Markets are rarely tractable, which is one reason why significant flexibility is required over an investment lifespan. Flexibility is something that target-date funds don’t have much of. In fact, target-date funds have a glidepath toward a fixed allocation at a specified time. I’ve written about the problems with target-date funds extensively—and why I think balanced funds are a much better QDIA (Qualified Default Investment Alternative). It appears that my concerns were justified, now that Rob Arnott at Research Affiliates has put some numbers to it. According to an article in Smart Money on target-date funds:
A target-date fund is a one-decision mutual fund that you can invest in over the course of your entire career.
Each fund is designed for those aiming to retire at a certain date. The fund starts with a lot of “risky” stocks, and over time it moves to “safer” bonds. The fundamental idea is that at any given moment between age 21 and age 65 you should be invested in a particular balance of assets — more stocks when you are younger, and more bonds when you are older.
The track to retirement, according to the industry jargon, is a “glidepath.”
Billions of dollars are invested in these target-date funds. They are today the default investment option in many 401(k) plans. Now comes Rob Arnott, the chairman of Research Affiliates and one of the handful of serious money managers in the country. In a new research paper he published yesterday, “The Glidepath Illusion,” he has blown this idea full of holes. “Shockingly,” he says, “the basic premise upon which these billions [of dollars] are invested is flawed.”
When Mr. Arnott investigated the results of such target-date funds, he found them to be incredibly variable—and possibly upside-down. (I put the fun part in bold.)
Arnott has mined data from the stock and bond markets going back to 1871 and then run simulations to see how these target-date portfolios would have worked in practice. He considered a fund that started out with 80% stocks and 20% bonds, and then adjusted gradually over an investing life of 41 years so that it ended up 80% bonds and 20% stocks. He considered an investor who invested $1,000 a year, adjusted for inflation, from the day she started work at age 22 to when she retired at 63.
Bottom line? This investor could have done very well — or very badly. Far from enjoying a smooth “glidepath” to a secure retirement, she could have retired with as little as $50,000 in savings or as much as $211,000. She could have ended up with a retirement annuity of $2,400 a year — or $13,100 a year. There was no way of knowing in advance.
That wasn’t all. Arnott found that in most eras, investors would have actually been better off if they had stood this target-date strategy on its head — in other words, if they had started out with 80% bonds, and then took on more risk as they got older, so that they ended up with 80% stocks.
No kidding. Really.
The median person following the target date strategy ended up with $120,000 in savings. The median person who did the opposite, Arnott’s team found, ended up with $148,000. The minimum outcome from doing the opposite was better. The maximum outcome of doing the opposite was also better.
Amazing. Even the minimum outcome from going opposite the glidepath was better! Using even a static 50/50 balanced fund was also better. Perhaps this will dissuade a client or two from piling into bonds only because they are older. No doubt path dependence had something to do with the way returns laid out, but it’s clear that age-based asset allocation is a cropper.
Asset allocation, diversification, and strategy selection are important. Decision of this magnitude need to be made consciously, not put on autopilot.
[You can read Mr. Arnott’s full article here. Given that most 401k investors are unfortunately using target-date funds instead of balanced funds, this is a must read. I would modestly suggest the Arrow DWA Balanced Fund as a possible alternative!]