Why auto-pilot investing isn't all it's cracked up to be

New research on target-date retirement funds will have the investment world and retirees in a tizzy.

One of the most appealing concepts in investing can be summed up as 'auto-pilot': the idea that you let someone else do the navigating and guide you to your destination.

But some prominent new research suggests that investors who have put their most important long-term assets on auto-pilot may wind up off-course.

The operative word here is 'may', but the situation is worth examining because it suggests that investors using target-date retirement funds should be careful about making selections, rather than simply accepting a one-size-fits-all course of action.

To see why, let’s look at the research that has the target-date fund world squawking.

Rob Arnott, chairman of Research Affiliates, recently published research that examined all 40-year time spans dating back to 1871, finding that retirement investors would be better off turning conventional wisdom on its ear and investing a higher percentage of assets into stocks as they age.

The standard target-date plan becomes more conservative as an investor ages, typically getting down to keeping just 20 per cent of assets in stocks over time. Arnott suggested flipping that strategy, and investing more in stocks as an investor ages. The results, he suggested , would be more than 20 per cent more in the retirement chest as a result.

Arnott told Bob Powell, editor of Retirement Weekly, that the standard glide path “fails its core mission on several levels. It doesn’t lead to greater retirement wealth or income. It doesn’t decrease the uncertainty about one’s retirement wherewithal even just 10 years from retirement. … It exposes young workers to too much risk, when they might need to cash in if they lose their job in a recession.” Read Powell’s column here.

As a result, Arnott finds the classic glide path for a target-date fund “inferior” to an inverse route -- but also to a balanced 50/50 portfolio -- when it comes to producing the biggest retirement savings while minimising uncertainty.

In short, the Research Affiliates study would suggest that an investor would be better off going with an ordinary balanced fund than a target-date fund as the default choice for retirement savings. (It’s important to note that, by rule, balanced funds don’t have to maintain a 50-50 split between stocks and bonds, but can put up to 75 per cent of their holdings into either side; swapping a target-date fund for a balanced fund, therefore, is no guarantee that an investor gets the kind of allocation Arnott was suggesting.)

The second piece of data that could change the way people view target-date funds comes from Morningstar Inc., which recently released its 2014 research paper on target-date issues. The findings directly contradict studies suggesting that any sort of market-timing approach (any tactic that deviates from the standard glide path) results in lesser results.

While Morningstar’s Janet Yang noted that it can sometimes be tough to tell which target-date funds are following a tactical approach (where management makes decisions based on market conditions rather than simply following the proscribed path), but the idea here is that some funds take opportunistic chances. Yang’s research shows those moves pay off.

Yang noted that through the end of 2013, “target-date funds for series that stick to the strategic glide path have an average five-year total return rank in the 54th percentile, while those that use tactical management have a 39th percentile average rank.”

In plain English, the issues that kept to the path topped 46 per cent of their peers, while the ones making tactical moves bested more than 60 per cent of the competition.

What the tactical funds have in common, besides superior results on average, is a heightened allocation to equities. Maybe not all the way to the inverse glide path of Arnott’s study, but more than the standard road to retirement.

What no one is going to say here (not even Arnott) is: “This is the one right way to do things.”

That’s problematic for consumers who have come to believe that a target-date fund is a solution to all of their decision-making problems.

They’re not wrong, they just can’t be so sure that all auto-pilot investment programs are set to the same destination.

Indeed, in different market conditions -- outside of the five-year bull run when a heavier allocation to stocks clearly would have paid off -- Morningstar’s results could vary dramatically.

What’s more, for all of the work showing which paths would work best, the plain truth is that no fund -- target-date, balance, target-risk, tactical allocation, whatever -- is sufficient for someone who hasn’t saved enough. The only way to make sure any fund can build an ample nest egg is to set aside enough dollars so that a range of returns from whatever path the fund follows results in satisfactory savings.

If you’re using retirement-oriented funds, set your auto-pilot or at least understand the glide path you are on, but make sure that the fund’s strategy, coupled with your savings ,creates some measure of confidence that you will reach your goals, or choose a different ride. 

This article was originally published at Marketwatch. Reproduced with permission. 

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