Time to retirement should not be the only factor in determining asset allocation for defined contribution (DC) plans, according to research.
In addition to target date funds (TDFs), academics suggested investors take risk preferences into account through target risk funds (TRFs).
“[TRFs] differ from [TDFs] in that they attempt to hold risks constant over time while a [TDF] attempts to lower risk as an investor’s time horizon approaches,” Edwin Elton and Martin Gruber of New York University’s Stern School of Business, and Andre de Souza of Fordham University, said.
The authors stated theoretical models of TDFs’ asset allocation over time revealed decreasing equity exposures as the plan participant gets closer to retirement may not be an optimal strategy.
By studying funds between 2001 and 2014, they concluded that not only were TRFs suitable alternatives to TDFs, but they also produced higher returns and better Sharpe ratios.
A portfolio of risk-focused funds was shown to have achieved a mean return about 40 basis points higher per year than an equivalent portfolio of TDFs. Even when the TRFs’ higher expenses were taken into account, they outperformed target-date funds by 33 basis points, the paper said.
The risk-focused funds studied by the authors typically invested in low-cost funds in a range of asset classes to keep expenses minimal.
However, the authors found that the benefit of TRFs using low-cost underlying funds was eradicated by the management fees of the TRFs themselves.
Read the full paper here.
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