Target Date Funds are becoming increasingly popular in the UK. The UK market is still very small (only around 0.5% of the DC market) but its expected to top £10 billion by 2018, with products such as BlackRock LifePath, State Street Timewise and Alliance Bernstein’s Retirement Strategies, becoming default options ifor DC investors, and JPM SmartRetirement and Architas BirthStar (managed by AllianceBernstein) launched in the advisory and D2C channels. We know that a few other providers are to follow.
WTF is TDF?
Technically speaking, TDFs are simply investment strategies based on the date a sperm fertilizes an egg! 🙂
Okay, seriously… TDFs (also called life-cycle funds or age-based funds) put asset-allocation on autopilot-based client’s age or more specifically, the time they have left before reaching their retirement age. Younger investors start out with high allocation to equities (and other growth assets) and this reduced gradually, while the fixed income (and other defensive assets) allocation increases proportionately as they approach that important retirement date. The typical asset allocation glide path will start at 80/20 stock/bond allocation and move gradually over time to 20/80 equity/bond allocation. This chart below shows a typical asset allocation glide path for TDFs.
Image from Alliance Bernstein
The idea behind TDFs appears very intuitive; younger investors have longer time to recoup losses, than older clients who are closer to retirement and haven’t really got time for portfolio to recover before having to draw income – but does it really stand up to scrutiny?
Do TDFs stack up?
Do we really think that younger investors, with very little or no investment experience and probably very little by the way other assets should allocate 90% of their portfolios into equities? TDFs take no account of the investor’s risk profile or behavioral biases and so when craps hits the fans, what’s to stop these folks from panic-selling and sitting on cash? And worse, they become scared of going back into equities. While the idea of high equity allocation for younger investors makes sense, it fails to account for the behavioral biases that has been known to have significant influence on investment outcome.
Behavioural biases aside, TDFs also result in suboptimal outcomes in terms of capital accumulation and by implication, retirement income. TDFs automatically allocates clients to defensive assets at the time when the probably have the highest account balances, reducing the overall growth in their portfolio when it’s most needed. In other words, when investors have very little money (to make returns on), we load them up on growth assets and when they actually have a decent-sized pot, we gradually take risk (and hence return) off the table.
Studies carried out by folks at Research Affiliates shows that doing the exact opposite of what TDFs do – i. e a rising equity glide path that starts out with low equity allocation (say 20% equity and 80% bonds) and increases as investor approaches retirement (say to 80/20 equity bond allocation) – or in fact, a the good old static 60/40 portfolio rebalanced Regularly – delivered better outcomes that the typical TDF glide path. In summary, their conclusion is that;
Markets don’t care about our glidepath (or lack thereof); we’re as likely to have our best stock market returns late in our career as early. If the best stock market returns come early, it’s clear that we’ll finish richer with a glidepath strategy. But if bonds beat stocks late in our career, we’ll do materially worse with a glidepath approach.
Having higher returns when our portfolio is large is important; over most historical spans, this means that finishing with an equity-centric asset mix trumps the classic glidepath strategy.
Their research is corroborated by Jarvier Estrada of EISE , whose comprehensive study that spans more 19 countries, and 110 years shows that when compared to TDF strategy, reverse glide path strategies (i.e increasing equity allocation as investor gets older) provides higher upside potential and more limited downside potential. In his words;
First, the mean and median terminal wealth are lower with strategies that become more conservative as retirement approaches (lifecycle strategies) than with those that become more aggressive as retirement approaches (contrarian strategies). Second, contrarian strategies outperform lifecycle strategies in terms of all the upside potential variables considered here.
Third, contrarian strategies keep investors more uncertain about their terminal wealth than lifecycle strategies. But, fourth, the former’s downside potential is typically more limited; that is, contrarian strategies tend to deliver a higher terminal wealth in bad scenarios than lifecycle strategies do. These last two points combined imply that, fifth, the higher uncertainty of contrarian strategies is basically uncertainty about how much better, not how much worse, investors are expected to fare with them than with life-cycle strategies.
The point here isn’t necessarily to suggest that increasing equity allocation as an investor gets older is always the right approach but more to demonstrate to folly of TDFs and the conventional view that asset allocation should become more conservative as people get older, regardless of their risk profile and whatever else going on in their lives.
With Pension Freedoms, we know that more and more people going into drawdown rather than buying an annuity, I find the idea of putting clients in 70%/80% defensive asset at the start of what is likely to be a 30 year plus retirement period worrying indeed. Strangely, Pension Freedoms is being seen as an opportunity to flog more of these products in the retail and advisory channels, and TDFs are replacing lifestyling as the default options for millions of DC savers. I fear we are heading in the completely wrong direction and I can only hope someone stops this madness before it’s too late! Then again, I’m totally used to being told I have no idea what I’m talking about, so here’s your chance to show me empirical evidence that I’m wrong. What am I missing?