In his paper, Optimal Portfolio Choice over the Life Cycle with Social Security*, Wharton economics professor Kent Smetters writes:
"So-called “target date” (or “lifecycle”) funds have grown enormously during the past five years in the United States. Their main purpose is to essentially simplify the portfolio allocation process along the lines consistent with the traditional lifecycle model, thereby reducing “mistakes.” The Pension Protection Act of 2006 increased the popularity of target date funds by allowing employers to make them the "default option" in their 401(k) plans. Of the 380 target-date funds currently in existence, more than 300 are less than five years old.
"Of course, relative to our model, any lifecycle allocation rule would, by definition, produce a lower level of welfare than the age-based allocation produced by our model itself. So, we instead ask a more meaningful question: do target date funds actually produce a higher level of welfare relative to what households were achieving on their own before they these funds were introduced? In particular, do target date funds potentially introduce more mistakes than they supposedly cure?"
Is the traditional target fund glide path the best way to invest for retirement? In Chuck's interview, Dr. Smetters tries to answer this question.
Chuck Miller: What is the traditional “glide-path” investment strategy and how does it differ from how people actually invest?
Kent Smetters: The traditional glide path follows something along the lines that John Bogle (made famous: the percentage held in equities is around 100 minus your age (although he modified this rule slightly over time). The idea actually has some theoretical justification in the work by Professors Bodie, Merton and Samuelson some years ago that demonstrated that people should reduce their investments in stocks as their safer human capital (wage income) declined over their lifetime.
Human capital is highly substitutable for bonds in their model, and so the shift toward bonds would maintain a “balance” of overall risk as people aged.
The problem, however, is that people don’t actually invest this way. In particular, their investments in stocks is more hump shaped (“inverse U”), with little stock early in life, more stock in the middle age, and then less later on - sometimes, though, ticking up again later in life.
CM: Which affects investment decisions more… age or income?
KS: In theory, age. Income should actually have very little impact due to “homothetic preferences.” In simple language, a richer person just scales up his consumption with income.
However, in practice, the rich invest more in stocks at each age. Some people claim it is due to the fixed “transaction” costs of getting into the stock market. But that story is not very plausible: those costs would have to be much larger than a standard no-load fund.
CM: How does Social Security affect a lifetime investment strategy?
KS: Social Security is actually a “chameleon” sort of asset class: for young people, it is more substitutable with stocks, but for middle aged, it is more substitutable for bonds.
When you are young, the future economy-wide average wage of the economy is still quite uncertain. That average wage, however, is what ultimately pins down the “wage adjustment factors” that are applied to your future Social Security benefit. It turns out that those wage adjustment factors are highly correlated with stocks - not annually but over long periods of time. However, as you grow older, you have already packed away (accrued) some Social Security benefits.
My own work has shown that this type of asset class is actually consistent with the hump shape that we see in the data, and the fact that the rich hold more equities.
CM: Are you smarter not to use the “glide-path”?
KS: It is always hard to put theory into practice. Besides being a professor at Wharton, I am also cofounder of Veritat Advisors (https://www.veritat.com), which aims to be the first fee-only and full-service financial planning model that is actually affordable for most households. So, I struggle firsthand with trying to apply theory to practice. I believe that theory – including my own - should be allowed to simmer and be challenged by peers before upending practice.
So, at Veritat Advisors, we tend to follow a form of the regular glide-path. However, we modify it in ways in which the vast majority of economists would agree. First, we incorporate the impact of human capital, which is the largest asset for most people. Second, all of our portfolios are goal based. In particular, each goal has its own savings amount and investment allocation, and a global optimizer then works across them to make sure that a client can afford them. Third, we take the market value of risk very seriously, using “risk neutral valuation.”
In sharp contrast, the best selling financial planning systems are, in my opinion, really afar from any sort of economic reasoning. They were built years ago as simple retirement calculators for those nearing retirement. Then a lot of adhockery got bolted on over time as they tried to handle younger people and more types of goals. Even though a lot of them call themselves “goal based,” they don’t really come close.
First, they put all goals – near, medium term, and far – into a single “pre-retirement model portfolio” and then suddenly switch it after retirement into an “after retirement model portfolio.” These portfolios are mainly based on “risk tolerance” – which is already a very unreliable measure since people almost always overstate their appetite for risk. Ignored are critical factors like human capital, type of goal, and time to goal. On net, this practice overestimates the amount of balances at retirement by a third or more.
Second, these packages encourage investing in riskier assets because they forecast larger expected returns that, will in turn, increase the end-of-plan “safety buffer.” This kind of stuff drives me bonkers. The whole idea that more risk can actually increase your asset “safety buffer” is contrary to commonsense and Economics 101. This mistake is so large that most people would be better off without a financial planner than hearing this kind of stuff.
Third, these best-selling software packages attempt to demonstrate risk using Monte Carlo analysis. But traditional Monte Carlo is bad economics (it ignores fat tails). More importantly, it is lousy client communication (people don’t understand it). So clients simply focus on expected returns and think larger is better. After all, that larger “safety buffer” certainly sounds like a good thing. That’s why a lot of advisors had a lot of angry clients in 2008.
Not surprisingly, we built our own systems at Veritat. Our systems take into account the intricacies of tax laws; maximum contributions by account type, income and marital status; minimum distributions, and so forth. And, of course, they take the economics of savings, investments and risk very seriously.
CM: What would you advise those nearing retirement age to do?
KS: It is a hard question to answer generically because I would need to know their other goals, including intergenerational transfer plans, and their importance to them. Almost half of wealth that is accumulated is eventually passed to the next generation. But there are two basic rules. First, an older person should obviously be assuming less risk in their portfolio than a younger person. Secondly, and almost as importantly, a person should invest in simple passive indexed products that keep the fees low – absolutely no commission-based products.
If your advisor is not strictly “fee only” – but instead calls himself “fee based” which really means he charges you a fee plus commissions - then you are probably losing a lot of money and don’t really know it. Obviously, everyone needs sensible financial planning. But there is no bigger impact on risk-adjusted returns than hidden fees.
*Optimal Portfolio Choice over the Life Cycle with Social Security, Kent A. Smetters and Ying Chen, Pension Research Council Working Paper, PRC WP2010-06, April 2010, p27