Retire at Your Own Risk

Are Target Date Funds missing the pensions bullseye?

11/12/2014

Javier Estrada

Javier Estrada, IESE Professor of Financial Management / Photo: Paul Mac Manus

The Journal of Portfolio Management recently published an article by IESE Professor of Financial Management Javier Estrada titled “The Glidepath Illusion: An International Perspective.” It showed that Target-Date Funds (TDFs), one of the most popular destinations for retirement savings, are frequently outperformed by alternative strategies.

TDFs, also known as lifecycle funds, are designed to reduce risk the closer the owner gets to retirement age. Simple to understand and, as a result, simple to sell, they have become the default option for many employer-sponsored plans.

How is the risk managed in TDFs? The funds typically begin their life cycles by investing heavily in equities. They then move assets over to bonds as retirement approaches. The theory is that investors are able to take their biggest risks when they are young and have many working years ahead of them. As retirement approaches, the funds look to reduce volatility and help protect investors' nest eggs from downside risk.

But while the strategy seems sensible, investors using it tend to come up short. After all, these funds are most aggressive when the portfolio is smallest and most conservative when the portfolio is largest.

Professor Estrada is not the first to question TDFs but he is the first to test how they fared compared with 10 contrarian and alternative strategies in 19 countries, digging into data spanning 110 years.


40 Years of Underperformance

Estrada first compared traditional TDF strategies with 'contrarian' strategies that mirrored them, looking at factors including retirement-date wealth and volatility.

Specifically, he examined the performances of five hypothetical TDFs that started heavily invested in stocks and then moved to bonds over 40 years. In Estrada's experiment the contrarian strategies, even the lower-performing ones, outperformed TDFs across the board.

In addition to contrarian strategies, Estrada looked at three 'equity-driven' strategies which focused on stocks, and two 'balanced' fund strategies which maintained a constant stock allocation of 50 or 60 percent. Performance was measured over 40 years, with rebalancing at the end of every year. The results were broadly similar for contrarian, equity-driven and balanced strategies. All generated greater retirement sums than traditional TDFs.

Even in times of economic uncertainty, the alternative strategies examined in Prof. Estrada's research generated greater returns than TDFs. He did note that because of their higher volatility, the alternative strategies were more likely to surprise investors near their retirement date. However, potential late drops in value were likely to be more than offset by larger gains across the full lifecycle of the funds.

According to Estrada, the only uncertainty that investors would have with alternative strategies would be the extent of their greater wealth at the time of retirement, rather than whether or not it would be greater at all.

"This controversy ultimately comes down to how risk is defined," Estrada stated. "A conservative strategy may deliver a smooth ride and few surprises but is likely to underperform an aggressive strategy in terms of the capital accumulated at retirement."


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