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Over the past 25 years the U.S. retirement system has experienced a substantial transformation whereby U.S. workers have taken on more responsibility for the management of their own retirement portfolios. Employees in 401 (k) plans, for example, are increasingly expected to decide on investment allocations and manage their portfolio asset mixes over time. In response to concern that many participants in self-directed retirement plans may not know enough to choose rationally among alternative investments, mutual fund companies have launched life-cycle investment funds, also known as target-date funds; see Mitchell et al. [2006] and Poterba et al. [2006].
Unlike balanced funds, which keep the mix between equities and bonds constant over time, life-cycle investment funds deterministically vary the proportion that is held in stocks and in bonds. Asset allocation is changed according to a predefined "glide path" that gradually tilts the asset mix away from equities toward bonds as the investor in the fund gets closer to retirement. Exhibit 1 shows the equity glide path of four major U.S. life-cycle investment fund providers. While there is no agreed-upon approach to the calculation of the equity glide path, the majority of funds place a large allocation to equities when the investor is young. This is gradually reduced as the participant draws closer to retirement. The rule used by life-cycle investment funds is a variant of the traditional rule of thumb that the percentage allocation to equities should be set to 100 minus the investor's age in years (see Shiller [2005]). As shown in Exhibit 2, the relationship between years to retirement and asset allocation using this rule is a straight line with a slope of one.
Life-cycle investment funds simplify the investing process for participants in self-directed retirement plans who find it difficult or too time-consuming to choose among investment alternatives. New participants can sign up without significant knowledge of investing by answering the question "When do I retire?" and choosing a fund with the closet retirement date. For example, Principal Financial Group offers life-cycle investment funds with target dates increasing in 10-year increments - 2010, 2020, 2030, 2040, and so on. A new participant expecting to retire in 2033 might select the 2030 fund.
Life-cycle investment funds are one of the fastest-growing segments in the...