Target date funds are here to stay. As a result of the Pension Protection Act of 2006, target date funds will likely become the auto-enrollment default option in tax-deferred retirement plans.
The potential growth in assets committed to target date funds over the next five to ten years is astounding. For example, at year-end 2006, there were 168 distinct target date mutual funds with $109 billion in total assets (if counting all share classes, the total number of funds was over 1,200). As of October 31, 2007 (Table 1) there were 226 target date funds with $164 billion in assets. This represents a 35% increase in the number of funds and a 50% increase in total target date fund assets in just ten months.
In light of anticipated growth in both the number of target date funds and the assets committed to them, it is critically important that appropriate benchmarks are developed to evaluate and benchmark their performance. Moreover, appropriate benchmarks increase the likelihood that (1) investors are better served, and (2) the fiduciary responsibilities of financial advisors and plan sponsors have been fulfilled.
The primary purpose of a target date fund is to replicate prudent, or best practice, transitions in a portfolio's asset allocation strategy over the lifetime of an investor. This transition process through time is often referred to as the "glidepath." The primary purpose of a glidepath is to adjust the return and risk characteristics of a portfolio over time (see Figure 1). When the portfolio is 30 to 40 years away from the target date, it is weighted toward higher return and higher risk. As the fund approaches the target date, the glidepath calls for allocations that emphasize lower risk, and hence lower potential return.
In Figure 1, the total equity allocation comprises U.S. equity and non-U.S. equity. The total fixed-income allocation is the combination of the allocation to bonds and the allocation to cash. For example, as of October 31, 2007, the average equity allocation for the 25 2040 target date funds was just under 90%, while the average allocation to bonds and cash was just over 10%.
As shown, the glidepath for equities descends from a high of roughly 90% in target date funds with a target date of 2040 to an average of 40% in funds that have reached their target date (i.e., current" target funds). Conversely, the glidepath of bonds/cash ascends from an average of 10% in 2040 funds to about 60% in current funds.
The average 2040 target date fund has a 90% equity/10% fixed-income portfolio, the average 2030 target fund has an 80/20 portfolio, the average 2020 fund has a 60/40 portfolio, the average 2010 fund has a 50/50 portfolio and the average current fund has a 40/60 portfolio.
The average allocations to the four core assets in target date funds (U.S. equity, non-U.S. equity, bonds and cash) for all 226 funds are shown in Figure 2.
Evaluating and comparing target date funds is no simple task because there are many interpretations of what constitutes a prudent and appropriate glidepath. Bear in mind that Figures 1 and 2 depict the "average" target fund, which masks the variation that exists among them. Consequently, there is a need for independent target date indexes that can serve as performance benchmarks for target date funds. To date, the only suite of target date indexes is the Dow Jones Portfolio Target series.
This article proposes a new methodology for the construction of target date indexes that take into account both the need for adequate capital growth and the need for safety of principal. It is curious that the remarkable growth in the number of target date funds during the past several years has not spawned the development and introduction of more target date indexes (or benchmarks). This represents a strange void in an era marked by the promulgation of literally hundreds of indexes, index funds and index-based exchange-traded funds.
Pure Target Indexes
A new suite of target date indexes developed by Target Date Analytics LLP is presented in Figures 3-6: the Defensive Pure Target Index, the Conservative Pure Target Index, the Moderate Pure Target Index, and the Aggressive Pure Target Index. Each has six target dates: today, 2010, 2020, 2030, 2040 and 2050.
These indexes, developed in collaboration with Joe Nagengast and Ron Surz, represent a departure from the typical glidepath guiding most target date funds available today. These new target date indexes are presented as a set of benchmarks to evaluate the risk level and performance of target date funds. Moreover, these indexes represent a blueprint for the construction of a new breed of target date funds. Importantly, the eight core components of each Pure Target index are investable, low-cost mutual funds.
Having four distinct target date index categories (defensive, conservative, moderate, aggressive) that share the same pedigree in terms of theoretical design and core portfolio holdings-but with different glidepaths in the 20 years before the target date-permits more meaningful benchmarking and categorizing of individual target date funds.
During the first 20 years (between 40 years and 20 years before the target date) the Pure Target indexes have subtle performance variations within each target date cohort based on differences in the allocation to the core assets. This can be seen clearly when comparing the differential in annual returns among the four current Pure Target indexes in Table 1 with the differential in the annual returns among the four 2040 Pure Target indexes in Table 6.
However, once the glidepath is initiated 20 years before the target date, the four different Pure Target indexes begin to differentiate themselves from each other. As a result, the Pure Target indexes have greater discriminatory power when used to benchmark target date funds in the current, 2010 and 2020 target date cohorts. Said differently, the Pure Target indexes categorize "near-term" target funds with greater precision than target funds that are 30 and 40 years from the target.
Achieving greater precision in benchmarking target date funds is an important step forward. Rather than simply comparing the performance of the XYZ 2020 Fund against the average performance of all 2020 funds, it is now possible to determine if the XYZ 2020 Fund is a defensive, conservative, moderate or aggressive 2020 fund based on its correlation to each of the four different 2020 Pure Target indexes. Just as non-target-date funds have their "best-fit" index, target date funds will now have their "best-fit" Pure Target index within each target date cohort.
