The Pros and Cons of Target-Date Funds in the Accumulation Phase

June 3, 2014

by Wade Pfau

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Lifecycle or target-date funds (TDFs) are frequently criticized for not being customized or tailored to individual situations. But this is unfair, as they are meant to serve as default investment options for individuals who are otherwise unwilling or unable to put in the effort to obtain a better result. Nonetheless, the debates around TDFs provide an opportunity for advisors to make clear how they can serve their clients.

TDFs have enjoyed rapid growth in recent years. Confidence in the approach led the U.S. Department of Labor to adopt them as a qualified default investment alternative for corporate defined-contribution pension plans in 2007.

Let’s look beyond using TDFs as the default option. I will explore the benefits of TDFs, and then turn to the challenges that have been raised against them – and how advisors can respond to those challenges and obtain the best retirement outcomes for their clients. This discussion focuses only on the pre-retirement portion of the glidepath.

The case for target-date funds

Target-date funds are promoted as a simple solution for retirement savers to invest with a hands-off approach. This investment strategy involves allocating a high proportion of one’s assets to equities during the early years, and gradually shifting to more conservative assets, such as bonds and bills, as the target date draws near. Two general justifications exist for TDFs.

The academic justification considers a household’s balance sheet over its lifecycle. At the beginning of one’s career, the present value of future labor earnings (human capital) typically dwarfs the size of accumulated financial assets, which may even be zero. Thus, even a 100% stock allocation represents a small portion of one’s household wealth. With a long time horizon to make plan adjustments and with most wealth stored in future salary, an aggressive asset allocation can be justified for young workers. As one ages and approaches retirement, however, financial assets grow relative to human capital, justifying a reduced allocation to stocks and other risky assets in the financial portfolio in order to reduce the volatility of overall household wealth. Figure 1 illustrates these lifecycle dynamics.

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Target-date funds