, the equity allocations diverge. The equity allocation in most target date funds declines to about 50% at retirement and then continues to decline to around 30%-40% once the glide path flattens out. According to the findings of the research, this allocation is too low for most retirees.
The researchers found that mutual funds, like target date funds where the asset allocation is a function of age, are inappropriate for many investors. This is especially true as investors age to where they have typically accumulated the most wealth for retirement.
Their model indicates that the 90th percentile of their optimal cross-household allocation to equities approaches 100% for retirement accounts at all ages in their study. The 10th percentile declines over time from about 30% allocated to equities at age 25 to less than 20% in retirement.
There are a number of possible reasons for these discrepancies in the optimal allocation to equities for different households. These could include differences in risk tolerance, plus higher non-portfolio retirement income streams such as a pension, annuities or other sources for those with lower equity allocations.
Target date funds do not take into account that two investors of similar age may have radically different retirement situations calling for distinctly different portfolio allocations.
Purchasing Power Declines
A third conclusion of their research quantifies the loss in purchasing power from going with a target date fund as opposed to the optimal investing behavior identified by the researchers in the study.
The researchers found that on average, investing in an age-based portfolio such as a target date fund resulted in an annual loss that was the equivalent of 1.7% of consumption or purchasing power if the investor reoptimized their other behaviors each year. The loss rose to 2.8% of consumption each year if the household did not reoptimize their other behaviors.
Improving Target Date Portfolios
Their research found that the advice inherent in mutual funds such as target date funds could be improved by taking a number of variables into account. These could include:
- Differences in the wealth levels of investors.
- The state of the business cycle.
- Dividend-to-price ratios.
They found that taking these variables and others into account and tailoring the fund allocations accordingly could add value to investors across the wealth and income spectrum.
Implications for Advisors
These findings and those of other studies that came to similar conclusions have several implications for financial advisors.
If you advise the sponsor of a 401(k) or similar defined contribution plan, you will want to consider whether a target date fund family is the best answer for offering a managed account solution for the plan participants. Do they offer the opportunity for the best participant outcomes? This is a key question with the emphasis on retirement readiness on the part of many retirement plan sponsors.
If your clients have money in a 401(k), 403(b) or other workplace defined contribution plan, you will likely want to help them construct their own portfolio from among the various investment options in the plan versus having them default to a target date fund option.
The research points out that all investors are different and that one-size-fits-all investments such as target date funds may not be a good fit for all investors at all stages of life.
Roger Wohlner is a financial writer with over 20 years of industry experience as a financial advisor.