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Are target date funds the easy bake option?

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Abstract

Target date funds provide a simple, automated approach to retirement savings in defined contribution plans. The passing of the Pension Protection Act of 2006 has seen an increase in the popularity of these funds in the United States, becoming the default option for many plans. However, recent research findings have challenged the easy bake or ‘set-and-forget’ nature of target date funds. This study explores some of the critical design features of target date funds (which shifts an individual’s asset allocation from growth to defensive assets following a pre-set glidepath) against a simple balanced (or target risk) fund design. Using both time-weighted and dollar-weighted returns, our results suggest that there is more to achieving successful retirement outcomes than the investor simply selecting a proposed year of retirement. Our findings can perhaps be summarized by Einstein’s famous epithet, that in the murky world of retirement product design, everything should be made as simple as possible, but not simpler.

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Notes

  1. Towers Watson survey as of 31 December 2012. See: http://www.pionline.com/article/20130131/REG/130139981/towers-watson-global-retirement-assets-hit-record-30-trillion?newsletter=defined-contribution&issue=20130204&utm_source=dc_digest&utm_medium=email&utm_campaign=weekly_digest.

  2. We note that there are a myriad of other approaches to TDF design (see, Scheuenstuhl et al, 2010).

  3. For Monte Carlo and bootstrap approaches to the problem, see Basu and Drew (2009) and Basu et al (2011).

  4. A TRF’s asset allocation strategy differs from a TDF as it is optimized on time-weighted risk to returns, whereas TDFs attempt to optimize dollar-weighted returns by employing only the target date into the model.

  5. The selection of these specific paths is simply to spark the discussion and is by no means a complete picture; the authors implore the reader to observe Figure 3 and derive further comparisons, there are too many to discuss within this article.

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Correspondence to Anup K Basu.

Appendix

Appendix

Figure A1

Figure A1
figure 4

Salary growth rate.

Replicating the methodology of Byrne et al (2006), we assume an age-real earnings profile our baseline. The additional real growth rate is set at 2 per cent per annum (see Byrne et al, 2006). Figure A1 incorporates both the 2 per cent per annum and the increase because of the differences in an employee’s ability to achieve a higher salary increase in the earlier-to-mid career life as opposed to mid-to-end of their career.

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Basu, A., Doran, B. & Drew, M. Are target date funds the easy bake option?. J Financ Serv Mark 18, 199–206 (2013). https://doi.org/10.1057/fsm.2013.13

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