Target date funds (TDFs) explain that glidepaths integrate human capital (present value of total future earnings) with financial capital, along the lines in the following exhibit:
A TDF’s glidepath is the sequence of risks in financial capital, starting out very risky because most of the wealth of young people is in human capital, but then as human capital depletes as we age, we become more conservative in our investments. This is the optimal lifetime risk pattern for all investors, not just those in TDFs.
Importantly this is the framework for TDF glidepaths, but has anyone actually read the book? If you read it, you will discover that TDFs are far riskier at their target date than the theory.
The book
The book that establishes the theory for TDF glidepaths is Lifetime Financial Advice: Human Capital, Asset Allocation, and Insurance, published in 2007, the year following the passage of the Pension Protection Act of 2006 that launched the preference for TDFs as the Qualified Default Investment Alternative (QDIA). Four respected academics wrote the book: Roger Ibbotson, Moshe Milevsky, Peng Chen and Kevin Zhu.
The book is 104 pages. I’ll summarize the key finding with just two graphs that show the allocations for the financial asset through time depending on the risk in the investor’s human capital. The authors show this allocation as the amount in a risk-free asset, where they define the financial asset as having just two components—a risky bundle of world assets, and a risk-free asset. So, whatever is not in the risk-free asset is in the risky asset.
Here’s the glidepath for an individual with very safe human capital, like a tenured professor.
This individual’s optimal financial asset allocation is 100% in risky assets from age 25 through 38, and then moves toward safety, ending 80% very safe at retirement age 65.
The authors also consider two scenarios for individuals with risky human capital, summarized as follows:
As you can see, these glidepaths also end very safely at the target date.
But the TDF industry does not follow the optimizations described in the book, although they say they follow the theory. The theory has been overided in practice.
TDFs are way too risky at their target dates, based on academic theory
As shown in the following graph, most TDFs are 85% in risky asets at their target date, far riskier than the theory that they say they use.
There are two groups of TDFs—safe and risky at the target date. The safe group is in line with academic theory. The risky group, with most of the assets, is not. The risky group is procedurally prudent. The safe group is substantively prudent, based on the theory that everyone says they use.
Here is a comparison of entire glidepaths:
Beyond the target date: decumulation glidepath
There’s a valid criticism of safety at the target date. When interest rates are near zero, as they were until recently, retirees cannot live on safe assets. Academia has an answer to this challenge. Dr. Wade Pfau and Michael Kitces researched the optimal post-retirement glidepath in their paper, Reducing Retirement Risk with a Rising Equity Glidepath and found that it is increasing in risk. The optimal lifetime glidepath is U-shaped. It re-risks in retirement.
Conclusion
Also in 2007—the same year as the book—I came to a similar conclusion about safety at the target date in the design of my patented Safe Landing Glidepath, but I used financial engineering with the objective of not losing participant savings. This additional approach reinforces the wisdom of safety over growth as we near retirement.
Either TDF marketers are fibbing or TDF designers have modified the theory (for profit?). There are complicated reasons explaining excessive risk at the target date that I describe in Target Date Fund Elucidations. Like excessive fees, this breach of fiduciary duty will only go way when lawsuits make them go away.
Now you know that academic glidepath theory is not even close to actual practice, except for a few TDFs.
SEE ALSO:
• The Secret Metamorphosis of Target Date Funds
Ron Surz is CEO of Target Date Solutions (TDS), co-host of the Baby Boomer Investing Show (BBIS), and author of the book "Baby Boomer Investing in the Perilous Decade of the 2020s." TDS licenses target-date fund usage of Ron’s patented Safe Landing Glide Path® (SLGP) that actually protects beneficiaries as they approach retirement. Individual investors can follow the SLGP at Age Sage, an educational interactive website. The BBIS educates baby boomers on the risks and rewards in contemporary investing, and Ron’s book is a tour of these shows. He can be reached at Ron@TargetDateSolutions.com.
