Target-date fund design may be wrong for retirees

Prominent retirement researchers are questioning whether target-date funds, the golden goose of the 401(k) industry, are structured appropriately.

TDFs have become the preferred investment for 401(k) savers, now holding about $1.1 trillion in assets. By 2023, roughly 70% of investors will use a TDF as their lone 401(k) investment, compared with 52% today, according to Vanguard Group estimates. But their design may be flawed.

TDFs available to 401(k) plans today use the same simple concept: They dial back equity exposure the closer an investor gets to retirement age (the “target date”), then maintain that exposure or continue reducing it in retirement. Financial planners have used this concept for years when building client portfolios.

However, retirement researchers have found this approach leaves investors vulnerable to stock-market risk in the early years of retirement. Decreasing stock allocations during one’s working years isn’t the troublesome part; rather, it’s what happens to stock allocations after reaching the target date. A better approach, researchers argue, would be to grow equity exposure in retirement rather than maintain or decrease it. A TDF with this glide path (the ratio of stocks to bonds) would have a U shape.

(More: Actively managed TDFs are getting edged out)

Michael Kitces, partner and director of wealth management at Pinnacle Advisory Group, and Wade Pfau, professor of retirement income at The American College of Financial Services, argue that a U-shaped glide path has a double benefit when compared with other approaches: It reduces the probability of running out of money in retirement and reduces the magnitude of the shortfall if a client does run short.

“Our research does imply that traditional glide-path funds are ‘wrong’ in what they’re doing,” Mr. Kitces wrote in an email.

In a sense, this flaw reflects an industry’s inability to adapt beyond an asset-accumulation mindset. Asset managers have long discussed creating products better suited to the income portion of an investor life cycle, but not much has changed, said Chris Brown, founder of Sway Research, who studies asset-management distribution in retirement plans.

“That’s the basis of the industry — it’s always been about accumulation,” Mr. Brown said. “How do we help people save more money and get more assets in the door? It’s sort of a built-in industry bias.”

The rising-equity glide-path concept “sounds like really smart thinking to me,” Mr. Brown said, adding that no major TDF providers currently use it.

(More: 10 things to know about TDFs)

The average TDF with a 2020 retirement date has a roughly 45% stock allocation, for example, according to Morningstar Inc., though funds vary greatly. Investors who retired in 2010 have lower allocations, an average 35%, showing an overall tilt toward declining stock allocations.

Traditional TDF design becomes an issue for retirees during an extended period of poor returns in the early years of retirement, Mr. Kitces said. In this scenario, a declining equity share leads investors to have less in stocks when the market rebounds in the second half of retirement; conversely, a rising-equity glide path exposes retirees less to losses when they’re most vulnerable to them (early in retirement) and increases stock exposure to take advantage of good returns if they emerge.

(More: Vanguard share of target-date fund market becoming ‘obscene’)

Mr. Kitces and Mr. Pfau, using a 30-year retirement and a 4% withdrawal rate as benchmarks, found a 95% chance of success (investors not running out of money) when starting retirement with a 30% stock allocation and ending with 70%.

A static 50% stock allocation as well as a declining 50% to 20% portfolio have a 94% chance of success. In a bad market, investors would run out of money after roughly 29 years, about a year earlier than the rising-equity portfolio.

A static 60% stock allocation through retirement yields a lower success rate, 93%. The result is the same for a portfolio reducing its exposure from 60% to 30%, according to their paper, “Reducing Retirement Risk with a Rising Equity Glide Path,” published in the Journal of Financial Planning in 2013.

Mr. Kitces and Mr. Pfau found a larger shortfall among static and decreasing-equity portfolios when markets performed poorly. Looking at the 5% worst market-return scenarios, a rising-equity glide path (30% to 70%) was able to support a 30-year retirement. The static 60% portfolio only supported 27.7 years and the decreasing glide path (60% to 30%) yielded 27.8 years.

These findings are especially important in the current environment, after years of a bull market when another downturn could be near and when mitigation of sequence-of-returns risk becomes especially important, Mr. Pfau said.

However, taking on greater equity risk in retirement may be a difficult sell to investors from a behavioral perspective, said Paul Sommerstad, partner at Cerity Partners. Retirees may sell out of their TDF at an inopportune time if the market tanks, and lock in their losses, he said.

“I think that behavioral element of hyper-loss-aversion, especially in retirement, would be our concern,” Mr. Sommerstad said.

Ron Surz, president of Target Date Solutions, has had funds with a U-shaped glide path on the market for since 2008. At retirement, the funds hold 10% in stocks, growing to more than 40% over 20-plus years. The SMART Funds hold just $10 million today, which Mr. Surz said is a result of a decade-long bull market in stocks that has led plan sponsors to seek out performance over prudence.

“The key thing is, you only get to do it once,” Mr. Surz said of retirement. “If you’re wrong, then it’s awful.”