Practical Applications of Target-Date Funds, Glidepaths, and Risk Aversion

Abstract

In Target-Date Funds, Glidepaths, and Risk Aversion, from the Winter 2020 issue of The Journal of Wealth Management, author Javier Estrada (of IESE Business School in Barcelona, Spain) explores why target-date funds (TDFs) use glidepaths that reallocate assets out of high-growth investments and into capital preservation funds as individuals approach retirement. The simple answer is that people become more risk averse as they get older. But therein lies a problem: People tend to have less to invest when younger and more when older–so shifting money into low-growth investments reduces investors’ earnings potential as they accumulate more principal to invest. This may leave them with less at retirement. Whether this strategy is suitable depends on how much investors’ risk aversion really increases with age.

Estrada investigates how much risk aversion would have to increase to match the risk reduction implemented by a popular TDF that starts off with a 90%/10% stock/bond allocation and ends up at 50%/50% at retirement. Using statistical analysis, Estrada determines that risk aversion would have to more than double during the last 25 years of working life to match the glidepath. Financial advisors may wish to take these findings into account in discussions with clients.

TOPICS: Equity portfolio management, retirement, wealth management, risk management