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Does Being Prudent Pay Off?

What constitutes appropriate risk-taking varies widely in the target-date universe. That could have a huge impact on retirement savings.

Janet Yang, CFA, 10/11/2013

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 investors know if their target-date fund has a reasonable approach?

Asset-allocation glide paths form the figurative backbone for target-date funds, and they map out a target-date series’ long-term changes in asset classes over time. Despite their key role in determining investment success, there are few ways to evaluate glide paths and compare one series’ asset-allocation plan with another’s. Exhibit 1 shows the industry average glide path, an average of the strategic equity allocations disclosed in funds’ prospectuses as of Dec. 31, 2012, as well as the industry maximum and minimum equity exposures for each year along the funds’ glide path. The data illustrate a wide range of target-date glide paths, demonstrating that target-date funds can be far from interchangeable with one another. For example, longer-dated 2055 funds, intended for younger investors with many years to go before retirement, have almost a 20-percentage-point difference between the most and least aggressive options.1

Evaluating a glide path isn’t a straightforward exercise, however, especially considering the 60-plus-year investing horizon that some funds on the marketplace imply. Vanguard and Principal, for example, have already launched funds intended for those planning to retire in the year 2060. A 65-year-old retiree in 2060 would be 18 today, meaning he or she has 67 years to go before reaching age 85. Meanwhile, the industry’s oldest series, BlackRock LifePath (formerly Barclays LifePath), is less than 20 years old. There are also fewer than 90 years of market data by which to analyze these asset-allocation plans; even using annually rolling 60-year periods, that results in fewer than 30 observations.

Monte Carlo analysis provides one means of testing the likelihood that investors will be able to successfully retire using a particular glide path. 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 to calculate the probability of success (and failure) for investors. It is not a new technique, and it is one that many target-date providers already use. However, 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.

Generally, we found that target-date investors in different series have very similar probabilities of having sufficient savings through age 85, the life expectancy of a typical 65-year-old woman. Beyond that age, though, the outcomes start to diverge, and series with more equities come with a higher likelihood of success through age 95. The results serve as a reminder that investors and plan sponsors choosing more-conservative target-date funds don’t just simply lower their market-risk exposure: They take on longevity risk—the possibility of outliving savings—in return.

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 conservative option, while those who have saved less may not be able to afford the comforts that come with a risk-averse strategy.

Setting the Stage
Basic glide-path testing requires two main inputs: risk and return assumptions for the asset classes underlying the glide paths, as well as a saving and spending profile for a typical target-date fund investor. For the former, we used Ibbotson Associates’ 2012 capital market assumptions.2 Ibbotson provides its asset-class return assumptions to pensions, foundations, endowments, and other institutional investors as an input for their investment policy decisions, so the forecasts are a reasonable starting point for this analysis.

Janet Yang is a fund analyst with Morningstar.
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