While they are an increasingly popular means of investing for retirement, with over $1 trillion in assets under management (AUM), target-date funds recently drew fire from Rob Arnott, noted as the developer of "smart beta" indexes that seek to beat the market averages. "No one's ever tested its core thesis, which is that starting aggressive and then getting more conservative as you get older leaves you with more money in retirement and less risk when, in fact, it does the opposite," Arnott told Business Insider. The table below summarizes Arnott's key contentions.
Where Target-Date Funds Are Falling Short
- They actually increase investment risk as the client ages
- An opposite strategy actually would have delivered superior results
- Young people would do better by saving more aggressively
- Older investors would do better by continue to work longer
Source: Business Insider
Significance for Investors
Arnott is the founder and chair of Research Affiliates, a firm that develops investment strategies utilized by a number of leading mutual funds, ETFs, separately managed accounts and commingled accounts. As of Dec. 31, 2018, a worldwide total of $170 billion in assets were managed according to its strategies, per Research Affiliates.
"The central tenet of TDF [target-date fund] investing is that young people should buy stocks and gradually shift to bonds over the course of their working years. (TDFs have also been labeled 'life-cycle funds.') There are many different designs, but, essentially, once investors state when they expect to retire, TDFs set a flight plan--a 'glide path'--and transition from stocks to bonds on automatic pilot. A fund that starts out holding 80% stocks might wind up holding 80% bonds," as Arnott described in a July 2014 commentary.
Arnott wrote that this strategy rests on two premises: "1. By accepting equity risk early on, TDF investors capture the equity risk premium and enjoy higher terminal wealth. 2. By reducing equity risk as they near their target date, TDF investors gain greater certainty about their eventual consumption in retirement."
A research paper co-authored by Arnott and published in 2011 tested alternative glide paths based on stock and bond market data starting in 1871. Its conclusion, as he summarized in his 2014 piece: "for a 41-year investment horizon...an inverse glide path would have improved outcomes."
"The simple model of lifetime risk-taking that is used to buttress TDF investing requires certain assumptions that we have reason to doubt," Arnott continued in 2014. The first assumption is: "Human capital (one’s ongoing ability to earn income) is safe enough to justify tilting the glide path toward equities in the early stages of life." The second is: "Equities carry a fairly high risk premium and bonds are safe." The 2008 financial crisis undermined both propositions severely, he noted.
"In addition, considering the very real desire to consume in retirement (not just having pieces of paper with people’s faces on them to look at), the entire reliance on stocks and bonds at the exclusion of other asset classes is worrisome," Arnott concluded.
Paul Merriman, a financial educator and investment adviser, is another critic of TDFs. He offered several critiques in a commentary for MW. They have minimal exposure to equity classes with superior long-term performance, notably small cap stocks and value stocks. They offer the same mix of equity classes to all investors, regardless of age. The treat all investors of a given age the same, despite personal differences in risk tolerance and other circumstances. They also are funds of funds, which adds extra layers of fees.
TDFs controlled over $1.1 trillion of assets by the end of 2018, up from $160 billion in 2008, for a 19.2% compound annual growth rate (CAGR), according to Pensions & Investments. This is more than twice the growth rates among actively-managed stock and bond funds over the same period. Weighted by assets, fees on TDFs have fallen at a compound annual rate of 4.6%, versus 2.7% for active-managed stock and bond funds, P&I adds.
The biggest player in TDFs is The Vanguard Group, with a 37% share of assets at the end of 2018, up from 32% three years prior, per data from Sway Research cited by Investment News. Next are Fidelity Investments, at 13.9%, and T. Rowe Price, at 12.6%, both losing market share over three years. Sway values the TDF market higher than P&I, at $1.8 trillion.
In a Sept. 2012 commentary cited by MW, Arnott laid out a more reliable scheme for achieving "financial longevity." This includes saving aggressively, spending cautiously, and working a few years longer. "No strategy can make up for inadequate savings or premature retirement," he wrote.