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The Paradox of Prudence

Is your target-date fund taking the risk you need?

Janet Yang, CFA, 07/23/2013

A primary worry for many retirement savers is that their nest egg won't last as long as they will. Target-date funds, which alter their asset allocation over decades to become less stock-heavy and more bond- and cash-heavy, try to solve for this "longevity" risk, but many sport drastically different asset-allocation glide paths. How do you know if your target-date fund has a reasonable approach?

Professionals use Monte Carlo analysis, which employs forward-looking risk-and-return expectations, as one means of testing glide paths. Although markets and existing target-date series lack the history necessary to judge a glide path's outcome, Monte Carlo analysis can simulate thousands of possible allocations that a glide path could take and calculate the probability of success (and failure) for investors. These models require many assumptions and inputs, so it is nearly impossible to compare one provider's output with another's (assuming that they even release the results, which is rare).

Using Morningstar's repository of glide-path and target-date-series portfolio data, though, we conducted Monte Carlo simulations for some of the industry's largest target-date providers, as well as the industry average glide path, using a uniform set of assumptions and inputs. (Details on our inputs and assumptions, as well as an expanded look at Morningstar's results, are in Morningstar's 2013 Target Date White Paper here).

Generally, we found that target-date investors in different series are likely to experience similar outcomes through age 85, the life expectancy of a typical 65-year-old female. Beyond that age, though, the outcomes start to diverge, and series with more equities generally come with a higher likelihood of success through age 95. The results serve as a reminder that investors or plan sponsors choosing more-conservative target-date funds don't just simply lower their market-risk exposure, they also increase the likelihood that retirees will outlive their savings.

Morningstar's results are by no means a final decree on any glide path's merits. Investors have other ways (saving more, spending less) to help improve outcomes. The results do, however, provide indications of which glide paths may be the most appropriate for certain investors. Workers who have been diligent about saving may be well served by a more conservative investment option, while those who have been less so may not be able to afford the comforts that come with a more risk-averse strategy.

The "Typical" Investor
To test glide paths, we established a profile for an average investor in a target-date fund: A 23-year-old worker who starts with $45,000 in annual wages, receives yearly raises to keep up with a 2% annual inflation rate, saves 7% of income each year, and expects to retire at 65. Standard industry studies suggest that this worker needs a retirement income that's 83% of his or her salary at retirement to maintain a post-retirement lifestyle that's similar to the pre-retirement one. (The retirement industry refers to that post-retirement salary percentage as a "replacement ratio.") As such, our hypothetical worker would need income of about $37,350 (in today's dollars) in the year following retirement. Social Security is expected to replace about 52% of the worker's pre-retirement income ($23,400 in the first year of retirement), leaving 31% (about $13,950 in the first year) to be funded through savings.

Defining Success
To test each glide path, we assumed that investors stay in the target-date series for essentially their entire working and retirement life, saving regularly from age 23 to 65, and then drawing down an inflation-adjusted income from age 66 on. The approach directly addresses longevity risk by measuring the probability that workers will maintain a positive savings balance as they age. Within each of the thousands of save-and-spend simulations, we counted as successful those that didn't run out of money at any given age.

Comparing the Industry's Behemoths
We looked at the glide paths for series offered by Vanguard, Fidelity, T. Rowe Price TROW, American Century, and BlackRock BLK --some of the industry's largest players. (Together, the Vanguard, Fidelity, and T. Rowe Price series represent roughly three fourths of the industry's target-date mutual fund assets.) Exhibit 1 depicts each of these series' glide paths, along with the industry average of all glide paths for comparison.

Janet Yang is a fund analyst with Morningstar.
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