Target Date Lifecycle Funds, also known as Target Horizon Lifecycle Funds, were conceived as a single-investment solution for less sophisticated members of participant-directed retirement programs such as 401(k), 403(b) and 457 plans. They are multi–asset class funds that adjust their asset allocation as time progresses toward a target date, generally an identified year such as 2015 or 2030. The adjustment to the asset allocation has come to be known as a glide path and can be thought of as a reduction in the allocation to higher-return/higher-risk assets (and a corresponding increase in lower-return/lower-risk assets) as the target date approaches. This adjustment is presumed to correspond to the changing risk tolerance of notional participants as they approach retirement. The glide path will approach an all lower-return/lower-risk allocation at some point on or after the target date.

Target Date Lifecycle Funds have seen dramatic growth in recent years, with currently more than $200bn invested and estimates of growth to $1tn in the next five years¹. This growth has been fueled by target date funds’ widespread inclusion in plans, for several reasons. One is to address a growing belief that most members of participant-directed plans have been making poor choices within the critical area of asset allocation. The second is to provide an investment fund alternative for participants who are uncomfortable making asset allocation decisions. Many plan sponsors have seen participants investing too conservatively to create sufficient wealth to sustain an acceptable post-retirement lifestyle; suffering crippling losses by chasing returns; or investing significant amounts in whatever asset classes are currently hot and not reacting when the market psychology changes.

Target Date Lifecycle Funds have also benefited from their designation as a Qualified Default Investment Alternative (QDIA) in the Pension Protection Act of 2006, making them attractive as a default options in participant-directed plans.

Asset allocation is among the most important decisions for any investor. Studies have indicated that the asset allocation decision is responsible for 85% – 95% of total investment performance, with manager or fund selection contributing only 5% – 15% of return.²

Target Date Lifecycle Funds can be viewed as having a three-phase hierarchy of investment decisions, each with different considerations.

Glide Path Construction

Changing the allocation over time between higher-return/higher-risk and lower-return/lower-risk assets.  The description of the rate of change and point when the fund is predominately or exclusively invested in lower-return/lower-risk assets – is referred to as the glide path. The glide path is unique to each vendor and is based on fundamental views about the nature of risk, the tolerance for risk at given ages, and an implied cumulative wealth-generation requirement. The glide path, being based on fundamental beliefs, typically changes infrequently at any given vendor.

Portfolio Structuring

A portfolio structuring process takes place when allocating the higher-return/higher-risk and lower-return/lower-risk portions to broad asset classes. This process depends on assumptions regarding the expected returns, risks and correlations of the broad asset classes. The objective is to develop an efficient portfolio (maximum return for a given level of risk or the minimum risk for a given level of return) at any given point in time. The portfolio structure will change as the fund rolls down the glide path and as assumptions for return, risk and correlations change.

Implementation/Vehicles

Finally, individual investment vehicles are implemented in each asset class; typically these vehicles are mutual funds provided by the lifecycle fund vendor. An advantage of the lifecycle funds is often the inclusion of mutual funds representing asset classes (such as emerging markets or even regional emerging markets) that are not available in the plan’s core investment option array, thereby providing a higher level of efficiency to a portfolio relative to what participants could obtain on their own.

Phase 3, the implementation of individual mandates, is usually via mutual or commingled funds that provide a narrow slice of the asset spectrum and/or a specific investment style. This is usually the easiest part of the target date fund management process.

There are many sound approaches to the portfolio structuring process, phase 2, including mean-variance optimization using forecasts for returns, risk, and correlation and more sophisticated approaches such as the evolving factor-analysis models that recognize that correlations depend on common factor risks such as the availability and price of credit, the availability and price of energy, consumer confidence, and government intervention – all on a global basis. Phase 2 will typically generate a portfolio of passive and active mandates chosen and sized to produce an efficient portfolio.

Phase 1, the changing allocation from high expected return/high expected risk to low expected return/low expected risk as the target date approaches, is both the most difficult and the highest-impact decision. In the earliest history of target date funds, the risk allocation approached or reached cash or near-cash risk levels at the target date, typically defined as the expected retirement date. This was based on the beliefs that a) people entering retirement had little or no current income to replace lost assets, b) the risk of market losses should be eliminated from the portfolio, and c) it was highly likely that people would withdraw funds at a faster rate than they had anticipated.