As shown in Figures 3 through 6, the asset allocation model and glidepath in these three target date indexes span a 40-year period, simulating only the accumulation period for an investor. The accumulation period ends at the target date, which typically coincides with the retirement year of the investor. A 40-year accumulation period may seem optimistic given that far too many people do not start investing in their mid-20s. However, auto enrollment of employees into retirement plans should begin to remedy this problem. Add to that the likelihood that today's young workers will not likely retire until their late 60s or early 70s, and a 40-year accumulation period begins to appear quite likely.
How are the Pure Target indexes different from the typical target date fund? First, we use only two broad investment classes: a "risky asset" group and a "reserve asset" group. The first comprises six separate sub-assets: two broad equity assets, two broad bond assets and two diversifying assets. Collectively, these six risky assets represent a capitalization-weighted, global basket of investable assets. It's instructive to note that we include two bond assets and two equity diversifier assets as components of the risky asset group. Including bonds as a "risky" asset is a departure from the norm, but is in keeping with the central tenets of Markowitz's efficient frontier (which includes all risky assets). However, missing from the Markowitz efficient frontier is cash (and other "reserve" assets). Enter the Capital Market Line. By including reserve assets in each Pure Target index, it is possible to create a portfolio mix that has risk/return characteristics that are superior to a portfolio that includes only those risky assets that reside on or near the efficient frontier.
Secondly, we implement a transfer-of-assets protocol (through rebalancing) that creates a "lockbox." The lockbox performs the role of insulating money from loss caused by equity market gyrations by moving portions of the portfolio into the reserve asset at an increasing rate as the investor approaches the target date. In fact, at the target date (i.e., the anticipated retirement year of the investor), the allocation of the Defensive Current Index is 100% reserve assets; the Conservative Current Index has an allocation of 75% in the reserve asset; the Moderate Current Index has a 50% reserve asset allocation; and the Aggressive Current Index has a 25% allocation in the reserve asset.
While not an annuity, this lockbox concept (advocated by Bill Sharpe) incorporates elements of liability driven investing (LDI) into the construction of a target date glidepath. At retirement, the investor is then able to determine how best to position his or her portfolio. We anticipate that many individuals will choose to purchase an annuity product at that point. We are suggesting that LDI represents a best practice that should be followed when building a target date fund and/or target date index.
Target date funds are built to handle two very separate functions: accumulation and or distribution. Both present unique goals and challenges. We have chosen to solely focus on the accumulation phase in our Pure Target indexes, though we suspect that in the future, target date funds may be segmented into two separate products: an accumulation vehicle and a distribution vehicle. In fact, this evolution is beginning already with a new breed of target date funds being introduced under the banner of "income replacement."
The performance assessment of the Conservative Pure Target Index is shown in Figure 7. Performance tables and charts for the remaining three Pure Target indexes can be found at www.tdbench.com. The three-year risk and return coordinates for the Conservative Pure Target Index are noted by teal-colored triangles, while the three-year risk and return coordinates for target date funds (only those with at least 36 months of performance as of October 31, 2007) are shown by small dots of various colors (according to their target date).
Only data for the most recent 36 months were used so as to maximize the number of target funds in this risk/return analysis. Recall that more than 60% of all existing target funds (as of October 31) have an inception date after January 1, 2005.
As would be expected by theory, the constellation of plotted risk/return coordinates demonstrates an upward slope suggesting that greater return is achieved by accepting higher volatility of return. In X-Y graphs such as these, the coveted location is the northwest corner.
Within each target date cohort (Current, 2010, 2020, etc.) the Conservative Pure Target Index sets the standard in terms of risk-adjusted return. In fact, the efficient frontier is established by risk/return coordinates of the Conservative Pure Target Index. All existing target date funds are inferior in terms of risk-adjusted return.
A distinct advantage of the Pure Target indexes is their enhanced resistance to loss and their superior risk-adjusted returns. These are achieved by two means: the design of the glidepath and the asset allocation model being used. It's important to remember that target date indexes (and target funds in general) have two vitally important elements: a core asset allocation model and a glidepath design. In the Pure Target indexes, performance during the first 20 years (beginning 40 years before the target date) is governed entirely by the asset allocation model, whereas the performance of the indexes during the final 20 years is largely influenced by the design of the glidepath.
This study illustrates the virtues of a target date fund design that incorporates two essential mandates: to prudently grow money and progressively protect it as the target date approaches. The Pure Target index asset allocation model-in conjunction with its lockbox-oriented glidepath-represents a blueprint for target-date design that supports both mandates. Avoiding losses is the number one priority as the portfolio approaches its target date. The Defensive and Conservative Pure Target Indexes are specifically designed for asset protection near the target date.
In addition to being a blueprint for the design of target date indexes and target date funds, the Pure Target indexes will facilitate more accurate benchmarking of target date funds. Currently, the tools available to categorize target date funds come up with nebulous results at best. With only one target date index series currently in the market (Dow Jones), it is difficult to clearly determine if a specific target date fund (within a particular target cohort, say 2020) is defensive, conservative, moderate or aggressive. The Pure Target indexes solve that dilemma.
The appeal of a good target date fund is simple sophistication. The Pure Target Indexes deliver exactly that.
For additional information about the Pure Target indexes visit www.tdbench.com
Craig L. Israelsen, Ph.D., is an associate professor in the School of Family Life at Brigham Young University in Provo, Utah, where he teaches personal and family finance. He holds a Ph.D. in family resource management from Brigham Young University.