On Optimal Allocations of Target-Date Funds

Abstract

We study optimal life-cycle portfolio allocation and its application to target-date fund (TDF) design. We show that optimal TDF allocation must be explicitly linked to a savings rate; for example, a higher savings rate generating higher financial wealth accumulation should necessarily come with a more conservative TDF. Further, we quantify the extent to which accumulated wealth, the investing environment, and participant characteristics affect TDF allocations and compare the resulting optimal allocations against the observed universe of US TDF products. Plan sponsors and asset managers can use these findings to improve TDF selection and design.

Key Findings

• ▪ We quantify how observed savings rates in 401k plans affect a TDF’s optimal allocation. Using a state-of-the-art life-cycle academic model, we find strong effects: for a moderately risk-averse participant, a halving in savings rate from 10% to 5% increases its optimal equity allocation by 10%–15%.

• ▪ We document the effects of real-life variations in other key determinants of TDF optimal allocations: participant’s risk aversion, relation between wages and equity returns, outside retirement income, start of savings, and expected returns. We measure the resulting wealth and consumption experience at and in retirement.

• ▪ We set these optimal glide paths against the glide paths pursued by US TDF mutual funds and observe a much narrower range for the observed ones, thus leaving some constituencies without an appropriate investment choice. Further, the optimal glide paths tend to slow the equity decline as they approach retirement; most observed ones do the opposite.