Target Date Funds, also referred to as Glide Path Funds or Life Cycle Funds, reduce the equity allocation in favour of more conservative investments, fixed interest and cash, as the investor gets closer to retirement.
They do this on the premise that as we get older we cannot recover from financial disaster because we are unable to rebuild savings through human capital (salary and wages). These Funds follow a rule of thumb that as you get closer to retirement an investor should be moved into a more conservative investment strategy. This is a generalisation that does not take into consideration the individual circumstances of the investor nor market conditions.
Target Funds are becoming increasingly popular. Particularly in situations where the Investor does not want or can afford investment advice. The “Product” adjusts the investor’s investment strategy throughout the Life Cycle for them, no advice provided.
All good in theory, nevertheless, these “products” have some limitations in their design which is increasingly being highlighted.
No, it is not that they are moving investors into cash and fixed interest at a time of record low cash returns and over-valued fixed interest markets. This is an issue, but a topic for another Blog. Albeit this is touched on below from a slightly different angle.
Essentially, Target Date Funds have too main short comings:
- They are not customised to an individual’s consumption liability, human capital or risk preference e.g. they do not take into consideration future income requirements or likely endowments, level of income generated up retirement, or the investors risk profile, appetite for risk, or risk tolerance.
- They are prescribed asset allocations which are the same for all investors who have the same number of years to retirement, this is the trade-off for scale over customisation.
- Additionally, the glide path does not take into account current market conditions.
- Risky assets have historically shown mean reversion (i.e. asset returns eventually return back toward the mean or average return, prices display volatility to the upside and downside.
- Therefore, linear glide paths, most target date funds, do not exploit mean reversion in assets prices which may require:
- Delays in the pace of transitioning from risky assets to safer assets
- May require step off the glide path given extreme market risk environments
Therefore, there is the risk that some Target Date Funds will fall short of providing satisfactory outcomes and meeting the key requirement in retirement of sufficient income.
Target Date Funds, Life Cycle Funds, focus on the investment horizon without protecting investors’ retirement needs, they focus on one risk, market risk.
The focus is not on producing retirement income or hedging risks in relation to investment risk, inflation risk, interest rate risk, and longevity risk.
As noted above, most target date funds don’t make revisions to asset allocations due to market conditions. This is inconsistent with academic prescriptions, and also common sense, both of which suggest that the optimal investment strategy should also display an element of dependence on the current state of the economy.
The optimal target date or life cycle fund asset allocation should be goal based and multi-period:
- It requires customisation by goals, of human capital, and risk preferences
- Some mechanism to exploit the possibility of mean reversion within markets
All up, this requirements a more Liability Driven Investment approach, Goal Based Investing.
My first blog outlines the revolution required within the industry to Mass Customisations.
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