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 Target date funds are becoming increasingly important as investment solutions for retirement savings plans. In 2007, the U.S. Department of Labor recognized target date funds as a possible suitable choice as the default investment option for defined contribution plans, and subsequently there has been a surge of assets into these funds. As of April 2009, assets under management in target date funds are estimated to be close to $314 billion.1 Investment managers have responded with new products and redesigns of existing products.
For the individual investor, investment adviser or plan sponsor, selecting from among the variety of target date products is a formidable task. One of the fundamental problems is the lack of an objective, returns-based measure of performance that is appropriate for evaluating target date funds. While investment decisions should never be based solely on past performance, any investor choosing among families of target date funds (whether an individual investor, personal investment adviser, plan sponsor or plan participant) is going to ask: “How have they performed? Have they done better than some simple but reasonable benchmark? How has the family of funds I am considering done relative to peers?” Over time, the investor will also need to know: “How will I be able to tell if my fund is doing what the investment manager said it would do?”
In this article, we provide an introduction to target date funds and identify the key determinants of differences in performance across target date fund families. We elucidate why the traditional approach to benchmarking and performance analysis, which has long been tested for single-asset-class and static-mix investment products, fails to meet the needs of target date fund performance measurement. We identify the desirable properties such a measure would have and introduce a measure that meets those requirements.
How Do Target Date Funds Work?
Although target date funds are offered by many investment managers with varying investment philosophies, they nonetheless share common features. The investor chooses a fund with a target date close to his or her retirement—for example, Target Date Fund 2040—and makes regular contributions. The fund manager selects appropriate asset classes, specifies an allocation among them that evolves over the life of the fund, and devises the best investment strategy within each asset class. Thus, there are three major components to target date fund performance: 1) the glide path (the evolution of the mix between equity and fixed income; 2) the allocation among the sectors of the broad equity and fixed-income asset classes; and 3) implementation through active and/or passive vehicles within each asset class. While all of these components determine performance, the glide path is the most important determinant of the risk and return characteristics of a target date fund.
The glide paths of target date funds have a common feature: The allocation to equity declines as the fund approaches the target date. Younger investors in funds with distant target dates therefore will have a higher allocation to equity than older investors in funds with nearby target dates. Despite this common framework, there is no commonly accepted glide path. Figure 1 demonstrates how different the glide paths—the dynamic allocation to equity and bonds—can be from one fund family to another.
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