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Be Careful With Target Date Funds And The Perilous Glide Path

This article is more than 8 years old.

While glide paths are an institutionalized process in target date funds, most investors follow some sort of glide path process – ad hoc or not – that reduces their risk profile over their investment lifecycle.

Generally, an investor’s lifecycle is broken into four stages: accumulation, transition, retirement, and distribution.

In the first stage – generally ages 25-to-40 – investors will hold between 80-90% in risky assets. In the transition phase – generally ages 40-65 – the risk profile of the portfolio is ratcheted down each year.

Depending on whether the glide path is “to” or “through,” the glide path will either have reached its least risky position by retirement (“to”), or continue to de-risk until late retirement (“through”), allowing for further accumulation to balance distributions.

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This philosophy is mirrored by the old adage, “own your age in bonds,” which will slowly transition an investor from approximately a 75% equity position to a 35% position at retirement.

The science of target date glide-path construction is generally proprietary, but we can look at industry-wide averages to get a sense of how risk-reduction is broadly recommended.  The below graph comes from a 2013 Morningstar study on Target Date series, showing the minimum, maximum, and average equity allocation among the Target Date series in the study.

We can see that investors with a 40-year horizon (the 2060s) have, approximately, 90% equity exposure.  Those at retirement (2015) hold, on average, a whopping 50% equity (likely due to the growth of “through” funds versus “to” funds).

Stock ownership is necessary for investors to create the accumulation potential they need before the distribution phase of their retirement.  But is this much exposure to equities prudent? It all depends on what your outlook is.

In the short-run (a 10-year horizon), we can utilize crude valuation tools and interest rates to create a return forecast.  Below I’ve plot a scatter chart of equity valuations (US equity market capitalization / US GDP) against 10-year U.S. Treasury rates.  Each point is colored based on the forward 10-year nominal compound annual growth rate (CAGR) of a 60/40 portfolio.

We can see that when rates are high and valuations are low, a 60/40 is primed for tremendous growth.  As rates fall and values climb, the potential decreases.

The black dots are the points for which we don’t yet have data.  In 2015, we sit way up and to the left: an indication that returns will be tepid at best.

Forecasting further than 10-years, however, is typically based, somehow and in some way, on historical returns.  Often a statistical technique like Monte Carlo simulation is employed, which allows for the construction of millions of simulated potential returns based on how stocks have performed in the past.

The problem with such an approach is that while it can give insight into potential future return streams, it only holds if the distribution of returns in the future looks like that of the past. But what if it doesn’t?

From the 1970s to present, U.S. equities experienced one of the highest annualized growth rates while simultaneously realizing one of the lowest annualized volatility rates among all global equities.  A glide-path that utilizes these returns therefore will naturally be biased upwards and encourage more equity risk.

Even a globally diversified portfolio will have this upward bias, as U.S. equities typically comprise between 40-50% of a global equity portfolio.

While Monte Carlo simulation can help us forecast alternate realities, I wanted to see what glide paths might look if these alternative futures were based on alternative pasts.

To do this, I downloaded local currency-based indices from MSCI for a variety of countries around the world, which gave me monthly returns from 1970-2015.  Using these monthly returns, I ran Monte Carlo simulations generate portfolio returns for different allocation profiles and investment lifecycle lengths.  I then used the process laid out by Betterment to construct the actual glide paths based on this data.

It should be noted that for this analysis, I assumed that bonds returned a fixed 3% annualized.  This certainly isn’t realistic, but the goal here was to focus on the impact that equity assumptions may have on our glide path.

The resulting glide path differences are staggering.

What we can see is that a glide path that was based on historical U.S. returns is on the more aggressive side, whereas glide paths based on countries which had lower CAGRs and higher volatility – such as Austria – suggest much less equity exposure.

Nobody knows what the future might bring.  But as we’re keen on saying in the finance industry, past returns are not an indicator of future performance.

There is nothing that says the next 20-years for U.S. equities couldn’t look like the last 20 in Japan.  The glide paths above highlight how much excess risk we’re taking if that is the case. Or, alternatively, how much potential we might give up if we’re too defensive.

Glide paths – ad hoc or scientifically constructed – are wonderful because they provide a guiding set of rules for us to follow: a long-term strategy in prudent wealth management.

As with any strategy, some improvisation will be necessary based on changing information: whether the future looks like the past, or something entirely different, will ultimately determine if your current allocation and on-going glide path is appropriate.  As we march towards the future, I believe that it is critical to utilize a disciplined process to constantly re-evaluate risk, hopefully enabling us to participate in growth when it is available but still mindfully protecting capital against significant losses.