Most target-date funds aren’t serving employees well, argues a paper published earlier this month in the Social Science Research Network.
While target-date funds are an easy option for employees who aren’t comfortable with making investment decisions, the funds don’t consider employees’ desired retirement incomes or how well the portfolio fares over time, writes researchers Peter A. Forsyth, Kenneth R. Vetzal and Graham Westmacott.
“If the plan participant has a great start and achieves her wealth target five years early, she could choose to lock in her comfortable retirement nest egg,” the paper notes. “Any surplus (i.e. not needed to fund her retirement) could be used to fund a charitable endowment, pay for the grandchildren’s education or any other purpose.
“Conversely, if the wealth accumulation process in the early years lags expectations, then is it rational for the investor to just throw in the towel and let the TDF take her to a lower equity asset allocation and a lower expected terminal wealth at retirement?”
Read: More pension plans using target-date funds as default option
Furthermore, the study found target-date funds “give virtually the same results” as funds using constant proportion strategies.
Forsyth, Vetzal and Westmacott argue a better method is the target-wealth strategy, in which the proportion of the portfolio that’s invested in stocks depends on both time before retirement and how the portfolio has fared compared to its target.
“One obvious consequence is that this TW approach has an asset allocation which changes with time,” they write. “The crucial difference is that a TDF uses a prescribed asset allocation while with the TW approach, the asset allocation is an emergent property dependent upon the investor’s objectives and the investment returns over time.”
The target-wealth strategy only works, however, if the employee makes a long-term commitment to the target level of wealth.
“If an investor is fortunate enough to be able to hit W (which is larger than her goal — recall that to hit the mark it is necessary to aim above it) simply by investing in bonds, then she should cash out her chips and not take on any more risk,” the report notes. “Of course, this requires investors to stick with their original target. The investor must pre-commit to being satisfied with the initial real target wealth.”