Over time, the philosophy changed as there was a recognition that people tended to live many years or even decades after retirement and that post-retirement portfolios should have an equity component to permit continuing growth and a modest hedge against inflation. As that philosophy was adopted, the glide paths extended to the extent that many vendors have relatively high allocations to equity well into the retirement period. While more aggressive strategies have been adopted, such strategies have tended to ignore the liquidity needs of participants in retirement.

While that higher allocation to higher-return/higher-risk assets could generate a very adverse result over a short period, there was a belief that the long-term return advantage of equity over low-return/low-risk assets would make up for losses during interim periods. Statistics were cited that showed that historically, equity outperformed cash over virtually any 10-year period.³

This extended glide path philosophy has been adopted to one degree or another by virtually all vendors of Target Date Lifecycle Funds. The recent market environment, with extreme losses in virtually all of the high-return/high-risk asset classes coupled with the extended glide path, has resulted in severe losses in many near-date target date funds just when many leading-edge baby-boomers are nearing retirement.

While much concern about this issue has been articulated by government, plan sponsors, and investment professionals, a strong defense has come from the vendors with the extended glide path philosophy.

Mercer believes that a key factor has not been considered in the development of the phase 1 glide path decision. Average target date fund investors have started saving too late, contributed too little, perhaps borrowed from the plan in the intervening years, and made poor investment decisions prior to the use of the target date funds, and for these and other reasons, have entered retirement with insufficient assets to retain the lifestyle to which they have become accustomed.

Typical participants attempt to maintain their previous lifestyle by drawing down their asset balance far more rapidly than is “actuarially sound” or that is considered in the vendors’ glide path assumption. Participants earning a preretirement $50,000 annual income who retire with an asset balance of $100,000 and may receive $20,000 in Social Security but attempt to maintain the lifestyle available with a $50,000 per year income will deplete their asset balance in little more than three years.

This short period in which the asset balance can be totally depleted because of an unsustainable “burn rate” makes these participants much more sensitive to short-term market volatility than previously thought as reflected by the simplistic assumptions based on mortality. Those assumptions are based on a totally unrealistic behavioral model. Participants are just not willing to suffer the reduction in lifestyle that an actuarially sound withdrawal rate from their low asset balance would require while they are still young (at heart) and healthy.

JPMorgan has some behavioral data that illustrate the problem. Pre-retirement, 15% of participants over the age of 59½ withdraw, on average, 25% of their assets. The average participant withdraws over 20% per year at or soon after retirement.⁴

Two other factors further negatively impact participants. Employers are now often contributing less to the 401(k) plan in a match, which further exacerbates a root problem – low balances when participants are moving into their retirement years. The mathematics of investment return also contributes to the problem. The large early withdrawals reduce the asset base that any improved returns from a subsequent rebound are applied. Even a high subsequent return, applied to few dollars, generates only a little wealth.

It seems clear to Mercer that the trend in glide path development (the assumption that the long-term-return advantage of equity over cash will provide a sufficient increment of wealth to compensate for short-term volatility) ignores critical asset balance and behavioral factors and thus is misguided. Participants typically deplete their accounts so rapidly that long-term advantages are meaningless.

There are a couple of obvious approaches to deal with these issues. First, realistic assumptions need to be made about participant behavior. Education about actuarially sound burn rates should be assumed to be effective only for more sophisticated participants, who probably don’t need it. The reality that most participants will consume their account balances at an unsustainable rate requires a dramatic shortening of the glide path, not back to the former state of little or no equity at retirement, but approaching that point in five years and not 15 years.

There also needs to be a range of return/risk funds to accommodate different participant needs. These could be low-, moderate-, and high-risk funds for each target date. Participants with access to defined benefit plans or high asset balances have very different return/risk profiles than participants with no defined benefit plans and typical asset balances. Education should focus on selecting the appropriate risk category and not just selecting the fund with the target date closest to the proposed retirement date.

Target Date Lifecycle Funds are a powerful tool for participants with limited knowledge about or comfort with making investment decisions, but an enhanced recognition of the real-world behavior of participants is needed. Target Date Lifecycle Funds could serve real-world participants far more effectively.

About the author

Terry Dennison is a worldwide partner in Mercer’s Los Angeles office. He is the US director of consulting and coordinates the development and dissemination of Mercer’s intellectual capital. Terry is a member of the US investment consulting leadership team.

In his 36-year career in the investment industry, Terry has had the opportunity to develop a broad and deep knowledge of all aspects of investment management.  His investment consulting clients include a number of large and middle-market private and public sector clients. Terry has a BA and an MBA from the University of Wisconsin – Madison, and is a Certified Public Accountant.

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