Conventional wisdom suggests younger individuals should invest more of their savings in riskier assets (e.g., stocks), while older individuals should invest more of their savings in safer assets (e.g., government bonds). This age-based approach has its roots in the theory of life-cycle investing and dates back to the 1950s in academic literature. Target-date investing, which is based on this theory, may seem like a fool-proof way to safely save for retirement, but as with any type of investment, it has its own dangers.
Financial Wealth and Human Capital
A key concept underpinning life-cycle investing is every individual investor has two types of wealth. The first type is financial wealth, the measure of wealth that is most familiar. It is held in instruments such as currency, bank deposits, stock in private or publicly-held businesses or real property, financial claims or bonds on governments or businesses, contracts with insurers, physical commodities, and funds comprised of one or more of these instruments.
The second type of wealth is human capital: the value of all expected future income from working. Total wealth is the sum of financial wealth and human capital.
Human capital usually accounts for a very large part of total wealth for younger investors. The ratio of human capital to total wealth declines as the individual ages, until it reaches zero at retirement. (For related reading, see: Human Capital: The Most Overlooked Asset Class.)
Life-cycle investing assumes human capital is less risky than financial wealth for most individuals. The theory suggests human capital is somewhat like a bond, such that younger investors can afford to invest a larger proportion of their financial wealth in stocks or other risky assets. Investors at or near retirement should have a lower allocation to risky assets since most or all of their wealth is in financial assets. In addition, the theory suggests investors can afford to take more risk with their financial assets when they are younger because if they lose money they can work longer or harder than they otherwise planned. This flexibility to adjust how much one works is slowly lost as the individual ages and argues for taking less risk with accumulated financial wealth.
Target-Date Investing in Practice
Financial practitioners have employed target-date investing with their clients for decades. Sometimes it is done with a high degree of precision, utilizing a formulaic approach that steps down risky asset exposure as the client ages. More often, the asset allocation is determined using rules of thumb, or less formal approaches that place more financial wealth in stocks if the investor is younger and more financial wealth in bonds if the investor is older.
Defined contribution employer retirement plans in the United States, including 401(k) and 403(b) plans, have steered more plan participants into funds based on the life-cycle investing approach. These funds go by various names—target-date funds, life-cycle funds, age-based funds, or dynamic risk funds. Regardless of the name, the approach is the same.
These funds tend to put 85-100% of assets in stocks for investors up to around age 40. By age 65, the stock allocation is reduced to 40-50%, and the majority of the fund assets are sitting in bonds or cash. Certain funds aimed at those already retired have even more conservative asset allocations. In between ages 40 and 65, these funds step down the exposure to stocks according to a chosen formula, dubbed the “glide path.” The exact allocations to stocks by age will vary by fund provider, but all follow this basic pattern. The figure below illustrates the stock allocation by participant age for a typical target-date fund. (For related reading, see: 6 Target-Date Fund Myths.)
Flaws and Consequences
A theory is useful only if its underlying assumptions are valid. Unfortunately, the key assumptions underpinning life-cycle investing theory do not necessarily hold true for many individuals.
The riskiness of human capital appears to be more akin to that of stocks than bonds for an increasing proportion of the population. Recent research has provided evidence of increased household income volatility since the 1970s. Part of this may be due to the changing nature of work that results in people switching jobs more frequently than in previous generations. In 2017, the U.S. Bureau of Labor Statistics released data from an ongoing longitudinal study that showed people born in the latter part of the post-World War II baby boom (1957-1964) held an average of six jobs between ages 25 and 50. It seems likely the number of jobs held by later generations will be even greater given the pace at which technological innovation is disrupting most industries.
Age Shouldn't Determine Stock Investments
We acknowledge that volatility is not inherently the same as risk. The range of lifetime incomes for the typical household may be more predictable than the range of future returns from risky assets like stocks, particularly if the household has sufficiently insured itself against the long-term disability or premature death of its earners.
However, the empirical evidence is not supportive of the notion that household income risk is low compared to risky financial assets. If we do not have confidence that human capital is less risky than stocks, the proportion of human capital to total wealth is no longer a key driver of the optimal allocation of financial wealth. In other words, age should no longer be the principal determinant of the appropriate mix of stocks in an individual’s portfolio. (For related reading, see: Why You Should Be Wary of Target-Date Funds.)
Labor Flexibility Is Inconsistent
The assumption that labor flexibility enables investors to take more risk with their financial assets when they are younger is more difficult to dismiss entirely. The flexibility to adjust total lifetime hours worked necessarily declines with age. But this flexibility is limited even for younger households. This is particularly true for a household with dependent children, or a household that includes sick or aging family members that require substantial care.
Although life spans have increased in recent decades, it is not evident that most of us will be able to continue our prime-age profession into what are normally retirement years if our financial assets fare poorly. As we age, the incidence of chronic illness rises, potentially limiting our ability to work longer even if desired.
The Efficacy of Target-Date Investing Rests Upon Practical Merits
Once the standard assumptions of human capital risk and labor flexibility are shown not to hold for an individual, the efficacy of target-date investing rests upon practical merits. Target-date investing undoubtedly will deliver a relatively high expected return given the elevated allocation to riskier assets until middle age (around age 40).
The potential for low or negative returns also is greater, but most of the time the individual will find themselves better off in early middle age than if they had invested more conservatively. The key exception will be younger individuals with low investment risk tolerance. Low risk-tolerant investors will be more prone to selling risky assets like stocks after prices have fallen sharply and thereby damage their lifetime wealth accumulation prospects.
The Risk of the Glide Path Formula
When middle age is reached, the glide path formula of the chosen target-date product will step down the allocation to riskier assets each year until the investor nears retirement. Unfortunately, this period of target-date investment introduces a new risk known as the "sequence-of-returns risk."
Sequence-of-returns risk refers to the phenomenon that the order or sequence of investment returns may affect lifetime outcomes when an individual is liquidating financial assets or changing their asset allocation. This risk is most commonly associated with the asset drawdown strategies of retirees, but it is an underappreciated risk of any investing approach in which the asset allocation is automatically adjusted regardless of recently experienced returns and future expected returns.
Risk of Target-Date Investing in Retirement
Once an investor reaches retirement, the target-date investing approach will dictate a more conservative asset allocation. This will be appropriate for some, but many individuals will need to manage their longevity risk—the risk of outliving their money. This risk grows with each subsequent generation as medicine improves. (For related reading, see: Americans Fear Outliving Their Retirement.)
Longer lives increase the incidence of chronic conditions that require costly care. A greater number of people will need to prepare for retirements that could be as long as 35 or 40 years. A conservative asset allocation may not provide sufficient returns to mitigate longevity risk depending upon one’s savings at retirement.
The flaws of target-date investing are evident for investors of all ages. The consequences of these flaws are the most benign for the very young with a high tolerance for risk, but increase through middle age with the introduction of sequence-of-returns risk, and are perhaps most serious for retirees that require decades of support from their savings. A customized investing approach provides superior outcomes for most individuals and their families. Such an approach would deliver investment portfolios optimized for the individual’s investment risk tolerance and that respond dynamically to changes in the outlook for investment returns and risks.
(For related reading, see: The Dangers of Putting Your 401(k) on Auto-Pilot.)