Are Target Date Funds Off Target?

by: Laurence Kotlikoff


Target date funds can be far off target.

They can be far too risky when young and far too safe when old.

The proper fiduciary default investment is TIPS (Treasury Inflation Protected Securities), not a target date fund.

Target date funds are now the default investment option for many, if not most, 401(k) and similar employer-sponsored retirement plans. Such funds entail an initial high allocation to stocks with a switch to bonds as the target date approaches. The target date is usually set at the firm's typical retirement age, with the employee defaulted into a target-date fund whose duration aligns with the employee's years to retirement.

Consider the Vanguard Target Retirement 2065 Trusts, designed for people intending to retire in 2065 or thereabouts. This life-cycle fund invests 90 percent of assets in stock and 10 percent in bonds through 2040, moving to a 50-50 stock-bond allocation by 2065. Between 2065 and 2072, the fund transitions to a permanent 30-70 stock-bond mix.

Does economic theory support this age-related investment strategy? Not necessarily as I'll explain.

In 1969, Paul Samuelson and Robert Merton independently showed that, given a set of simple and reasonable assumptions, we should hold the same portfolios as we age. Thus, if hypothetical Sandra puts 75 percent of her resources in risky securities and 25 percent in safe securities at 30, she should invest the same at 90.

This may seem strange to those who think stocks are safer the longer they're held. But this is a common fallacy. Holding stocks longer doesn't make them safer. Indeed, the market charges far more to insure the long-term return to stocks than the short-term return. My Boston University colleague, Zvi Bodie, has been pointing this out for decades.

Since holding risky assets longer doesn't make them safer, Sandra's investment decision at 30 is fundamentally no different than at 90. Does this mean that target date funds are off target?

Yes and no.

First, the Yes. The Samuelson-Merton result applies to our overall holdings of resources, which goes beyond our stocks and bonds to include our human wealth (future labor earnings), Social Security benefits and other resources.

Take labor earnings and Social Security benefits. If both entail no risk, they are fundamentally no different from holding bonds. Hence, if the optimal mix of stocks and bonds for Sandra is 50-50 and Sandra's labor earnings and Social Security benefits constitute half of her total resources, she should invest the rest of her resources - her financial assets - 100 percent in stocks. In so doing, she achieves a 50-50 division of her total resources. A similar result arises if labor earnings and Social Security benefits are risky, but their ups and downs aren't correlated with the stock market. Zvi Bodie, Robert Merton and Bill Samuelson (Paul's son) provide an excellent analysis of this issue.

As we age and get closer to retirement, the share of our resources represented by future labor earnings declines. On the other hand, the share represented by future Social Security benefits rises. On balance though, these potential bond-equivalent assets fall as a share of resources up through retirement. Consequently, the share of our financial assets invested in stocks should fall. This is what life-cycle funds produce.

Now, the No.

There are many reasons a given life-cycle fund may be exactly the wrong investment vehicle for any given investor. For one, such investors may have labor earnings that are highly correlated with the stock market. This includes the millions of workers in highly pro-cyclical industries. Such workers already effectively hold a large share of their resources in stock, albeit indirectly through their employment.

Second, the non-financial share of resources may vary dramatically across investors. Richie Rich may have no labor income, whereas Penny Poor may have only labor income.

Third, some workers may be highly risk averse. In this case, their optimal share of risky resources (and stock share of financial assets) will be miles lower than that of less risk averse investors. (My paper with Francois Gomes and Luiz Viceira illustrates this point.) But when it comes to a given life-cycle fund, it's one size fits all.

Fourth, as the paper with Gomes and Viceira points out, after retirement, the optimal share of financial assets allocated to risky securities, i.e., stocks, is likely to rise dramatically. The reason is that in retirement, many households optimally spend down their financial assets at a faster clip than their Social Security wealth. In this case, their resources automatically become more bond-like every year and they need to reallocate their dwindling financial assets to stocks to satisfy the Merton-Samuelson prescription of a fixed, age-independent ratio of risky to safe resources. For such households, the optimal share of stocks in financial assets can be as high after age 70 as before age 40.

To summarize, Target Date Funds aren't right for everyone and, after retirement, they may be far off base for most households. But a separate and important question is whether employers are fulfilling their fiduciary responsibility in defaulting their workers into risky investments, be they life-cycle funds or a balanced portfolio. The fiduciary standard would seem to require employers to default workers into the safest retirement saving vehicle, namely long-term inflation-indexed bonds (e.g., 30-year Treasury Inflation-Protected Securities, or TIPS). Yet, whether by regulation or choice, no large employer appears to permit their workers to invest their savings in the safest possible manner, namely buying and holding long-term TIPS. Instead, employers are presuming to know what is best for their workers, even it means risking much or all of their workers' financial assets.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.