In recent years, target-date funds (TDFs) have become an increasingly popular option for retirement investors. The funds are designed to automatically adjust an investor’s asset allocation and risk exposure as the investor approaches retirement. This is accomplished by systematically reducing a portfolio’s equity exposure over time according to a predetermined schedule, or glide path, and replacing these investments with more conservative, less volatile asset classes such as nominal bonds, inflation-protected securities, and cash. The glide path dictates at what ages, and to what extent, the asset allocation is modified, in effect transferring the onus of portfolio management and rebalancing to a professional money manager.

Currently in the financial services industry there is no universally accepted glide path for these funds. This lack of consensus became particularly evident in the market downturn of 2008 as TDFs from a number of providers with the same target date posted noticeably different returns. This paper outlines some target-date methodologies across providers, highlighting different risks associated with the various strategies and illustrating the impact of those strategies on TDFs’ performance over both a longer period as well as a shorter, more volatile, period like that of 2008.[1]

Varied TDF Strategies, Varied Results

In constructing a target-date fund glide path, investment providers differentiate their portfolios in three ways, each of which contributes to the funds’ relative performance. TDFs vary in their broad asset allocation, in their sub-asset allocation of the broader asset classes, and in their implementation strategy.

It is well documented that asset allocation is the most important determinant in explaining the return variation for broadly diversified portfolios over long periods (for a recent discussion, see Davis, Kinniry, and Sheay, 2007). Typically, the higher a fund’s exposure to stocks, the more aggressive we can assume the fund to be, and the higher a fund’s exposure to bonds and cash, the more conservative we can assume it to be. Historically, from 1926 through 2008, the broad U.S. stock market returned 9.65% annually, and the overall U.S. bond market returned 5.51% annually, creating an equity-return premium of 4.14%.[2] For the same period, the 20-year return for stocks was higher than that for bonds in 61 of 64 years, or 95% of the time.[3] Since expectations of higher returns come with higher risk, it makes sense that portfolios that are more aggressive can potentially yield higher returns and greater wealth for investors over longer time frames.[4] However, to realize these long-term benefits, investors must be willing and able to withstand short-term periods of potentially high volatility, periods such as occurred in 2008.

Among TDF providers, there is no universally accepted process for establishing an optimal glide path: More quantitative, probabilistic frameworks generally have higher equity exposures, based on long-term expected returns, whereas frameworks that admit less risk and focus more on downside protection can be expected to have greater exposure to fixed income securities. As such, much depends on the professional judgment of the individual investment provider—which is why TDF asset allocations vary from provider to provider and why the funds have posted a range of returns in recent years. Figure 1 highlights sample asset allocations of four TDF providers, each of which used proprietary methodologies to construct target-date portfolios as of December 31, 2008.

Given the research findings on the importance of asset allocation in explaining variation in long-run returns (e.g., Davis et al., 2007), one should expect somewhat longer-term differences in results to be driven largely by variations in the portfolios’ broad asset allocations. As shown in Figure 2, the three-year return differentials between each fund, by provider, ranged from 3 to 5 percentage points. Generally, for a given target date, funds with higher equity allocations underperformed those with more conservative allocations—normally a counterintuitive finding, but attributable in this instance to the market environment of 2008.

Over a shorter time horizon, however, funds with similar asset allocations posted a wide range of returns. For example, Figure 3 shows that the one-year (2008) return for the 2025 Fund from Provider B was –36% (78% equity allocation), while the one-year return for the 2025 Fund from Provider D was –30% (77% equity allocation). Likewise, for the same period, the more conservative 2015 Fund from Provider B returned –30% (64% equity allocation), while the 2015 Fund from Provider D returned –24% (63% equity allocation). Such return differentials imply additional, potentially significant, differences in the composition of the portfolios at the sub-asset class level and/or in the implementation strategy used to construct these portfolios.

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