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The Paradox of Prudence

Is your target-date fund taking the risk you need?

A primary worry for many retirement savers is that their nest egg won't last as long as they will. Target-date funds, which alter their asset allocation over decades to become less stock-heavy and more bond- and cash-heavy, try to solve for this "longevity" risk, but many sport drastically different asset-allocation glide paths. How do you know if your target-date fund has a reasonable approach?

Professionals use Monte Carlo analysis, which employs forward-looking risk-and-return expectations, as one means of testing glide paths. Although markets and existing target-date series lack the history necessary to judge a glide path's outcome, Monte Carlo analysis can simulate thousands of possible allocations that a glide path could take and calculate the probability of success (and failure) for investors. These models require many assumptions and inputs, so it is nearly impossible to compare one provider's output with another's (assuming that they even release the results, which is rare).

Using Morningstar's repository of glide-path and target-date-series portfolio data, though, we conducted Monte Carlo simulations for some of the industry's largest target-date providers, as well as the industry average glide path, using a uniform set of assumptions and inputs. (Details on our inputs and assumptions, as well as an expanded look at Morningstar's results, are in Morningstar's 2013 Target Date White Paper here).

Generally, we found that target-date investors in different series are likely to experience similar outcomes through age 85, the life expectancy of a typical 65-year-old female. Beyond that age, though, the outcomes start to diverge, and series with more equities generally come with a higher likelihood of success through age 95. The results serve as a reminder that investors or plan sponsors choosing more-conservative target-date funds don't just simply lower their market-risk exposure, they also increase the likelihood that retirees will outlive their savings.

Morningstar's results are by no means a final decree on any glide path's merits. Investors have other ways (saving more, spending less) to help improve outcomes. The results do, however, provide indications of which glide paths may be the most appropriate for certain investors. Workers who have been diligent about saving may be well served by a more conservative investment option, while those who have been less so may not be able to afford the comforts that come with a more risk-averse strategy.

The "Typical" Investor
To test glide paths, we established a profile for an average investor in a target-date fund: A 23-year-old worker who starts with $45,000 in annual wages, receives yearly raises to keep up with a 2% annual inflation rate, saves 7% of income each year, and expects to retire at 65. Standard industry studies suggest that this worker needs a retirement income that's 83% of his or her salary at retirement to maintain a post-retirement lifestyle that's similar to the pre-retirement one. (The retirement industry refers to that post-retirement salary percentage as a "replacement ratio.") As such, our hypothetical worker would need income of about $37,350 (in today's dollars) in the year following retirement. Social Security is expected to replace about 52% of the worker's pre-retirement income ($23,400 in the first year of retirement), leaving 31% (about $13,950 in the first year) to be funded through savings.

Defining Success
To test each glide path, we assumed that investors stay in the target-date series for essentially their entire working and retirement life, saving regularly from age 23 to 65, and then drawing down an inflation-adjusted income from age 66 on. The approach directly addresses longevity risk by measuring the probability that workers will maintain a positive savings balance as they age. Within each of the thousands of save-and-spend simulations, we counted as successful those that didn't run out of money at any given age.

Comparing the Industry's Behemoths
We looked at the glide paths for series offered by Vanguard, Fidelity,  T. Rowe Price (TROW), American Century, and  BlackRock (BLK) --some of the industry's largest players. (Together, the Vanguard, Fidelity, and T. Rowe Price series represent roughly three fourths of the industry's target-date mutual fund assets.) Exhibit 1 depicts each of these series' glide paths, along with the industry average of all glide paths for comparison.

Exhibit 1: Selected Target-Date-Series Glide Paths

Data through Dec. 31, 2012.
Source: Morningstar.

Exhibit 2 presents the results of the simulations, and a few notable patterns emerge. More equities generally correspond with a lower probability of outliving savings, particularly in the more advanced years. T. Rowe Price, for instance, has a notably higher allocation to equities compared with Fidelity. At age 85, investors in the former have a 22.7% chance of depleting their savings, while investors in the latter have a 24.2% chance of doing so. The difference is small, and given the nature of Monte Carlo testing, it can narrow or widen depending on the simulation. However, the general relationship is stable and consistent, and the difference becomes more pronounced over time because of the compounding effect of returns on wealth. At age 95, 38.2% of T. Rowe Price target-date investors have used all of their savings, while 43.0% of Fidelity investors have done the same--an almost 5-percentage-point difference.


When that higher equity allocation occurs seems to matter, too. For example, American Century and BlackRock have similar overall equity allocations throughout the entire glide path, with both having roughly 60% average allocations to equities across their entire glide paths. However, American Century has markedly less in stocks than BlackRock in the pre-retirement year (70.5% versus 77.1%), and that relationship switches in the post-retirement years (46.2% versus 38.2%). Both target-date series have similar outcomes when investors reach age 85, with a little less than one fourth of investors reaching a $0 balance. The higher equity allocation in retirement appears to give retirees a small but stable edge in maintaining a positive savings balance as they age; in this case, 41.9% of American Century investors have exhausted their savings by age 95, while 43.2% of BlackRock investors have done so.

Trading Longevity Risk for Market Risk
Despite the apparent advantage displayed by higher-equity glide paths, more equities aren't always the optimal choice. A lower allocation to equities corresponds to less market risk and less uncertainty--not trivial factors when considering that wary investors may be prone to selling at market troughs, thus locking in losses. Using Ibbotson's capital-market assumptions, Exhibit 3 shows the expected worst-case one-year returns for the glide paths at various ages, given each glide path's allocations at those points. In this instance, "worst case" means that investors should have less than a 2.5% chance of experiencing a worse annual return than the figure at each given age.

Using this viewpoint, the glide paths with lower-equity pre-retirement allocations measure up particularly well in the years leading up to retirement, as they were largely designed. American Century and BlackRock's worst-case losses of 11.2% and 11.9%, respectively, at age 55 are less severe than the worst-case scenarios for the other three glide paths. Meanwhile, Fidelity's market-risk profile shines strongly during the in-retirement years, with a worst-case expected loss of 6.5% at age 95 that's clearly lower than those of the rest of the group.

Comfort Isn't Free
Much of the divergence in results between glide paths with more versus fewer equities comes on the upside: A greater allocation to equities gives investors more potential for gains. The more optimistic scenario may leave workers with the happy prospect of legacy planning. What's more, a greater allocation to equities gives workers who have been less diligent about saving a higher probability of having enough retirement savings.

The implications for the results essentially come down to a trade-off between taking more longevity risk or more market risk; one doesn't happen without the other. Investors choosing more-conservative target-date strategies may gain peace of mind that their savings balance will fluctuate less on a year-to-year basis than if they were invested in a more aggressive alternative. In exchange, they give up the potential for higher expected returns that can be as important in the years following retirement as they are in the years before, resulting in an increased risk that they'll outlive their savings.

Particularly following the market volatility seen in 2008, market risk jumped to the forefront of investors' minds, while longevity risk has since received relatively scant attention. As results here suggest, though, the two are inextricably linked, and lessening exposure to one means taking more of the other. Ultimately, investors must weigh these risks as they choose and implement a target-date investment.

Janet Yang Rohr, CFA does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.