Target Wealth: The Evolution of Target Date Funds

Target Date Funds (TDFs) have become very popular with investors saving for retirement. The main feature of these funds is that investors are automatically switched from high risk assets (stocks) to low risk assets (bonds) as retirement approaches. The transition from a high allocation to stocks to a lower allocation over time is often referred to as a glide path. It differentiates TDFs from investment strategies with a constant asset allocation.

TDFs have an intuitive appeal: investors are able to take more risk when they are young, with many years to recover from market declines, and then reduce their exposure to risk when they are older. However, to objectively assess TDFs requires a performance measure. In our white paper, we assume that, given a future wealth target, an investor would prefer the investment strategy that is most likely to achieve the target. This seems reasonable given that the goal is to build a retirement nest egg. How do TDFs fare against this objective?

Given this objective, and for a given savings rate and savings period, we calculate the optimum glide path. Perhaps surprisingly, the optimum pre-determined glide path offers no significant advantage over a much simpler constant asset allocation (a point already illustrated here). Commercially available TDFs typically use non-optimal glide paths and are also more expensive than balanced funds using a constant asset allocation, leading to the conclusion that TDFs are serving investors poorly.

One obvious shortcoming of TDFs is that they do not use information about the current wealth of the investor. A strategy that incorporates this knowledge and re-optimises the investor’s future investment strategy is presented. We find that if we allow the asset allocation to adapt to reflect progress made (current wealth), and the distance to go to achieve the target wealth, then the risk of missing the target is significantly diminished when compared with even the optimal pre-defined glide path. In one example discussed in the paper, the probability of getting within 10% of the target wealth rises from 45% using a pre-determined glide path to 75% using the adaptive strategy.

The adaptive strategy requires discipline over a long period (20 years or more) to be successful. Investors are well used to the incantation to “stay the course” and for those prepared to do so, there are tangible rewards.