A growing popular option for retirement plan investors is to use a target date fund as the investment medium. These funds are now being offered in corporate retirement plans and are offered by a growing number of mutual fund firms. For more information on retirement plans and tax deferred investing please refer to Retirement and tax deferred investing.
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1. Life Cycle Funds by Viceira, Luis M., (May 2007)
This paper reviews recent advances in academic models of asset allocation for long-term investors, and explores their implications for the design of investment products that help investors save for retirement, particularly life-cycle funds and life-style (or balanced) funds. The paper argues that modern portfolio theory provides scientific foundation for the "risk-based" asset allocation strategies and the "age-based" asset allocation strategies that characterize life-style and life-cycle funds. Risk-based allocation strategies can be optimal in an environment where investors face real interest rate (or reinvestment risk), while human wealth considerations give rise to horizon effects in asset allocation. However, this theory also makes a number of suggestions about how life-style and life-cycle funds should be structured, and shows for which types of investors these funds are appropriate investment choices. Thus, modern portfolio theory provides only qualified support for these funds. Nevertheless, the paper argues that properly designed life-cycle funds are better default investment choices than money market funds in defined-contribution pension plans. The paper also argues for the creation of life-cycle funds that allow for heterogeneity in risk tolerance, and for the creation of life-cycle funds specific to defined-contribution plans that can better account for the correlation between human capital and stock returns. It also suggests that investors who expect to receive Social Security benefits and pension income after retirement should choose a target retirement date for their funds based on their life-expectancy, not their expected retirement date.
2. Making Investment Choices as Simple as Possible: An Analysis of Target Date Retirement Funds
by Bodie, Zvi and Treussard, Jonathan (January 2007)
Many participants in self-directed retirement plans (401k, IRA, etc.) do not know enough about investing to choose rationally among alternatives. Others may know enough, but find it unpleasant or too time-consuming. Target-date funds (TDFs), also known as life-cycle funds, are being offered as a simple solution to their dilemma. A TDF is a "fund of funds" diversified across stocks, bonds, and cash with the feature that the proportion invested in stocks is automatically reduced as time passes. Empirical evidence suggests that a simple TDF strategy would be an improvement over the choices currently made by many uninformed plan participants. This paper explores one way to achieve an even greater improvement. Using a compact continuous-time optimization model, we characterize a person for whom a TDF strategy would be optimal: a "natural TDF holder." We then show that the TDF strategy may be far from optimal for people who — although of the same age — differ from the natural TDF holder in their risk aversion or exposure to human-capital risk. To bring such plan participants much closer to their optimal strategy it is enough to add a second simple investment alternative — a safe fund matched to their time horizon. Participants with the same time horizon could then choose (or be advised to choose) either the TDF or the safe target-date fund depending on their risk aversion and human-capital risk. We find that people who are very risk averse and who have a high exposure to market risk through their labor income would experience a substantial gain in welfare from being offered a safe target-date fund rather than a risky one. Recent empirical research suggests that human-capital betas change over one's working career. They are typically quite high during the early years when human capital represents the largest part of total wealth for most people, and they decline with age. To reflect gradual changes in human capital risk over the life-cycle from predominantly "stock-like" to mostly "bond-like," TDFs should switch from a "linear" strategy to a "hump-shaped" strategy with respect to age.
3. Popping The Hood: An Analysis of Major Target Fund Families by Joseph C. Nagensatt, John Bucci, William S.Coakley, II (2006)
A study of major fund family life cycle funds from Turnstone Advisory Group LLC.
4. Funds For Retirement: The "Life Cycle" Approach by Vanguard Investment Counseling & Research
Life-cycle funds have attracted increasing interest because they answer the desire of many plan participants for a single, professionally planned, comprehensive investment that requires little or no maintenance by the individual. For plan sponsors, too, life-cycle funds can be useful from a fiduciary perspective, particularly as default options. In choosing a type of life-cycle fund, sponsors should consider the trade-offs involved, fund methodologies, and the unique characteristics of the participants in the plan.
