The rise of target-date funds over the past decade has been seen by many as a way to provide plan participants with an easy glidepath to retirement. Yet the simplicity of many existing target-date funds conceals a number of obstacles that can impede investors' efforts to adequately fund their retirement income needs.

The target-date fund universe is not homogeneous. Many such funds are managed as if the date of retirement were the final destination. But some target-date funds continue after the retirement date. These funds have a greater allocation of assets in equities at the retirement date than funds that terminate at the target date.

Many funds can trap investors by managing their assets up to, but not through retirement. This leaves retirees underfunded for living expenses, or increases the potential for them to take excessive risks during retirement. Just as you wouldn't recommend an airline that stops on the runway and fails to bring its passengers to the terminal, you wouldn't recommend a target-date fund that cannot bring investors safely to their destination: financial security throughout retirement. Yet that's exactly what many existing target-date funds are doing.

New Concerns

Events on Wall Street in recent weeks are causing many investors to question whether any type of market investment will sustain them through retirement. Indeed, the media is echoing concerns about wealthy individuals nearing retirement being disappointed by the realization that they won't retire in the style that they'd planned, and about less-wealthy people somberly planning to postpone retirement.

During periods when many investors have been suffering huge losses from individual stocks, managed long-term investments like target-date funds tend to have comparatively more appeal to the average investor. Moreover, a key benefit of target-date funds with a long glidepath through retirement (see chart, page 130) is that it gives even the portfolios of those in or close to retirement more time for market recovery. Most retirees will need 60% to 80% of their preretirement income to support themselves during retirement. About 43% of households are at risk of not being able to maintain living standards into retirement, studies by the Center for Retirement Research show. This number is expected to rise because of widespread awareness of recent market distress.

The Evolution of Target Maturity Portfolios: A Liability-Aware Approach to Investing for Retirement, a study by Wilshire Funds Management, a business unit of Wilshire Associates, highlights the deficiencies of existing target-date approaches as they relate to individuals' needs through retirement. The research shows that most existing target-date portfolios invest too conservatively by prematurely shifting allocations away from equities toward fixed-income investments.

This is characteristic of funds whose design basically treats the retirement date as the end of the investment term. This endgame mentality fails to adequately account for retirees' need for investments governed by an asset allocation glidepath that continues to shift assets from equities to fixed-income investments throughout retirement.

This approach discounts the impact of a triad of foes for target-date fund investors: longevity risk, inflation risk and liquidity risk. The next generation of target-date funds needs to be designed with an asset allocation approach that accounts for these liabilities in ways that take participants not just to retirement, but through it.

The first problem target-date funds must tackle is longevity risk. Many target-date fund portfolios incorporate a static investment horizon that may inadvertently increase the risk of outliving one's investment assets by assuming a shorter-than-appropriate time horizon. Longevity risk can be managed through portfolios that continually adjust their post-retirement allocations using life expectancy as a factor.

Inflation Risk

The second major risk is inflation, or the risk that retirement investment returns will not keep up with increasing costs. Without properly managing this risk, assuming a steady inflation rate of 2.5% per year, investors can lose up to 40% of their purchasing power during retirement. Inflation risk can be managed with target-date funds that balance capital accumulation and capital preservation.

This brings us to the third of the risks facing retiring investors: liquidity. A fund should be structured to serve clients in such a way that there should be no need to liquidate at the designated retirement date.

Portfolios designed to see beyond is the target retirement date, and to include a cushion of cash and Treasury Inflation-Protected Securities (TIPS) to preclude the necessity for untimely sales of equities, can help investors avoid liquidity risk. By the time the participant reaches age 80, such portfolios' allocations are primarily in cash and fixed income: 40% cash, 40% fixed income. Participants redeem shares as cash needs arise.

Nose-Diving