Equity Allocations By Age

One of the objectives of target-date funds is to provide a declining rate of equity exposure by age across participant accounts. Target-date investors do have a markedly different pattern of equity exposure by age compared with non-target-date investors (Figure 10, top panel).

Among non-target-date investors, equity exposure tends to rise with age, peak around age 35 to 44, and then decline in an inverse U-shaped pattern. The change in participants' equity allocations from age 25 to 65 and older is less than 10 percentage points.[11] By contrast, target-date investors have a consistent decline in equity holdings by age, reflecting the funds' "equity glide path." For target-date investors, equity exposure declines by more than 30 points across the age spectrum.

The decline in equity exposure over time occurs for both mixed and pure target-date adopters, although it is more pronounced among the latter (Figure 10, bottom panel). Among pure investors, equity allocations decline by more than 40 percentage points from age 25 to 65 and older. Even among mixed adopters, who typically hold only a small allocation in a target-date fund, the decline over the age spectrum is 20 points.

Equity Allocation Extremes

One of the benefits of target-date funds is that they eliminate extreme equity allocations. Non-target-date investors tend to hold greater extremes in equity exposure (Figure 11). Sixteen percent hold no equities, while 30% hold only equities. Target-date investors cannot hold extreme positions because target-date options include both equity and fixed income assets.

Among pure target-date adopters, 95% have equity allocations ranging from 60% to 95% of their account balances, reflecting the underlying equity allocations of the target-date funds. Mixed investors tend to have a wider dispersion of equity allocations, but still have no extreme allocations because of their partial investment in a target-date strategy.

Implications

Target-date funds have emerged as a strategy to simplify the construction of participant retirement portfolios. Rather than engaging in the complex task of selecting and monitoring a portfolio of retirement assets, investors simply choose an expected retirement date. The fund advisor is responsible for making all critical asset allocation and rebalancing decisions, including reducing equity exposure as the investor grows older.

The introduction of such funds has led to the creation of two distinct classes of target-date investors: pure investors, who hold a single target-date fund; and mixed investors, who combine a target-date fund (or funds) with other options. Pure investors are more likely to be strongly influenced by the plan's default fund designation, while mixed investors are more likely to actively make their own portfolio choices.

By design, target-date options provide two important investment benefits to pure and mixed investors. The funds sharpen the age-based gradient of equity exposure. They also eliminate extreme equity allocations—both zero- and all-equity positions. In this sense, target-date funds encourage arguably better-diversified portfolios than those constructed by non-target-date investors.

The main concern with target-date funds appears to be whether mixed investors are naïvely diversifying their portfolios. The typical mixed investor uses the target-date fund as an incremental or supplemental holding in a portfolio with four funds in total, and typically combines the target-date fund with domestic or international equity funds. Further research is needed to disentangle to what extent rational or naive strategies (or both) drive this decision.

That said, the concern about naïve diversification is not unique to mixed target-date investors. There is evidence of inadequate diversification across a range of participant portfolios, whether or not target-date options are in the mix.

Sponsors concerned about the quality of participant portfolio decisions can consider several strategies. One is to expand educational efforts regarding target-date options and their "all in one" approach. Some participants may fail to realize that the funds are intended as a single portfolio solution and that they are already broadly and professionally diversified across the global capital markets. This education effort could also contrast rational approaches to portfolio diversification (e.g., core/satellite) with naive ones (e.g., holding multiple funds regardless of their objective).

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