Valsalan-Vathussery Saikia

More and more retirement investors are using target-date funds (“TDFs”). These funds are an investment solution where the assets are invested with a goal in mind (e.g., preparing for retirement or paying for college).

Central to each TDF is its glide path. The glide path is an investment strategy that specifies the change in asset allocation across time. Typically, glide paths start with an equity-heavy asset allocation, but transition to a more conservative allocation over time. Something like this:

Whether you know it or not, there’s a good chance your retirement assets are in a TDF and thus, the efficacy of the glide path directly impacts your preparedness for retirement.

I have always been intrigued by glide path design research. How do you truly construct an optimal glide path? With this in mind, I decided to read up on the most prevalent academic approach behind glide path design — the Theory of Life Cycle Saving and Investing — and compare and contrast it to the approaches for some of the major industry players. I’ll discuss those findings here. Then, in part 2 of this series, I will actually construct a glide path using a quantitative framework to demonstrate how one could do this.

There are many different types of approaches taken by the retirement industry to create a glide path, but theoretically, they all tie back in some way to the Theory of Life Cycle Investing. This theory provides a framework to guide an investor’s decisions about working, spending, and saving (not only how much but also where to invest it) over their lifetime.

An important takeaway with respect to asset allocation is that the optimal strategy not only depends on an investor’s financial wealth but also all their future cash inflows and outflows. For most people, labor income is the primary source of cash inflows and everyday spending is the primary source of cash outflows (referred to as “consumption” in economics literature).

Under life cycle theory, the source of labor income matters. For the majority of investors, human capital — defined as the net present value of an investor’s future earnings — can be thought of as a bond-like asset because their future earnings are pretty stable over time. However, there are exceptions where human capital is more stock-like (e.g., entrepreneur or stockbroker).

For younger investors, human capital is typically the largest component of their overall portfolio. Assuming human capital is bond-like, the glide path strategy should then be heavily weighted towards risky assets like equity. However, over time as investors age, the ratio of human capital to financial wealth gets smaller, meaning that the glide path should allocate a higher proportion of assets towards bonds.

On the other hand, for investors whose human capital is more stock-like, the optimal glide path strategy may be to stay allocated towards low-risk assets throughout the whole life cycle. While this may seem counterintuitive, the point is that the asset allocation strategy should be heavily weighted towards risky assets only to the extent that the risk profile of the investor’s human capital allows for it.

I reviewed the glide path design white papers for the top 3 providers, as measured by assets under management per this source. They are, in order, Vanguard, Fidelity, and T. Rowe Price.

I will be discussing their glide path design objectives and methodology. What is the problem that the glide path is solving for? And what concepts does each provider use in their analysis? While the objectives are all tied to helping retirement investors in some way or another, they actually differ quite a bit in the details.

Vanguard

Per their white paper, Vanguard’s objective is to maximize utility — which represents the value that an investor places on an investment outcome, given how risk averse they are. More specifically, the objective is to maximize the expected utility value of wealth at the end of retirement (referred to as “terminal wealth”).

Vanguard calculates terminal wealth from the ground up. They incorporate obvious things like savings and spending amounts and portfolio growth rates. They also factor in household assets like Social Security and pension benefits as well as investor salary growth (which itself is affected by the human capital risk profile), all of which are key components of life cycle theory.

Applying this kind of framework — i.e., maximizing utility with respect to terminal wealth — is a traditional approach in portfolio selection and appears to be relatively common in the financial planning industry. However, it does differ from the Life Cycle Saving and Investing approach that I outlined above. Namely, the objective does not directly consider the investor’s consumption across their lifetime, since maximizing terminal wealth is not the same thing as maximizing the utility value of lifetime consumption. That being said, they do leverage and utilize many concepts important in life cycle investing in their glide path process, so overall, I think that Vanguard’s approach is pretty consistent with life cycle theory.

Fidelity

Per Fidelity’s white paper, their overall goal is to help investors achieve an income replacement level in retirement, while considering investors’ loss aversion and capacity to take on market risk (as a function of their age).

Loss aversion refers to the idea that the pain experienced from losses is much more psychologically powerful than the pleasure received from equivalent gains. Fidelity emphasizes this in their design, trying to minimize loss aversion for investors who follow their glide path by anchoring their analysis on the 20 worst periods for US equity returns in the last 100 years.

Fidelity also focuses on the concept of risk capacity in their analysis. In a nutshell, the idea is that, as investors get older, assets should be allocated more conservatively because investors have less ability to recover from a market crash and are more sensitive to the pain of a market downturn. This risk capacity analysis is not in line with a life cycle investing approach since time itself does not diminish market risk. Yet the outcome of this type of risk capacity analysis is actually very similar to the outcome of analysis grounded on Life Cycle Saving and Investing Theory (assuming human capital is bond-like). That is, young investors should invest aggressively, whereas older investors should invest conservatively.

Fidelity’s analysis did not include many core life cycle theory components, like human capital, consumption, and non-financial assets. So while Fidelity does employ some unique and interesting analysis — e.g., their loss aversion methodology — their approach does not seem to align that closely with the Theory of Life Cycle Saving and Investing.

T. Rowe Price

Last, but not least, is T. Rowe Price (“TRP”). In their white paper, they discuss both economic and behavioral objectives for their glide path. Economic objectives refer to the financial ability of investors to support their goals, while behavioral objectives are about helping investors avoid decisions that can harm their ability to achieve their economic objectives.

TRP discusses how emphasizing one objective over the other can lead to contravening portfolios strategies, so they actually designed two separate glide paths: one to emphasize capital growth to support lifetime income and another to emphasize reduced market volatility around retirement (to mitigate bad investor decisions). They then let others choose which glide path to follow.

TRP’s two glide path approach illustrates an interesting point about retirement investing: there isn’t an objective answer for which objective is most important. Rather, the right objectives to emphasize in a glide path differs for each individual. It really depends on your preferences and your life circumstances. In fact, the right set or the most important objectives for you may not even be captured by any of the objectives outlined by Vanguard, Fidelity, and TRP.

Returning to TRP’s glide path, I did note that their approach seems to fall somewhere in between Vanguard and Fidelity’s. Similar to Vanguard, their analysis is grounded on many relevant life cycle investing concepts; they model key components, like salary, financial assets, Social Security benefits, and spending in retirement. Somewhat similar to Fidelity, they also factor in behavioral considerations, meaning that the glide path may need to emphasize capital preservation in order to mitigate against investor behaviors like selling after the market drops. While there are plenty of differences, my overall assessment is that TRP’s approach is grounded in life cycle investing theory.

Summary

So what should we make of this? First, industry practitioners can have very different glide path objectives. This is because there isn’t an industry consensus for the “correct” retirement objective. The most appropriate objective is subjective, and varies by investor.

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