A good glide path strives for high returns in the early years when the investor should be less risk averse because there is plenty of time to recover if necessary and asset balances are low. Investor risk aversion should increase as account balances grow and the target date nears.
The two key decisions a target-date provider must make are when to start applying the brakes, and how forcefully to apply them. One timing decision rule is to wait until the horizon is short enough to have a risk of loss. My research indicates that it is highly unlikely that an investor in a well-diversified portfolio of risky assets will lose money over a 10-year period. In other words, an investor who will stay with the program for 10 years is highly likely to make money. Accordingly, this risk-of-loss rule argues the brakes are first applied at 10 years before the target date.
The magnitude of transfer from risky to protective assets can be determined using the principles of liability-driven investing. Sufficient assets are set aside in the protective asset such that even if the worst-case risky return is realized over the horizon, the total account balance is insulated from purchasing power loss. This structure leads to a non-linear glide path because transfers increase geometrically.
A bad choice of glide path is applying the brakes too soon, sacrificing performance, or too late, jeopardizing asset values. Some have argued that asset protection should be provided early in the fund's life cycle to keep the investor in the game. Others argue an opposite case: that the brakes should be applied as late as possible, and they should only be applied a little. These providers see the fund at target date morphing into a distribution fund. Target-date funds do not close down at target date; they continue as “current” funds.
Attempting to protect asset values throughout the life cycle is a very expensive proposition, and is tantamount in early years to insuring the house on the mountain against floods. Leaving the brakes off, or almost off, exposes the investor to unnecessary and unwarranted risks. So far the competition for target-date business has been based on performance and has led most to favor a very gentle application of the brakes, leaving the target-date fund in a substantial risky asset allocation at target date.
An ugly glide path choice evolves from this performance horse race. Exposing the investor to too much risk at target date could be catastrophic. The motivation of supporting the distribution phase is probably not in the best interests of the investor. All sorts of distribution alternatives are springing up to accommodate a diverse set of objectives and circumstances in retirement. These distribution choices are much more complicated than the accumulation decisions, so target-date funds should stick to just the single objective of accumulation, which is in keeping with the appeal of simplicity.
Ronald J. Surz is principal with Target Date Analytics Inc. and president of PPCA Inc., both in San Clemente, Calif.