Target-Date Funds, Glidepaths, and Risk Aversion

Abstract

Target-date funds feature asset allocations that become increasingly conservative as investors approach retirement. An important shortcoming of this strategy is that it is suboptimal in terms of capital accumulation, which begs the question of why these funds are so popular. A possible answer is that investors become more risk averse as they age, gradually favoring more downside protection as they approach retirement. The main issue explored in this article is how much more risk averse would investors need to become during their working years to select asset allocations similar to those in target-date funds; the evidence here shows that investors would have to roughly double their risk aversion during the last 25 years of their working period. An intuitive interpretation of this result, based on how much an individual would pay to avoid a gamble, is also discussed.

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

Key Findings

• • This article explores why target-date funds switch from a goal of capital accumulation early in the accumulation period to the goal of downside protection as individuals approach retirement.

• • This switch is motivated by the increase in risk aversion observed as individuals age, which leads them to value downside protection more as they approach retirement.

• • The evidence here shows that if individuals roughly double their risk aversion during the last 25 years of their working period, they would choose asset allocations similar to those featured by the glidepaths of target-date funds.