5. Target date funds and goal-based benchmarks by Vanguard Investment Counseling & Research, 08/23/2007
Target date portfolios are one of the fastest-growing segments of the mutual fund industry. At the end of 2006, these funds held $114.3 billion in assets, up from $12.3 billion in 2001, according to the Investment Company Institute. The growth of these portfolios reflects broad-based demand for funds designed to meet a single goal-based objective: to help investors achieve financial security in retirement.
Unfortunately, existing benchmarks provide no sense of the funds’ success in meeting this objective. It’s almost as if a tour guide agreed to take a traveler from point A to point B, but never clarified how they would get to point B, or even precisely where point B was. The traveler would be lost.
6. Evaluating and implementing target date portfolios: Four key considerations by Michael Hess, John Ameriks, Ph.D., Scott J. Donaldson, CFA, CFPVanguard Investment Counseling & Research, 03/04/2008
The recent growth in popularity of target date funds (TDFs) has led to greater product differentiation and complexity. Target date offerings are becoming more specialized and vary significantly in terms of investment methodology and portfolio construction.
This new Vanguard® white paper provides a road map for plan sponsors in selecting the best target date products for their participants. Authored by Vanguard Investment Counseling & Research, this paper identifies and explores four key considerations for plan sponsors when evaluating and implementing TDFs:
* The right asset allocation glide path for plan participants.
* The pros and cons of indexing versus active management.
* The choice between packaged and customized solutions.
* The impact of TDFs on participant portfolios and adoption rates.
7. Missing the Target by Craig L. Israelsen and Joseph C. Nagengast, published in Financial Planning Magazine, September 2007.
By virtue of the relatively high equity allocation in the average near-term fund, it appears that many target-date funds have an accumulation-mode mentality up until the target date. We suggest that transitioning a tar-get-date fund from accumulation mode to distribution mode—which theoretically begins at the target date—should begin more than three years before the target date inasmuch as the primary goal of a distribu-tion portfolio is to avoid large losses. A 62-year-old with a 46.5% equity allocation (based on the average 2010 target-date fund equity allocation) suggests that the equity glidepath during the last several years before reaching the target date will be fast and steep—not exactly the ideal way to safely land a plane or prudently position a portfolio. If you don’t think that can be a problem, just ask an equity-heavy investor who had planned to retire in 2002.
8. Pure Target Indexes: Better Benchmarks for Target Date Funds by Craig L. Israelsen, Ph.D., Submitted to Journal of Indexes Fall 2007
Target date funds are here to stay. As a result of the Pension Protection Act of 2006, target date funds will likely become the auto-enrollment default option in tax deferred retirement plans. The potential growth in assets committed to target date funds over the next 5-10 years is astounding. For example, at year-end 2006, there were 168 distinct target date mutual funds with $109 billion in total assets. As of September 30, 2007 (see data table below) there were 222 target date funds with $164 in assets. This represents a 32% increase in the number of funds and a 50% increase in total assets in just nine months. In light of anticipated growth in both the number of target date funds and the assets committed to them, it is critically important that appropriate benchmarks are developed to evaluate and benchmark their performance. This will increase the likelihood that (1) investors are better served and (2) the fiduciary responsibilities of financial advisors and plan sponsors have been
9. The Dynamics of Lifecycle Investing in 401(k) Plans by Mitchell, Olivia S., Mottola, Gary R., Utkus, Stephen P. and Yamaguchi, Takeshi, (October 2007)
In an effort to improve 401(k) portfolio choices, many US plan sponsors are offering target maturity date (TM) lifecycle funds, which place younger workers into higher-equity-share portfolios and then automatically rebalance them into more conservative holdings as they near retirement age. Our study of over a quarter-million participants offered TM funds shows that sponsor-driven menu decisions do influence adoption patterns. Yet many participants also prove to be active decision-makers, particularly new plan entrants and seemingly less financially literate employees. Comparing portfolios before and after TM fund adoption, we observe that such funds meaningfully change the age structure of equity exposure, eliminate zero- or all-equity portfolios, and reduce the share of idiosyncratic portfolio risk. We conclude that recent pension legislation sanctioning TM as default funds will modify 401(k) investment patterns. The speed with which behavior changes will depend both on employer plan menu decisions as well as voluntary choice by new entrants and low-literacy employees.